Credit spreads are at historically tight levels. Short-term interest rates (and therefore interest income) are likely staying low for the foreseeable future. The rate curve is poised to steepen to potentially unprecedented levels as inflation fears grip the markets. The global pandemic has not gone away and may be accelerating toward a second (though probably less severe) public policy reaction. And fixed income investors aren’t getting sufficiently compensated for taking on longer-term or equity-like risks.
But today’s investors have been convinced by market professionals to focus not on risk but relative performance; not on strategy but fees; not on fit but trends. As a result, situations which might seem obvious in retrospect, such as the unsustainability of an indiscriminate bull market, become “doh” moments as investors belatedly realize their mistakes, only to repeat them over and over again. What these situations have in common is a fear that reducing risk will be punished in the form of relative underperformance if the risk doesn’t manifest itself. We suppose there’s logic to this thought process. After all, don’t we all regret buying homeowners insurance if our house didn’t burn down last year? Oh wait. No. We don’t. But we do generally sleep better at night.
As a value-oriented credit manager, we bristle at the term “junk bonds” to describe debt with high yield ratings. In reality, issuers and bonds may be rated below investment grade for a variety of reasons.
First, it is important to recognize that the credit rating agencies have certain immutable criteria which weigh into rating assignments. It is true that there are some companies that have significant risk. They may have too much leverage. They may have unsustainably low margins. They may be cyclical. For these reasons, the agencies have tended to use metrics such as leverage, margins and business cyclicality as proxies for risk. But this is imperfect and results in many babies being thrown out with the bathwater. Businesses such as Hanes Brands (BB+ rated) have low margins but a strong market position which enables them to control prices and pass costs through to customers. As a result, they can demonstrate a level of stability that even many investment grade companies cannot match. Acquisitive companies such as Hyland Software (B rated) often increase leverage for mergers and then use strong cashflows to reduce debt until the next target company comes along. They may appear on average to carry more leverage than a rating agency might want to see, but a disciplined strategy and cashflow resilience can point to a lower risk level than ratings would imply.
Second, rating actions tend to be reactive to good or bad news. That is, the agencies rarely if ever make a rating change because they expect something to happen. The only scenario in which we have seen regular exceptions to this rule is when an investment grade issuer assumes large amounts of leverage for an acquisition and promises the agencies they will bring leverage back down if they can keep their investment grade rating. (AT&T, we’re looking at you.) Regardless, we won’t fault the agencies too much for being reactive. In our experience, corporate CFOs have a knack for pulling rabbits out of hats and foiling market expectations (in both directions). Notably, this is one reason why we focus our portfolios less on being “right” about the direction of a credit and more on companies whose resilient profiles give us high degrees of confidence that they will repay their debt regardless of what happens. That said, this reactive approach to credit ratings is not a reasonable way to develop an investment strategy. Who would want to invest in a strategy which buys bonds after they have been upgraded or sells them after they have been downgraded? Anticipation is the key difference between investment analysis and ratings analysis.
Lastly, agencies tend to issue ratings at the issuer level, meaning they are assigning a rating which will be assigned to all bonds in a company’s capital structure whether they mature in one year or ten years. It seems obvious to us that the inherent credit risk in these two bonds would be different, and the market tends to treat them differently (shorter-term bonds tend to exhibit lower volatility than longer-term bonds even during times with stable interest rate outlooks). But the ratings agencies treat them the same. The only time a ratings agency tends to rate individual issues is if they are being paid by the issuer to do so, a conflict of interest we have written about before. At times, if an issuer is too small to warrant a regular reevaluation of its ratings, the ratings assigned to debt at issuance will persist even if the issuer’s underlying fundamentals have changed.
We share these observations not to complain but to highlight the significant potential for mispricing in credit ratings. And make no mistake about it: market mispricing is the bread and butter of value investors. We spend our days looking at companies, understanding business models, evaluating resilience factors and forming views on creditworthiness so that we may identify those issuers who are misunderstood by the market and the rating agencies. We believe that long-term success comes from a simple investing rule: If you buy good things, good things will happen. Some investors outsource what is good and bad to ratings agencies, and some do the work themselves. We are in the latter category.
But why should investors want managers who do the work themselves? Because the devil is in the details. It is rare to find that a simple screen of publicly reported metrics results in a portfolio which achieves its goals. To understand this, we will dive into three categories of credit factors which together allow us to determine an issuer’s creditworthiness: financial (quantitative), business (qualitative) and sustainability (ESG). Financial factors tend to be the most commonly analyzed, though most credit investors tend to be more focused on projections which support a directional bet on a bond price (e.g. will a credit spread narrow). We at Zeo spend our time in a less crowded room, looking at the same metrics such as liquidity, cashflow and leverage but with an eye toward evaluating a company’s resilience.
However, evaluating resilience cannot be done with numbers alone. We must also evaluate qualitative factors such as business model and management team. This is an area where we feel we have an advantage as a team which cuts across all sectors. Where many analysts are focused on their primary sectors and limit their risk evaluations to those which they deem most relevant to the industry, we have learned over the course of our careers that the risks inherent in issuers cut across an industry classification. What matters more than sector is business model, and by having a team which evaluates companies of all shapes and sizes, we believe we have more experience in drawing these parallels between companies who would otherwise not be considered similar in a way that identifies mispricings.
The same applies to sustainability factors, and it is no less important. In “ESG: A Data-Driven Definition”, we highlighted research being done at the Wharton School which concluded that only those strategies which integrated ESG factors into their investment analysis demonstrated a positive alpha when compared to traditional benchmarks. And yet, investors are directing assets mainly toward approaches which have negative alpha instead. These include strategies in which the primary approach to ESG factors is to screen out certain unacceptable sectors. Similarly, outsourcing ESG evaluations to a third party, which may or may not contradict a different third party, means the manager simply does not fully know the risks in the portfolio, which in our opinion is unacceptable. Rather, just as with relying on credit ratings, the manager is relying on someone else’s conclusion as to whether a company is “good” or “bad.” Setting aside the possibility that they are wrong and the manager would not know, or that their definition of “good” differs from her own, there is a bigger problem with these approaches. Put simply, they avoid those companies which are most likely to have the biggest impact with respect to ESG issues.
Only by doing the work ourselves can we assess a company’s room for improvement and its intentionality to make progress.
By Venk Reddy
Originally published in Q2 2021 letter
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Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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