The Dimensional Approach to Monitoring Credit Risk
Dimensional’s investment approach is based on rigorous theoretical and empirical research and a consistent investment philosophy. A core principle of our philosophy is the belief that current market prices contain reliable information not only about systematic differences in expected returns but also about differences in credit risk.
Driven by this insight, Dimensional has developed a thorough and robust process to evaluate information embedded in market prices to establish market-informed credit ratings. Within this process, Dimensional uses several sources of market data to assess credit risk during the management of our fixed income portfolios.
Stated Credit Ratings
Nationally recognized statistical rating organizations (NRSROs) provide investors with a wide range of information on issuers and individual debt issues. While NRSROs (such as Standard & Poor’s or Moody’s) may vary their credit rating methodology by the issuer’s industry, they generally use a common framework to analyze an issuer’s business risk and financial risk profiles. Within their framework, NRSROs typically consider information taken from historical financial statements, cash flow forecasts, and meetings with an issuer’s management to arrive at a stated credit rating.
Dimensional uses information in stated credit ratings when designing and implementing strategies. For instance, default and transition studies have historically shown a strong relation between higher ratings and lower default rates and between lower ratings and higher default rates. Studies have also shown that higher ratings have tended to change less frequently, while lower ratings have been more volatile. Furthermore, among defaulting issuers, the period of deteriorating creditworthiness before default was generally shorter for lower credit ratings.1
When designing strategies, Dimensional considers this information to establish minimum stated credit ratings for securities eligible for purchase. For example, strategies designed with the objective of a stable rate of return may require that bonds be rated AA or higher at the time of purchase by an NRSRO. If the bond’s stated credit rating falls below the minimum required by the strategy, Dimensional will deem the bond ineligible for purchase. If the bond is already owned, Dimensional will monitor and may sell the bond.
While we acknowledge that there is information in stated credit ratings, we believe that stated credit ratings may only focus on a subset of information about an issuer and may sometimes become stale or outdated. A credit monitoring process that includes information from stated credit ratings and information from current market prices may provide a more complete representation of an issuer’s credit quality.
Market-Informed Credit Ratings
Dimensional believes that current bond prices contain information about the expectations of market participants. Among those expectations is the probability that an issuer’s credit rating may be downgraded in the future. Because of this, Dimensional combines market-based data with stated credit ratings from NRSROs to form a more complete and real-time assessment of an issuer’s credit quality.
Dimensional’s research has found that bonds trading at substantially higher yields than their peers—defined as those with the same stated credit rating—performed more like bonds with lower credit ratings when credit spreads widened. Furthermore, bonds trading at substantially higher yields than their peers also experienced a higher frequency of downgrades.
To assess the yield at which a bond has traded, Dimensional uses price information from the Trade Reporting and Compliance Engine (TRACE). For instance, if prices in TRACE imply a lower credit quality than the bond’s stated credit rating, Dimensional may assign that bond a lower rating. Exhibit 1 illustrates an AA rated bond trading at a yield similar to BBB rated bonds. In this simplified example, all else equal, Dimensional would assign that bond a BBB rating, and the bond would not be eligible for purchase in Dimensional strategies that focus on securities rated AA or higher. When assigning issuers an internal credit rating, Dimensional uses a conservative approach. For example, if a bond is rated BBB by a NRSRO but is trading like an AA rated bond, Dimensional would assign that bond an internal rating of BBB.
Market-Informed Credit Rating
AA Rated Bond Trading Like BBB, Dimensional Rating: BBB
In practice, Dimensional uses information from many sources to assign issuers and their bonds real-time credit ratings. Credit default swaps (CDS) are an example. CDS are a form of insurance against the default of an issuer, and the cost of that insurance generally increases when an issuer’s business and financial risk profiles deteriorate. If the price of an issuer’s CDS is higher than the CDS prices of comparable issuers, Dimensional may assign a lower credit rating to that issuer’s bonds.
Summary
Market prices contain reliable information about differences in credit risk among issuers. Dimensional evaluates market prices from many sources including traded prices in TRACE, CDS prices, live bid-offer spreads, and an issuer’s stock price. Dimensional aggregates all this price information with liquidity and trading volume considerations to assign a market-informed, up-to-date credit rating to every issuer before purchasing its bonds and to continuously monitor bonds already held in portfolios.
Footnotes
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1S&P Global Ratings Default, Transition, and Recovery: 2016 Annual Global Corporate Default Study and Rating Transitions.
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