Too many fixed income managers take credit ratings as gospel and follow them blindly without doing enough of their own fundamental credit research, according to FE fundinfo Alpha Manager Shalin Shah and Matthew Franklin, who manage the Royal London Corporate Bond fund.
Managers who don’t do their homework properly take ratings as their North Star, the pair recently told Trustnet, which generates “longstanding inefficiencies in credit markets” that they are looking to exploit.
Franklin said: “A lot of people in the market take ratings as gospel, even though they really only give them half the story, and they use them to set the credit spread. What really sets credit spreads, however, is when ratings move, not fundamental risk.” In other words, upgrades and downgrades matter even more than the rating itself.
“What rating agencies tell investors is quite simply the probability that a company defaults,” he continued.
At the same time, they omit another and “absolutely vital” piece of information, which is how much money investors are going to get back if that default really happens. One company might give back 95p in the pound and another only 5p.
“There are instances of companies where ratings can be completely disconnected from the fundamentals,” Franklin continued.
An example is UK gas networks, which the Royal London fund has been keeping a close eye on since 2019, particularly on the asset-stranding implications of reaching net zero by 2050.
Risk and rating agencies have started to admit that these very long-dated bonds could become obsolete by 2050.
“These businesses are facing long-term existential risk and agencies are starting to admit that, but because they only look two years into the future in their analyses, the rating stays the same,” Franklin said.
“It feels bizarre, but they're only looking through a box-ticking methodology – if it doesn't meet their requirements, they’ll just ignore it.”
On top of that, ratings are getting even more embedded into credit markets because of regulation, Shah added.
“In the UK, Solvency II regulation imposes insurers to hold an amount of capital on their bond holdings that is directly correlated to the bonds’ credit ratings,” he said.
“That creates another inefficiency that effectively perpetuates the issue of investors delegating their investment decisions to rating agencies, rather than actually looking at the true underlying risk of their lending.”
The largest opportunity this has created for Shah and Franklin was with housing association Swan Housing, which has been one of the best performers in the fund.
Swan Housing faced some problems due to its high leverage and in 2022 was in the process of being acquired by a bigger peer, which only afterwards realised that it was too big an acquisition and walked away.
At that point, another potential buyer, Sanctuary Housing, stepped in to the rescue.
“But, in October, S&P Global Ratings lost its patience and downgraded the bond from investment grade to high yield, setting off a huge sell-off as passive funds had to sell it and active investors also lost their nerve and sold regardless of the price,” Franklin recalled.
“We found it quite surprising given that investment-grade-rated Sanctuary said it was going to buy it, and it was trading at quite a low level in the pound. We bought more and as that merger progressed and completed, S&P turned around and re-instated investment-grade status.”
This is an instance where the market took its cue from what the rating agencies said, and the spread tightened significantly back to where it was before.
“People sell first and think about it later,” said Shah.
“Most housing associations are A or BBB-rated. A high-yield housing association looks very strange. But if you go and do the work and understand that special situation, the protections in place and the bond documentation which the assets are secured on, you can get very comfortable and realise actually, that rating looks out of place.”
Franklin concluded: “Essentially, we were able to transfer 20 points of value from passive and lazy active managers to ourselves, because we did the work and looked beyond the rating.”