Sunday, August 25, 2013

Can Credit Ratings Be Sexy?

The Mae West quote that “too much of a good thing is wonderful” reflected her playful method of sexual innuendo and is the way many investors view credit ratings. Upon her other revelations, I do not believe that the burlesque queen, movie star and stripper was conversant on how bond credit ratings affect relative stock price performance. But that is the dilemma that I have been working on this week. I come to view this issue from two divergent vantage points .

My challenge

I manage a number of balanced (bonds and stocks) accounts for institutions as well as wealthy individuals. As part of our responsibility for one client with multiple accounts we have the task of managing an all fixed-income portfolio in separately managed fixed-income securities and fixed-income mutual funds. In connection with this client I am reviewing and updating the account’s investment policies. At the time of the inception of the account in 2007 certain quality and diversification standards (or what now appear to be constraints) were mandated. As mere thoughtful mortals drew up these policies they did not consider the current tiny short-term interest rates and their manipulation by the major central bankers of the so-called developed world.

High quality, poor relative performance

My associates and I have been reviewing various stock investments of certain equity funds to understand their past two years of relative under performance compared to their perceived peers. In these cases the absolute performance of individual stocks and funds has produced positive results. However their relative investment performance was disappointing. The one common characteristic of the portfolio managers of these funds is that they are oriented toward owning high quality investments, a bias that I share. On average many of these relatively underperforming stocks are higher quality than those found in their relatively better performing peers.

These formerly successful funds are believers in investing in quality companies many of which would have sounder balance sheets and higher margins than found in their relatively better performing peers.  The market recovery phase started in 2009, accelerated in 2012 and continued thus far in 2013. During this period of extremely low interest rates the less credit worthy companies were able to borrow money at historically low rates. With new capital they expanded their capacity and were also able to lower their selling prices which put their higher quality companies at a disadvantage, at least in the eyes of the stock market.

The fiduciary’s selection dilemma

On the one hand we need to set the filters so that managed accounts can meet their funding requirements under practically all absolute conditions. And on the other hand we seek to earn relatively good intermediate and long-term investment performance.

One of the characteristics of all professions is to use codes to abbreviate concepts. In the investment world one very important code set is bond credit ratings. These are thoughtfully issued by three major credit ratings groups Moody’s*, Standard & Poor’s*, and Fitch in various stylized alpha numeric abbreviations starting with the most secure, AAA and declining in terms of potential defaults down to D. On average and over time these ratings have done a more than reasonable job of alerting investors as to forthcoming defaults. However, as with all work done by humans, they are not perfect. As a practical matter investors worldwide recognize as far as taxable issuers are concerned that the first four full ratings are so-called “investment grade.” The term investment grade came out of a case in the 1930s that decided that the first four grades  (AAA, AA, A, BBB or their equivalents) were appropriate as high quality investments for fiduciaries. Since then the lower credit ratings were referred to in polite society as non-investment grade or high yield but the in argot of  “the street” as junk. Notice this whole exercise deals with the probability of timely payment of principal and interest, not whether they are good investments particularly in considering current prices.

Funding vs. performance

There is another decision tree axis which is not quite as well known, but in many respects more important. The filter for this matrix is the earliest expected involuntary pay back or maturity date. Once one is assured that the debt will in all likelihood be paid back, the twin questions facing the investor are how long will this stream of income be delivered and (in many ways much more significantly) the interest earned on the reinvestment of the interest received. For long-term bonds, under “normal” conditions, the size of repayments of principal, total interest received and the income earned on reinvestment are listed in reverse order of aggregate size. For instance even a low 3% coupon payment reinvested for 30 years in available, high-quality paper will be significantly greater than just adding up the interest payments paid on the bond, or the return of the original issue price. While this concept of interest on interest is mathematically correct, for many individual and institutional investors it doesn’t work that way. The reason they own fixed-income securities is so that they can consume the interest payments to meet their various funding needs, for example to make grants, pay for maintenance of people and facilities, etc.

Investment Policy Statements

One of the advantages of blogging is that occasionally one can see the discontinuity in one's thinking. Investment Policy Statements (IPS) are legal documents typically imbedded within contracts or board minutes. Often they are drawn up by lawyers or at least blessed by them. As with the U.S. Constitution, essentially they are limiting the powers; in this case the investment manager or investment committee. IPSs do not focus on how to make money for the account, but detail what not to do. This blinding realization came to me as I started to write about credit ratings, recognizing credit ratings can be sexy.

AAA vs. AA

We prize high credit ratings in an IPS, the closer to AAA, the better. In terms of attempting to make money for the account, as an analyst/portfolio manager and investor there are times that I question the cost to the investor of an AAA rating. Let me give an example of two holdings in my private financial services fund. Both Automatic Data Processing* and Berkshire Hathaway* are major beneficiaries of the floats of their clients' money. At one time both companies had AAA ratings. Now ADP has the highest rating, Berkshire does not. (Berkshire was downgraded to AA some time ago.) ADP is one of a handful of large US companies that has an AAA. The reasons given for the downgrade of Berkshire was the increasing risks inherent in its reinsurance activities. Both of these companies have had a practice of acquiring other companies. ADP has slowed down in these activities while Berkshire has not, as it has been buying large and mid-sized companies. While both companies' stocks and bonds have risen in price, the AA has clearly outperformed the AAA. Many analysts believe if ADP could find suitable acquisitions that do not threaten the perceived quality of its large short-term float, the prices of its securities would have done better.

Betting against dropping ratings

Recently Moody's* announced that will be lowering the ratings on four of the leading financial services companies; JP Morgan*, Goldman Sachs*, Morgan Stanley* and Wells Fargo*. For the moment Moody’s is leaving the ratings on Bank of America* and Citigroup* unchanged. Interesting the two unchanged companies have very recently done better shedding their endangered zombie species. The bulls on these two stocks will acknowledge that they are work in progress with the hope that they can approximate the returns of the four leaders.

* Owned in a wide range of sizes by my private financial services fund or by me personally.

The official reason for the downgrade is the belief that if any of the four leaders ran into financial problems the levels of bailout will be less. Quite possibly true, but I wonder how germane? As an investor and entrepreneur addicted to the long-term, I would much rather own the businesses and more importantly the people of the four leaders than the two turnaround candidates. If protecting their credit ratings and other fortress-like characteristics has prevented them from intelligently expanding their activities or handling their leverage better, the lower ratings could help us shareholders.

I could use your help

I am still struggling with what to put into an institutional IPS in terms of its fixed-income investment accounts to meet some specific needs as well as general strategic balancing needs. Please contact me with your views.
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