Credit Downgrades and How to Beat Them

There is far less top-quality fixed income around—and investors need to adapt, argues Loomis Sayles.

Investors must adapt their fixed income strategies as overall credit quality is set to fall in the coming years, according to Loomis Sayles.

The proportion of AAA- and AA-rated bonds in broad bond markets has fallen significantly in the past few decades, and there is no sign of this trend reversing, said Chris Gootkind, director of credit research.

“In the early 1970s, more than 58% of the index was rated AA+, while Baa was less than 10%,” he wrote. “Today, only AA+ is 20% while Baa is 44%.”

Only 13 US debt issuers are rated AAA, he added, and only two of them have kept this rating since 1988—Exxon and Johnson & Johnson.

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Gootkind illustrated a wider trend of falling credit ratings: Since 1981, in only 11 of 34 full years did rating agencies upgrade more issuers than they downgraded.

“There is really only one direction AA+ quality can go—and that’s down,” he wrote.

Gootkind gave several reasons for the long-term decline in credit quality: falling central bank interest rates, low-cost debt, and the rise of passive strategies leading investors to focus less on individual credit quality.

Lower-quality credit does not always mean investors are fully compensated for the extra risk, Gootkind found. While total returns increase on average when moving from AAA down to A, this does not always ring true for high-yield bonds.

“High yield is a more mixed story, with lower-quality credit (B and CCC) providing lower cumulative total returns relative to higher-quality credit (BB) over the past 20-plus yields,” Gootkind said.

However, he emphasized that, despite the overall downward trend, default rates have continued to be cyclical rather than increasing.

To beat these conditions, Gootkind suggested investors should diversify holdings and “avoid a rigid, rules-based approach, such as mandating average or minimum ratings, which can hurt returns from forced selling.”

In addition, buy and hold approaches should be reassessed, particularly with lower-quality bonds which could see their ratings change.

“Rather than relying on benchmark quality, consider specifying investment percent by rating categories, consistent with your own risk tolerance and return objectives,” he added.

“Credit market investors should bear in mind that credit ratings are not static,” Gootkind concluded. “In making an investment or structuring a portfolio, credit quality migration—downward—should be expected and factored into one’s investment outlook, strategy, and return forecast.”

Home > News > Manager Selection > Hedge Funds’ Latest Defector: Family Offices

Manager Selection September 8, 2016

Hedge Funds’ Latest Defector: Family Offices

Family offices join other institutional investors in retreating from the much-maligned investment vehicle.

Add family offices to the list of investors backing away from hedge funds.

Much like endowments and foundations, family offices are scaling back their hedge fund allocations, with 34% planning decrease their commitments, according to a survey by Campden Wealth Research and UBS.

The survey, which included 242 family offices with an average of $759 million in assets, revealed concerns about poor performance and high fees similar to those shared by endowments and foundations in an NEPC poll last month.

“This year’s report shows a re-appraisal of hedge funds amongst the family office community,” said Stuart Rutherford, director of research at Campden Wealth. “There are also some doubts about the ability of hedge funds to generate alpha going forward, even with the benefit of volatility.”

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But while endowments returned 2.4% in 2015, family offices earned just 0.3%—down from annual returns of 6.1% and 8.5% in 2014 and 2013.

“The endowment funds of top universities tend to be prepared to take greater risks than the average family office, and often have much lower allocations to cash and fixed income,” said Rutherford. “There is also more stability in their investment approach and management because they don’ t have to navigate changes to family control and investment objectives.”

Perhaps due to these lower returns, the survey found that family offices are shifting their investments to riskier growth assets. Globally, investors pursuing growth strategies grew from 29% to 36% this year, with nearly two-thirds of US-based investors adopting these approaches.

“In the search for yield, family offices are playing to their strengths by allocating longer term and accepting more illiquidity,” said Philip Higson, vice chairman of UBS’ global family office group. “This approach is successful when experienced in-house teams have sufficient bandwdith for conducting due diligence and managing existing private market investments.”

Private equity in particular has become a favorite of family office investors, who grew their allocations from 19.8% to 22.1% this year. Hedge fund commitments, by comparison, dropped from 9% of the average portfolio to 8.1% in the last 12 months.

“Most family offices can trace their roots back to the growth and success of a single business,” Higson said. “Strong performance from private equity over the last five years has only served to strengthen this natural affiliation.”

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