There are many myths within bond markets that distort investors’ thinking and lead to sub-optimal portfolio construction, of which one of the most widely held is that unrated bonds are riskier than rated bonds.
This has led to a significant value opportunity between rated and unrated securities, which experienced active investors can exploit. The absence of a rating does not necessarily make a bond more risky. In fact, unlike rated bonds, most unrated securities have attractive structural characteristics and offer genuine credit enhancements.
The vast majority of unrated bonds on which we focus are secured, meaning that bondholders have a charge on a specified asset or pool of assets. This also means that such bonds should provide superior recovery characteristics in the event of default. Secured unrated bonds also benefit from additional protection in the form of strong covenant packages that require the maintenance of asset values in excess of debt outstanding and restrict the issuer’s ability to increase indebtedness. By contrast, the majority of rated ‘benchmark’ bonds have little or no tangible covenant protection.
Sectors that have typically issued unrated bonds tend to be asset-rich, such as investment trusts and real estate, with issuers including large FTSE 100 companies such as Tesco and British Land. Indeed, the majority of our unrated bonds have investment grade qualities. Furthermore, despite these bonds offering better protection to investors, they can also offer enhanced yield to compensate for the lack of a rating. This valuation anomaly is further exacerbated by the market’s increased focus on benchmarks and issue size. Our focus on exploiting such fundamental inefficiencies within the credit market is long-standing.
In practice there is little difference in our approach to researching unrated credit compared to rated credit. We review the industry in which the issuer operates and examine the prospects for the company, scrutinising balance sheets and the sustainability of cash flow generation.
Where research into unrated debt does differ from rated debt is in the emphasis that we place on assessing the quality and saleability of the tangible assets over which we have security. For example, if we hold an unrated bond that is secured on a specified property, we will pay particular attention to the value of that property and estimate its value for alternative use. So that we can analyse individual credits on a like-for-like basis, we apply internal ratings to unrated bonds that are comparable with those used by external rating agencies. However, they key difference between the two is that our internal ratings capture the ‘credit enhancement’ of security and its likely impact on recovery in the event of a default, rather than simply assessing the probability of default.
Finally, it is worth highlighting that although the supply of unrated bonds may decrease in the future as the influence of rating agencies and their use by regulators increases, we do not expect the opportunity set to reduce materially. For one, there is likely to be an increasing flow of debt assets shifting from loans to bonds, as banks continue to reduce the size of balance sheets. More generally, investment in unrated bonds is a reflection of our focus on exploiting significant and increasing inefficiencies in corporate bond markets, as investors’ over-reliance on transitory risk concepts such as ratings and benchmarks accelerates.