In today’s low interest-rate world, investment-grade bond funds face an all-too-familiar trade-off: buy risky debt to improve returns or play it safe and underperform.
But some of them, it seems, have managed to have it both ways.
In particular, funds are loading up on bonds where ratings firms are split on whether they’re investment grade or junk. While reasonable people can disagree about which one is right, for a growing number of firms, the answer is always the same: the higher one.
The practice has obvious advantages. With high-grade corporate bonds yielding less than 3% on average, managers can pick up an extra half-percentage point on split-rated debt. And funds can say they’re invested in safe assets while running a portfolio that actually looks a lot like a junk bond fund.
The downside for their clients, however, is it may obscure just how much credit risk they’re exposing themselves to.
“You don’t want the manager to just cherry pick grades,” said Thornburg Investment Management’s Lon Erickson. “You need to trust that they’re doing their due diligence and not just going out and fishing for yield.”
Granted, managers have always had the discretion and the flexibility to choose which ratings standards to follow. The methodology is there for all to read in the fund’s prospectus, though it’s often tucked into the fine print. Then, there’s the question of how much stock to put into ratings anyway. Many managers lean on their own analysis to determine a bond’s credit risk.
The potential for trouble, however, is clear. Of particular concern is whether managers are moving into investments that could be tough to sell if investors rush for the exits all at once. And in extreme cases like H20 Asset Management and GAM Holdings, consequences can be damaging. Definitive numbers are hard to come by. But as ultra-low rates have seemingly become a permanent fixture, it’s easy to see why bond funds play the split-ratings game.
Three in particular stand out: the Nuveen Preferred Securities and Income Fund, First Trust Preferred Securities and Income Fund and the ICON Flexible Bond Fund. According to a Bloomberg analysis, the credit quality of each of the funds fell into junk territory when using a methodology that either averages the ratings or took the lower of the two instead.
The Nuveen fund is the largest of the three with $4 billion in assets. In its latest annual report for the year through September 2018, 58% of the fund’s holdings were rated BBB — the lowest high-grade tier — or higher. Yet based on Bloomberg’s composite ratings methodology, the weighted-average credit quality was BB+, the highest level of junk. It was still BB+ as of last month.