An Inefficient Asset Class
By: Tim Gramatovich, CFA, CIO for Peritus Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD)
We believe that the best approach to credit investing is to be agnostic on the credit ratings. This ratings agnosticism is central to our investment philosophy and process. We believe that credit ratings have created inefficiencies in corporate credit and an opportunity for those willing to step down on the ratings spectrum. Credit ratings tend to be backward looking algorithms that favor the size and longevity of a business. The reality is that we are lending money to companies today and care about the future. As such, historical ratings are interesting, but we believe not particularly relevant. Think of equities: how many investors consider issuer/credit ratings for a company when they buy its stock? If you are buying the most junior piece of the capital structure and don’t consider them, then why is so much emphasis placed on ratings for bond investors?
What I have seen in 30 years is that many investors continue to avoid bonds and loans rated below BBB (the dividing line between investment grade and non-investment grade) which is what creates the first structural inefficiency for the high yield market and can allow us to generate potential alpha. What is mind numbing to me is that we have now gone through two “nuclear winters” (2002 and 2008) and the absurdity of credit ratings were at the core of both. Do you remember what the ratings for Worldcom and Enron were just before they filed for bankruptcy and set the world on fire? Investment grade! How about the 2008 meltdown? Weren’t Moody’s and Standard and Poor’s at the center of the flame with their AAA ratings on sub-prime Collateralized Debt Obligations (CDOs)? It was so bad that government intervention and even legislation was pursued to remove credit ratings for bank and insurance determined capital ratios. It never happened and all just quietly died. Yet some investors continue to invest by and are beholden to this ratings process, which we view as limiting and potentially misguided.
Once investors migrate below investment grade, there is a further bi-furcation in high yield, as many players pitch what we like to call the “cream of the crap” story. In essence, they will buy only BB rated securities. Again, an investment process that is being dictated by rating agency black boxes. We would argue that a portfolio of BB securities today could quite possibly be the worst of both worlds: you are still exposed to credit risk yet generate minimal yield. Additionally, many BB securities trade like investment grade, meaning they are often very sensitive to changes in interest rates and may have much longer durations given their lower yields.
No diatribe on ratings would be complete without a little chat about investment grade corporate bond markets. Investment grade is defined by Standard and Poor’s as BBB- and higher, while Moody’s defines it as Baa3 and higher. I have been in the leveraged finance business for 30 years. I cannot tell you the fundamental difference between a BB+ credit and a BBB- credit, yet one is “investment grade” and one is “junk.” Who gave these firms the right to determine this and how is it determined?
What this all means is that we see continued pricing inefficiencies in single B and CCC credits as most investors avoid them given their perceived “risk.”