Rating credit ratings is a lucrative business, if you can do it

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Credit rating agencies offer a considered opinion on the ability of borrowers to satisfy their debt obligations in the form of timely payments of interest and principal. Those ratings often inform the strategies of passive funds and large institutional investors. But for active managers who don’t rely on those reports, credit ratings offer an additional opportunity — to arbitrage those ratings and lock in better yields at lower risk.

The historic basis for North American credit rating dates back to the 1830s, when American mercantile credit agencies assisted businesses in determining the creditworthiness of customers too far away to assess personally. These services grew ever more sophisticated as the field narrowed to the current Big Three players — Moody’s Investor’s Service, Standard & Poor’s (S&P), and Fitch Ratings.

The costs associated with obtaining credit ratings were initially assumed by lenders, who subscribed to credit rating reports. That relationship changed circa 1970, when borrowers increasingly financed credit ratings for their own companies in pursuit of access to cheaper capital.

Timothy Hicks, portfolio manager at Canso Investment Counsel (“Canso”), an experienced Canadian investment manager, notes that the firm relies exclusively on proprietary risk analysis to assess corporate credit opportunities.

“We don’t rely on the Big Three’s credit ratings for the same reason that you wouldn’t base investment decisions for a stock portfolio on the advice of two or three companies,” he says. “However, some of our funds are mandated by a client, for example, to have no bonds below the BBB category. In those cases, it makes us more mindful about buying BBB bonds, on the possibility that they slip into sub-investment grade. The moment something’s been downgraded is the worst time to sell.”

But the company also looks at credit ratings in search of arbitrage opportunities — for example, where a company reports bad news that results in a sudden credit downgrade.

“We love situations where we believe either the market or the credit rating agency is over-reacting,” Hicks says. “If we see bonds downgraded and we believe the company has better prospects over the longer term, then buying when a lot of people are selling represents a great opportunity for us.”

He highlights the $5.8-billion acquisition of more than 200 Western Canada Safeway stores by Sobeys in 2013. At that time, S&P had given Sobeys its lowest investment-grade rating of BBB-. When the integration of the new stores failed to create the rapid synergy expected, against a backdrop of heavy debt, S&P downgraded Sobeys to non-investment grade in December 2016.

“Even though things hadn’t gone as well as Sobeys thought over the short term, we felt they were going to work things out,” Hicks says. “We were able to buy these bonds at pretty attractive levels even as Sobeys was beginning to make some significant changes. That included bringing on new CEO Michael Medline from Canadian Tire, who eventually turned things around as head of the parent company, Empire.”

Canso saw another opportunity involving the Confederation Bridge linking Prince Edward Island with New Brunswick. Construction of the project was financed by a bond issued by New Brunswick crown corporation Strait Crossing Finance Inc. (SCFI) and secured by the Government of Canada, to be paid by the federal government over 35 years beginning in 1992.

“In 2017, SCFI decided that it didn’t make sense to keep paying a credit rating company to rate those bonds, because no new debt was being issued,” Hicks says. “So they suspended bond ratings.”

In the resulting fallout, investors who were constrained from holding unrated bonds began to sell.

“We didn’t care if those bonds had a rating, because the fundamentals of the situation were good,” Hicks says. “We were able to buy some of these bonds at an advantageous price as investors were dumping them. When it became apparent that having no credit rating was causing these problems, the ratings were reinstated.”

Hicks notes, however, that the market often conflates the risk of default with the likelihood of recovering assets in case of a default. Canso always considers its position within the capital structure to determine how much it would recover in a default scenario.

“From a company’s unsubordinated debt down through subordinated debt, the credit rating agencies place lower ratings on these securities,” he says. “But the risk of that company defaulting is the same for all of the bonds issued. We look at how much we would recover in the worst case scenario, and whether we are being adequately compensated for that risk. To us, risk of default and likelihood of recovery of assets are two entirely different things.”

Canso is the portfolio manager of certain investment funds offered by Lysander Funds. For more information on Lysander Funds, visit: www.lysanderfunds.com

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