Just what is the formal definition of high yield? High yield, or its more polite acronym, non-investment grade, is based off of the ratings grids provided by the two major credit rating agencies, Moody’s and Standard & Poor’s. All bonds rated below Baa by Moody’s are considered high yield or non-investment grade. Similarly, all ratings below BBB by Standard & Poor’s are considered high yield. We remain perplexed as to how these two private companies came to monopolize the business and have become the definitive standard on who gets credit and on what terms. Ironically, even after their well-publicized gaffes in the scandals of Worldcom and Enron, and more recently with the ratings of structured products, they ended up with more power. Post the financial crisis, efforts to remove the power of ratings in the fixed income market have been undertaken, but have failed so far given how ingrained these ratings are in the system.
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 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 30 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.
For instance, we see certain funds or vehicles setting arbitrary limits on holding only investment grade corporates, or only holding a small percentage of their portfolio in high yield bonds. As we have noted in prior writings, high yield bonds and loans encompass about 30% of corporate debt1, yet these securities are often given limited allocations purely due to their ratings classification. We believe that these restrictions based on ratings are a disadvantage to investors as they limit investment universe. Yet at the same time, we see these arbitrary restrictions as an inefficiency within the high yield market, creating an opportunity for investors who are able to access the entire spectrum of corporate debt.
For more on the history and development of the high yield asset class, a discussion the legislation and ratings methodologies that have created what we see as opportunities in the marketplace, and comparative historical risk adjusted returns with other asset classes, click here to read our updated piece, “The New Case for High Yield: A Guide to Understanding and Investing in the High Yield Market.”
1 Source SIFMA as of 9/30/2014 for total corporate debt. High yield bonds market size from Acciavatti, Peter D., Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan, North American High Yield and Leveraged Loan Research, January 9, 2015, p. 40. Loan market size from Blau, Jonathan, James Esposito, and Amit Jain, “Leveraged Finance Strategy Monthly,” Fixed Income Research, January 6, 2015.
This article was written by Tim Gramatovich, CFA, CIO & Heather Rupp, CFA, Director of Research for Peritus Asset Management, the sub-advisory firm of the AdvisorShares Peritus High Yield ETF (HYLD).