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Posted by on Aug 26, 2015 in Market Insight, Peritus Asset Management

What Value are Credit Ratings?

What Value are Credit Ratings?

By Heather Rupp, CFA, Director of Research for Peritus Asset Management, Sub-Advisor of the AdvisorShares Peritus High Yield ETF (NYSE Arca: HYLD)

If there was any question about it, the financial crisis of 2008 demonstrated to us all just how flawed the ratings process is, where AAA debt was suddenly in default and highly rated companies all of a sudden required bailouts seemingly overnight.  However in the aftermath, while there have been efforts to reduce our reliance on ratings, it has also become clear that changing the ratings process is exceedingly difficult, if not impossible.  They are ingrained in our system and ingrained in the way many people and institutions invest.

As we have previously discussed in our piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market,” we see several problems with credit ratings:

Investors should understand what the ratings agencies themselves say about their ratings. Among their various disclosures, the ratings agencies caution that their ratings are opinions and are not meant to be relied upon alone to make an investment decision, do not forecast future market price movements, and are not recommendations to buy, sell, or hold a security. So if these opinions have no value in forecasting where the security price is going and are not investment recommendations, what good are they? Candidly this is a question we have been asking for the past 25+ years. We see the ratings agencies as reactive not proactive, yet many investors in fixed income rely almost entirely on these ratings in making investment decisions.

Peritus views credit as either “AAA” or “D” and places limited value on the rating agencies and their methodologies, which we see as backward looking, reactive, and lagging the market perception of risk (e.g., Worldcom, Enron, Lehman, AIG).  Peritus believes that many fixed income investors continue to use ratings as one of their primary investment tools, which we believe ultimately creates inefficiencies and opportunities in the high yield market for active managers.  For instance, some institutions have policies whereby a security is automatically sold once it is downgraded to a certain level.  The problem is that by the point, if there are issues, the market has generally already recognized them and taken the security price down.  And vice versa with ratings upgrades.  So, investors waiting to take action based on ratings moves would have likely already missed the boat to either sell at a higher price or buy at a lower price.

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 inefficiencies created by credit ratings have created an opportunity for those willing to step down on the ratings spectrum.  Investors need to do their own homework, undertaking their own fundamental and valuation analysis to determine the viability of a credit and when to buy and sell, rather than just taking the rating agencies’ word for it and trading accordingly.

Credit ratings are not going away, as they are too ingrained in the system.  And frankly, we feel that is to our benefit.  Be it those that focus only investment grade or higher rated non-investment grade bonds, we will take advantage of others who blindly rely on these ratings to make investment decisions or who have investment policies that restrict investing in certain ratings category.  We believe arbitrary restrictions inhibit investment results.

Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. Information on this website is for informational purposes only. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risk and uncertainties, as well as the potential for loss. Past performance is not an indication or guarantee of future results.

The AlphaBaskets blog provides frequent market insight and commentary by AdvisorShares Investments, LLC, created by AdvisorShares and other leading active managers.  AdvisorShares Investments is an SEC-registered investment adviser and the investment adviser to the AdvisorShares actively managed ETFs. The views expressed on AlphaBaskets should not be taken as investment advice or a recommendation for any of the actively managed ETFs advised by AdvisorShares.