Credit Analysis

Bond Concepts by Madison Investments

History has taught us that even highly-rated bonds can quickly experience deteriorating credit quality and wreak havoc on a portfolio. Naturally, credit quality becomes a focus in weakening market conditions, but the importance of credit research in all market conditions must be considered.

What is credit risk?

Credit risk is the potential for an issuer to default on its loan obligations. In the event of a default, the investor (or lender) will suffer a loss.

The level of credit risk at the individual security level varies within the bond market. U.S. Treasury bonds tend to have the lowest “credit risk profile” because they are backed by the full faith and credit of the U.S. Government (rely on the promise of the United States to repay the bonds at maturity, whether that maturity is in three months or 30 years).

In the corporate bond market, there are over 15,000 issuers, each with very different risk factors. To understand these risk factors, many professional investment managers will conduct “credit analysis.” Similar to analyzing an individual stock, a credit analyst researches the bond issuer’s balance sheet, income statement, and periodic financial reports to assess the strength of the issuer’s financial position and the likelihood it will be able to meet its interest and principal repayment obligations. The credit analyst also analyzes the bond indenture – a formal document that lays out the issuer’s responsibilities to bond buyers and the buyer’s remedies if things don’t go as planned. Based on such data, the credit analyst forms an opinion on the quality of the bond, which can be used to compare it to other issues in the marketplace.

Credit ratings: the role of rating agencies

Several Nationally Recognized Security Rating Organizations (NRSROs) conduct research and publish bond ratings for investors to use as a guideline in assessing credit quality. Moody’s and Standard and Poor’s (S&P) are two of the most widely known NRSROs. These firms publish ratings when a bond is issued and update them periodically when rated issuers file financial statements.

While NRSRO ratings are a valuable, publicly available guideline for assessing the quality of a bond issuer, there are limitations investors should be aware of. NRSRO ratings tend to be backward-looking and lag the market. By the time a bond receives a new rating, the market has likely already priced in the change in conditions. An active investment manager may use NRSRO ratings as a starting point in evaluating an issuer’s risk profile but will likely have their own credit research process.

Credit spread: How credit risk affects bonds

The credit risk of a bond is reflected in the bond’s credit spread. Credit spread is the difference in yield between two bonds with the same maturity but different credit ratings. Simply put, the riskier the market deems a bond to be, the more compensation (yield) will be required to take on the additional risk. The most common measure of a bond’s spread is to compare its yield with that of a treasury with the same maturity.

Credit Spread = Corporate Bond Yield - Treasury Bond Yield

Credit spreads will typically widen during periods of economic stress or if an issuer’s risk factors are amplified. Widening spreads result in rising corporate bond yields, negatively affecting a bond’s price and portfolio performance. Conversely, spreads will tighten during “risk on” market sentiment, positively affecting a bond’s price.

How does credit analysis add value?

The two primary ways credit analysis adds value are: risk management and total return opportunity. After reviewing an issuer’s financial statements, an analyst may deem the issuer to have either more or less risk than the market is pricing in. Suppose an issuer is currently out of favor with the market, but the investor’s credit analysis concludes that the market’s sentiment is misplaced or short-sighted. In that case, the manager will buy the bonds at an attractive spread, hoping that the spread will narrow, and the bond’s price will rise as their thesis on the issuer plays out.

Similarly, suppose the investor feels that the bonds of an issuer currently held in the portfolio are selling at too small of a risk premium compared to their evaluation of the issuer’s risk. In that case, the investor will sell the issuer’s bonds and “swap” into another issuer’s bonds. Repeating this process as opportunities become available in the marketplace provides an additional opportunity to pursue incremental returns for a portfolio already actively managing the other risks of bond investing.

By the numbers: Credit ratings in the market

The size of the BBB market is $3.02 trillion outstanding as of May 31, 2023, growing from $822 billion outstanding since May 31, 2009 and representing about 48% of the total investment grade market, which stands at $6.30 trillion as of May 31, 2023.

Year-to-date, as of May 31, 2023, roughly $12.8 billion has been downgraded from investment grade to “high-yield” across 6 issuers. Conversely, approximately $40 billion has been upgraded from “high-yield” to investment grade across 11 issuers during the same period.