Why managing credit risk matters

Market Insights: November 7, 2016 • Credit risk
 

“To invest in higher yielding securities, I believe you need to be selective. That requires a very robust, active approach which includes a lot of credit work to appropriately identify risks and opportunities in the market.”

— Dan Bastasic, MBA, CFA
Senior Vice-President, Investments iA Clarington Investments
 

Credit risk: A critical concern when seeking higher yields

In this low-yield environment, investors are looking to asset classes that provide the potential for higher levels of income. But when looking for higher yields in income markets, as the old saying goes, “There is no such thing as a free lunch.” One risk an investor assumes when buying a higher-yielding instrument is credit risk. This is the risk of default on a debt security through a failure by the issuer to make required payments or to maintain covenants.

Fixed-income instruments can be categorized into two broad categories: investment grade and high yield. The categories are based on an assessment by credit rating agencies of the debt issuer’s ability to meet its financial commitments (Chart 1). Companies that are seen as more vulnerable to problems in meeting financial commitments will have to pay a higher coupon rate for investors to buy their debt.

These higher coupons translate into higher yields. The current range of higher yields can be seen through a review of differently rated asset classes, examining their credit spread over government bonds (Chart 2).

Lower-rated instruments can offer a substantial yield premium compared with higher-rated issues. But the trade-off is that default rates typically increase as credit quality decreases. A study going back over 30 years reveals that, on average, cumulative default rates increase from low single-digit percentages for issuers of investment-grade-rated bonds to over 45% within five years for issuers rated CCC or below (Chart 3). Investors seeking a higher-yielding payoff in lower-rated securities need to be extremely mindful of the capital loss potential associated with credit risk.

Chart 1: Credit risk: Rating overview

chart

Source: Standard & Poor’s.

Chart 2: Credit spreads of select rated asset classes

chart

Source: Federal Reserve Bank of St. Louis (September 12, 2016). Data represents the Option-Adjusted Spread (OAS) of various subset (by credit rating) of the BofA Merrill Lynch U.S. Corporate Master Index. The subsets include all securities with a given investment grade rating. The BofA Merrill Lynch OASs are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization.

Chart 3: Global corporate average cumulative default rates by rating (1981-2015)

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Source: Standard & Poor’s Global Fixed Income Research and Standard and Poor’s CreditPro®, for the period of 1981-2015.

 

Help reduce the risk

There is no shortage of ways to participate in the higher-yielding asset classes. But navigating the opportunities and pitfalls requires skill and diligence that are actively applied. A sound approach includes assessing the economic fundamentals that can affect a company’s ability to meet its financial obligations and avoid default. In turn, the ability to structure a sufficiently diversified portfolio of holdings is a measure of added risk control investors may want to consider

 

To help manage credit risk, diversify your clients’ income portfolios through an active solution. Consider:

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Dealer use only . Statements by the portfolio manager or sub-advisor responsible for the management of the fund’s investment portfolio, as specified in the applicable fund’s prospectus (“portfolio manager”), represent their professional opinion, do not necessarily reflect the views of iA Clarington, and should not be relied upon for any other purpose. Statements that pertain to the future represent the portfolio manager’s current view regarding future events. Actual future events may differ. iA Clarington does not undertake any obligation to update the information provided herein.
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