Ratings Challenges from a portfolio manager perspective
For various types of funds, ratings are an indicator of both the risk and return, especially for fixed income funds where the main parameter for portfolio managers is the return and the risk take to earn the return (or interest). When looking at fixed income funds or funds with fixed income components, ratings are usually a reliable indicator of the underlying securities within these funds and they play an instrumental part in understanding the fund and the underlying fund’s constituents. The rating given will be a key indicator of the risk and return profile of the fund, differentiating the fund’s constituents between investment grade, high yield, junk bonds and crossover debt. The best indicator of the risk are the underlying constituents ratings, where the higher the rating, the better the creditworthiness and lower the level of corresponding interest. The reverse will be true for the lower rating, which implies lower creditworthiness and a higher level of interest as compensation for the riskiness.
There are several different rating agencies providing rating classifications for funds. Some of these most well known rating agencies include Moody’s, Fitch, Standard & Poors.
In broad strokes fixed income ratings estimate the creditworthiness of a specific lending agreement. At the highest end a AAA rating will represent the lending for the highest quality lender and will be accompanied by a much lower lending rate. Conversely a Single B rating would be for a riskier lender and would be accompanied by a higher lending rate. This higher rate will compensate the lender for the additional risk and higher likelihood that they may not receive back all of their coupon and maturity payments.
Precise reporting of this information is crucial to fund managers. There are two primary ways that the ratings can be presented for securities within funds. The first way, is via an average rating (one figure). This can be beneficial because this is a simple and clear definition of the riskiness of the fund. The primary disadvantage is that there is not enough critical information to judge the actual risk and there is not a view on the deviation of rating classes. A second possible way that ratings could be presented is via a rating distribution. This primary benefits for this scenario is that it gives a view on the deviation and provides more granular level information. There aren’t any noticeable disadvantages for this approach, as it is always preferable to provide investors with a deeper level of insight for an investment fund and this can also be presented in a straight-forward manner via a bar chart distribution.
In the video below, Johannes Hauptmann gives us a short insight in the different ways of displaying portfolio ratings:
When considering ratings for securities within funds, the quality of the information is the most important thing to consider. There are two primary issues that come into play when we consider the quality of this information. Firstly,, is the presence of non-rated bonds. This is the scenario when there is not any available information about the creditworthiness of the security in question. This scenario can pose a significant challenge especially when calculating the average rating for a fund where securities can actually be treated by some standard reporting tools with an even better quality than AAA rated securities. As a result this method will significantly skew the average rating to a point where it might not have utility. The second issue that may be encountered related to the quality is the presence of a wrong rating. This is the case when the issuer’s rating is used for standard reporting, but especially with more complex bonds, the issuer may not be the guarantor for the bonds. In these scenarios, the rating being presented is that of the guarantor and not the issuer, whereas it should be the issuer’s creditworthiness that is tied to the coupon and interest payments. The presence of guarantors is becoming more prevalent in the current low interest rate environment.
Overcoming these challenges may not be feasible in standard reporting, thus it is important to consider individual or custom reporting based upon fund and constituent specific criteria.
In a changing and challenging regulatory environment it is important for investors and fund managers to have proper insight into ratings and provide this clarity for their investor class.
This brief video below, about calculation of Average Ratings, offers a snapshot of this discussion from our recent webinar, if you are interested in hearing more about this and other aspects of our reporting solutions you can view this webinar via the following form and contact us at any time.