Every weekend in the business pages of our newspapers, we are bombarded with advertisements from finance companies advertising debentures, capital notes and other similar investment offerings, with very attractive headline returns.
Often this high return is accompanied by a credit rating or ‘investment grade’ claim. Does this mean investment nirvana, ie. high returns and low risk? This article from ING looks at what a credit rating actually means and how it relates to the returns being offered.
Credit rating equals default risk Essentially, a credit rating represents a possibility of default. The following table shows the various ratings offered by the two main international rating agencies and the expected default rates over a five-year period.
A company rated A- by S&P (equivalent to an A3 Moody’s rating) has a 0.60% probability of defaulting over a five-year period. By comparison, a company rated B+ by S&P (equivalent to a B1 Moody’s rating) has a 25% probability of defaulting over the same period.
In other words, an investor that has investments spread across five B+ rated companies should expect at least one of these to default every year over a five-year period.
An ‘investment grade’ rated company is one where the rating is BBB- and above (S&P) and Baa3 (Moody’s). Sub-investment grade or ‘junk bond status’ refers to those rated below BBB-/Baa3.
The risk/reward trade-off Investment theory tells us that high returns are usually associated with high risk. So why are advisers happy to believe (and recommend to their clients) an investment that claims to be offering both? As the saying goes, if it seems too good to be true, it probably is!
To better understand risk/reward, we need to estimate the likely recovery rates after a company has defaulted.
After defaulting, a company will typically be liquidated and residual proceeds distributed to the senior lenders or, in the case of finance companies, the debenture holders. If the debenture holders recover, say, 60% of their original investment, the loss severity will be 40% (i.e. you lose 40 cents in the dollar).
To calculate the estimated five-year loss rate, we take the default rate and adjust it for the loss severity. In this example, we take the five-year default rate of 25% and multiply it by the expected loss severity of 40% to arrive at a net loss rate of 10%. So, over a five-year period, there is a 25% probability that the company will default and, after adjusting for the anticipated recovery rate, the anticipated loss rate will be approximately 10% as shown below.
On an annualised basis (i.e. 10% divided by five years), the anticipated loss rate is 2.0% per annum. In other words, given the B+ rating, an investor should expect a 2.0% loss per annum on their investment. This 2.0% loss should be deducted from the anticipated returns to derive an anticipated risk or loss-adjusted return.
Once it has been risk adjusted, the advertised return – which initially looked so attractive – now looks modest versus the return from an A1+ rated bank term deposit.
Why would you expose yourself or your clients to such an investment, with all its inherent volatility, when the loss-adjusted return is not too dissimilar from what they could earn from a considerably more secure bank?
This article is written by ING and comes via FundSource
