Portfolio stress-test III: Credit rating and bond valuation

Portfolio stress-test III: Credit rating and bond valuation

A holder of a portfolio of bond securities faces various risks that could drastically affect the price of the underlying holdings. The most prominent factor that could introduce such price variations is the Central Bank’s interest rate regime (as we addressed in our recent article «Portfolio Stress-Test II: Interest Rates Rising«). Another important factor that could adversely or favorably change the price of a bond, thus the returns and the overall riskiness of a bond portfolio, is its credit rating. Given the importance of credit rating movements, stress testing these movements is vital to portfolio management.

The credit rating of a bond security largely indicates the probability of it defaulting on its payments. Considering that a non-zero-coupon bond has two payment streams, namely its principal and its interest payments (the former being paid at maturity and the latter being frequently paid via its coupons over time), the probability of failure to service its debt on time and in full would constitute a default event.

Bonds (government and corporate ones) are rated by agencies which specialize in evaluating the credit quality of given securities. These agencies attempt to assign a credit rating to a bond, based on models that take into account various parameters such as the macro-economic environment as well as the revenue and debt profile of a company (for corporate bonds). The analysis done by the agencies aims to determine a corporation’s ability to cover its debt, usually via its available revenues, thus, the higher the ability to cover its payments to investors, the higher the credit rating assigned by the agencies.

The big three credit rating agencies are Standard & Poor’s (S&P), Moody’s and Fitch. S&P and Moody’s are based in the U.S., while Fitch is dual-headquartered in New York City and London.

Post the credit rating that a bond is assigned when initially issued, ratings are frequently reviewed and they may change, for instance due to macro-economic events (when referring to government bonds, whether of developed or emerging market economies), or sector and firm-specific circumstances (when referring to corporate bonds).

Considering that credit ratings affect the interest rate that a firm-issuer needs to pay in order to attract buyers, bonds with higher quality credit ratings have lower yields, the bond yield in essence reflecting the bond’s creditworthiness. If a bond is downgraded (i.e. its credit rating is lowered), the bond price declines and the bond yield increases, and vice versa.

Therefore, to protect the value of their portfolios but also attempt to enhance the yield return of their bonds, investors can select securities from a combination of higher credit quality (known as ‘investment grade‘, denoting a ‘good’ margin of safety) and of lower credit quality (known as ‘high yield‘ or ‘junk‘).

Taking into account that bond prices may change even in anticipation of a credit rating upgrade or downgrade, bond investors may want to assess how potential credit rating ‘fluctuations would affect the valuation of a bond portfolio. Income-focused investors with large fixed income portfolios should be stress-testing their holdings through changes in their credit ratings, in order to gauge a portfolio’s behavior in different scenarios, like ones with rating downgrades or upgrades.

Although ratings usually go up or down by a notch in the rating scale (hence the bond prices adjusting down or up in response), a risk management system can allow for larger jumps in the rating scale. Portfolios may hold bonds of 20 or 30 years maturity, hence an initial credit rating given to such security has a very high probability of changing throughout the life of the bond. Stress-testing by credit rating allows an investor to decide whether one wants to keep owning a bond security or not.

The impact of the ‘stressed’ credit rating scenarios can be viewed though a number of output risk analytics, such as the change of the expected short-fall of the portfolio and the expected new stressed market value, post the credit rating changes, accordingly helping one to decide if a portfolio rebalancing is needed.  Even in cases where, in an effort to diversify the portfolio’s credit risk, an investor holds bonds of different issuers and different maturities, one should be measuring the risk emanating from potential credit quality changes and thus assist an investor in determining the overall portfolio risk and set relevant selling or hedging strategies to mitigate potential losses.

Posted Makis Ioannou, CEO, Finvent