In all, about 12% of the Nuveen fund was in split-rated bonds where S&P Global Ratings and Moody’s Investors Service disagreed on whether they are investment grade or junk. That compares with 3.7% of bonds in a widely followed benchmark index for investment-grade debt. The fund considered all the bonds investment grade, while Bloomberg’s standard rated them junk.
“Our goal is to provide investors with the most relevant data to make informed decisions in alignment with their financial goals and risk tolerance,” the firm said in an emailed statement in response to questions from Bloomberg.
The weighted-average credit quality of First Trust’s $279 million fund was also below investment grade, based on Bloomberg composite ratings. And its holdings yielded 5.17% on average versus 2.91% for U.S. corporate bonds, data compiled by Bloomberg show.
“If split-rated bonds correspond to the yield of the lower rating, that gets to the incentive for managers to hold them,” said Craig McCann, a principal at Securities Litigation & Consulting Group.
In a statement, First Trust said its decision to use the highest available rating was due to the intricacies of the preferred and hybrid debt market, and called the approach the “industry standard.” The firm added that “ratings from agencies are only one input into a much larger internal credit review.”
That extra yield comes with a price. Historical data from S&P shows that lower initial ratings correspond with higher rates of default. The gap is notably stark in the divide between investment grade and junk. Ten-year default rates on bonds with BB ratings are double those with BBB grades.
Often times, bonds that become split rated because of a downgrade aren’t split rated for long, according to Smith Asset Management’s Frank Smith. That means investors in a traditionally safe, investment-grade fund with a disproportionate number of the securities could wind up being exposed to many more junk bonds than they intended. If either S&P or Moody’s cut their ratings, “the odds are the other will soon downgrade” as well, he said.
It’s not clear whether the added risk is really worth it. While two of the three funds eked out slightly above-average returns in the past year, only one had a risk-reward profile that is better than a vanilla fund tracking investment-grade corporate bonds, data compiled by Bloomberg show. (The higher the Sharpe ratio, the more investors are being compensated for the risk their funds take.)
Jerry Paul, who runs the $154 million ICON Flexible Bond Fund, says he speaks candidly to his clients about his approach and added that he’s targeted split-rated bonds for decades to help give his fund an edge.
“We have limits on how much junk we can own, so the provision helps me with clearing that hurdle,” Paul said. “I had this in my prospectus back in the 1980s and it was really unusual back then. Now, everyone seems to have this provision that allows you to rely on the highest rating available.’’