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Bond Ratings – One Person’s Junk is Another Person’s Treasure

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ABC BlocksI recently spent some time reviewing the non-investment grade portion of my fixed-income allocation.  It consists of the individual bonds, exchange-traded debt, and preferred stock of more than 20 companies.  From JPMorgan’s Series T preferred (Ba1 from Moody’s) to FirstEnergy’s 2031 maturing notes (BB+ from S&P) to D.R. Horton’s 2023 maturing notes (Ba1/BB ratings) and many more, I own a diverse allocation of so-called “junk”-rated securities.

Given the recent decline in the AdvisorShares Peritus High Yield ETF, symbol HYLD, I wanted to peruse my non-investment grade allocation, looking for securities I might consider selling to make way for a future HYLD position (should HYLD fall to my price targets).  While looking over the allocation, I couldn’t help but wonder why it was that certain securities were assigned “junk” ratings, when, in my opinion, they deserved an investment-grade rating.  Then I began looking over some of my triple-B-rated holdings and wondered the exact opposite; how it was they managed to hold on to investment-grade ratings.  The entire exercise led me to a few thoughts worth sharing.

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  1. The distinction between the creditworthiness of a triple-B-rated bond and a double-B-rated bond is often ambiguous.  Yet, being on one side or the other of the line that divides investment grade debt from non-investment grade debt could mean the difference between being bought by an investor or not being bought by an investor.  Relying on ratings, especially in the double-B and triple-B realm of the credit-ratings spectrum could actually cause an investor to take on more risk than he or she realizes.
  1. All too often, credit ratings are backward looking.  The market eventually figures it out, and, in many cases, often figures it out before the rating agencies.  This only further helps to blur the lines between investment grade and non-investment grade debt.
  1. Why are people so afraid of junk bonds?  How do we make sense of investors who are willing to buy the common stock of a company that issues junk-rated debt but won’t buy “junk bonds” because they are “too risky”?  If a company issues junk-rated debt, what type of credit rating does that imply for the bottom of the capital structure (the stock)?  The answer: an even junkier  credit rating.
  1. There are pricing-inefficiencies galore in world of junk bonds.  Between rating agencies, which are far too often behind the curve, and investors, who shun high-yield bonds simply because of a credit rating assigned to those bonds, investors willing to spend the time digging into a company’s prospects, can often find opportunities that shouldn’t exist in a truly efficient financial market.

 

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