In 2021 we published a series of articles highlighting the benefits of being classified as a Wholesale Client, and how it impacts the choices you can make as a bond investor.
We feel it is an important classification to be aware of as it significantly improves your choice of available bonds, and so we are going back through the series as a recap.
To begin, it is important to define what a Wholesale Client (or ‘Sophisticated Investor”) actually is. This is defined in law in the Corporations Act 2001 (here comes the legal bit).
Essentially, everyone is a Retail Client unless they satisfy one of the requirements to be classified as a Wholesale Client under section 708(8) or (11), section 761G(5), (6), (6A) or (7) or section 761GA of the Corporations Act 2001.
The details can be found at this link to the factsheet and certificate that needs to be signed by a qualified accountant.
The key determinants are:
- A person or entity that has obtained an accountant’s certificate dated no more than two years ago that confirms the client:
a) has net assets of at least $2.5 million; or
b) had a gross income for each of the last two financial years of at least $250,000. - A person or entity that is controlled by a person or entity that meets the requirements of (a) or (b) above.
- A person or entity who invests where the purchase price of the product is at least $500,000.
There is also a defined Professional Investor with other determinants that can be found at the link above, but these are less common.
What are the benefits?
There are a number of benefits which we will focus on in the upcoming series of articles. For this edition, we will concentrate on credit ratings.
Credit ratings are issued by many agencies, but the two largest and well known are Standard & Poors (S&P) and Moody’s.
Ratings issued by these two agencies are only available to Wholesale Clients, as ratings have been defined in Australia as a financial product, and therefore the issuer of a rating requires an Australian Financial Services License to issue their product.
Both agencies have obtained a Wholesale only license, which means their product is only available to Wholesale certified investors.
Both use a letter-based system, with S&P using a ‘+’ or ‘-‘ to denote the higher or lower quality at a particular band, with Moody’s choosing to use a numerical system. However, both are basically equivalent, which can be summarised in the below diagram:
More letters are better than fewer, and an A rating is better than a B rating and so forth.
The scale of creditworthiness implied by a rating can be split into two definable sections: Investment Grade (IG) or Speculative Grade (also known as Sub-Investment Grade, High Yield, or a little more pejoratively, “Junk”).
IG ratings are defined as ones with a rating of BBB- (or equivalent) or higher, and historically represent a low risk of default.
For example, S&P do a study each year of the historical rate of default of all bonds in their rated universe.
During the 40-year history of the study, only 1.48% of BBB rated bonds in a 5-year time horizon defaulted during the period. Another way to look at it is that 98.52% of bonds paid their interest and principal when due.
These statistical bases give investors a good guide to the creditworthiness of an issuer, as well as a means for comparing issuers across different sectors.
For example, a resources company with an A rating should have a similar risk of default to a financial services company also with an A rating. Clearly the risks affecting the two issuers are different, but the ratings allow investors to look across sectors for comparable bonds, allowing one measure in assessing relative value.
Ratings are typically reviewed regularly, such as when results or other pertinent information is released by the issuer. Another example is when something material changes in relation to the creditworthiness of the issuer, such as a regulatory change or a reassessment of the overall risk of a sector.
Conclusion
Credit ratings are not the sole indicator of the risk inherent in a bond investment. They should be used as part of a wider analysis of the issuer and the particular bond, but are a very useful part of that analysis, especially for their equivalence across different issuers.
The distinction between Investment Grade and Sub-Investment grade is also very useful, as the bar is high to be awarded an IG rating and it is similarly a big thing to be downgraded.
Historical default rates climb exponentially as issuers move down the ratings spectrum for a given tenor, making lower rated bonds a more complex situation to analyse than their IG brethren.
As a starting point, ratings give investors a widely recognised benchmark with which to begin their investigation into a prospective bond investment, while also a measure of comfort that a third party – albeit one paid by the issuer and this conflict must be understood – is monitoring the performance of the issuer and whilst updates may not always be timely, are likely to give some warning of a deteriorating position.