Credit ratings help investors judge risk and return. In this note we compare credit ratings, yield and probability of default for US investment grade bonds. Diversification into USD bonds has been a popular move for wholesale qualified investors and, with the Australian dollar trading towards the higher end of its recent range, is likely to continue in 2017
The USD bond market has approximately USD40 trillion* of bonds on issue compared to around AUD1.6 trillion in the domestic market. It is much bigger and offers enormous opportunity to diversify, as well as hedge against the Australian economy and currency. The high yield USD market is mature, offering a huge assortment of bonds compared to its fledgling AUD counterpart and for investors chasing yield, can offer some exciting opportunities.
The question becomes, how to differentiate between the bonds on offer? An easy preliminary assessment might be to analyse the yield on offer given the credit rating.
Table 1 and Table 2 provide an overview on the bonds FIIG offers in the investment grade universe and the perceived risk, as qualified by the S&P credit rating. Taking the basic analysis one step futher, I’ve added in the S&P probability of default for the term of the bond#.
Table 1 shows USD bonds we make available in the Standard and Poors ‘A’ range. The order is based on expected maturity dates, with the shortest term bond at the top of the table to the longest dated bond at the end. The range of maturity dates from nine months out to 28 years attests to the depth of the market.
These highly rated bonds have very low probabilities of default and a range of corresponding lower yields. Practically all the bonds are fixed rate, so while credit risk may be low, there is increasing interest rate risk with the longer dated bonds.
USD minimum 'A-' rated bonds (in expected maturity date order)
Table 1
Source: FIIG Securities
Probability of default percentages from S&P's 2016 Corporate Default Study and Rating Transitions report
Based on the term to maturity
Graphically, a selection of bonds is shown in Figure 1. It’s important to note the issues cannot be directly compared given a range of credit ratings, but it does provide a framework for comparison. The 32 basis point pick up for going with the longer dated Anheuser-Busch bond doesn’t seem sufficient given a three notch rating downgrade and an extra eight years to maturity, when compared to the GE Capital Corporation bond.
Figure 1
Source: FIIG Securities
Table 2 shows the bonds in the S&P ‘BBB’ range which range from BBB+ to BBB-. These are higher risk than those in the ‘A’ range, and you’ll notice yields are higher as is the probability of default. The range between the yields and the ratings starts to increase as a BBB+ rated credit has a substantially lower probability of default than a BBB- rated credit – the BBB- bonds are known as marginal investment grade credits.
For example compare CIMIC Finance, a BBB rated credit maturing on 13 November 2022 with a worst case yield of 3.57%pa to the bond directly below, TransAlta Corp rated a notch lower at BBB-, that matures at virtually the same time with a yield to worst of 4.05%pa. Investors pick up 48 basis points (0.48%pa) for taking on perceived additional risk. Using the S&P probability of default table given, the term shows a probability of 1.47% for CIMIC versus 3.01% for TransAlta. In other words, the one notch lower rating doubles the probability of default risk.
USD minimum 'BBB-' rated bonds (in expected maturity date order)
Table 2
Source: FIIG Securities
Probability of default percentages from S&P's 2016 Corporate Default Study and Rating Transitions report
Based on the term to maturity
Figure 2, like Figure 1, shows a selection of bonds. It’s important to note the issues cannot be directly compared given a range of credit ratings, but it does give you a framework for comparison.
Figure 2
Source: FIIG Securities
A couple of things to keep in mind
- The lowest risk bonds can still default
- Default doesn’t necessarily mean investors lose money and this may take some time to determine
- The credit rating agencies sometimes get it wrong. Anyone that followed markets throughout the GFC may remember quite a few structured collateralised debt obligations (CDOs) that were rated AAA which defaulted without warning
- Bonds that seem to offer good relative value may be in riskier industries for example oil and gas exploration or mining services
- The longer the term to maturity, the greater the risk, thus the higher returns on offer for longer dated securities
- Practically all the bonds on the list are fixed rate and the US has started to raise rates again. That can mean fixed rate bond prices decline
- Unhedged positions take on extra risk which can also work in favour of the investor if the Australian dollar falls, but can reduce returns if it rises
- For those investors wanting a pure currency play, the best credit quality bonds, that is the lowest risk bonds, that somewhat negate credit risk, offer the best possible outcome
For more on the S&P default rate table, see this week’s article “Quantifying the risk of bonds with S&P credit ratings
”.
Credit ratings give an indication of risk and should not be relied upon.
Investors need to do their homework before investing, including reading up on the company, its management team, strategy and assessing its financial position. It is also important to consider the industry the company is in and any future projections.
Look out for Part 2 next week on high yield, sub investment grade USD bonds.
For more information, please call your local dealer.
Note: Pricing is accurate as at 4 July but subject to change
#The S&P Probability of default tables only extend to 15 years. If the bond has a longer term to maturity, we’ve assumed the 15 year probability of default rate.
*SIFMA as at 31 December 2016