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Income and unrated bonds: a match made in heaven?

Income and unrated bonds: a match made in heaven?

A low interest rate environment and a continuing wish to diversify funding sources has led a growing number of companies to issue unrated bonds.

Paired with the increasing number of investors scrambling for income, for some, unrated bonds are a match made in heaven.

For portfolio managers like Lesley Dunn, who co-runs the Baillie Gifford Strategic Bond fund, it is about picking out companies which choose not to be rated, rather than those that are too small.

‘There are a lot of issuances out there where the company, particularly family-controlled companies, don’t want to take on the time or cost involved with obtaining a rating, but they have investment grade or near investment grade profiles,’ she says.

‘Prada is a good example. It issued an unrated bond in August 2013, and its credit profile compared well to larger competitors like LVMH and Kering.’

Indeed, big names such as Adidas, Ferrari and Air France-KLM have all issued unrated bonds as they look to avoid the cost, work and management time involved with obtaining a rating.

Dunn adds: ‘Sometimes it’s the case that these companies will go to the agencies and then don’t like what they’re being told, and so they think that the market can better price the risk than the agencies can.’

But as with all niche asset classes, liquidity can be an issue for some.

Among other securities, unrated bonds have also become something of a scapegoat in the unravelling of GAM’s now-stricken Absolute Return Bond fund.

It emerged that Tim Haywood’s fund held an unrated bond sold by a Chinese chipmaker’s British Virgin Islands subsidiary.

But Ewan McAlpine, a senior portfolio manager at Royal London Asset Management, does not believe liquidity is a problem.

‘If you’ve got a client base who are medium to long-term minded, they’ll be happy to accept there’s no need to buy something today and sell it tomorrow, particularly if you have securities attached to it,’ he says.

‘But still, when I deal with pension funds, the trustees sometimes sit there squirming [over unrated bonds], but then, what’s the average duration of their liabilities – 15 years?’

While managers like Dunn look for the bigger names when it comes to unrated bonds, McAlpine believes the opportunity lies with smaller firms’ non-benchmark issuance.

To get into a benchmark index a bond issuance has to be above £250 million.

McAlpine says: ‘If you’re a big issuer putting £500 million into the sterling market, you’d probably be daft not to spend the extra £100,000 to get the rating from a few agencies because that will give you the exposure.

‘But if you’re issuing a £150 million bond for example, the people who’ll be looking at that are specialist buyers anyway who are already keen on unrated bonds. Plus, we internally rate the bonds anyway and we use the same methodologies as the rating agencies.’

The appeal of the unrated

A study from Société Générale looking at 577 euro bonds from 411 companies found the average size of an unrated bond to be €142 million (£127 million).

The main benefit of unrated bonds is the yield premium, but in a research note, Banque Internationale à Luxembourg’s group investment office warns that unrated bonds ‘can allow companies to raise capital whilst masking ailing financials’.

It adds: ‘Going unrated can also avoid the negative image associated with a low public rating, or sell-offs that could occur if their rating was to be downgraded. Unrated bonds have lighter covenant packages, meaning the issuer enjoys more flexibility than it would from bank loans. However, this means less protection for investors.’

The bank gave the example of the bond market in Germany’s Mittelstand, the country’s small and medium-sized enterprises famed for their so-called reliability.

Between 2014 and 2015, it suffered a damaging wave of defaults and insolvencies, five years after several firms began issuing bonds to reduce their reliance on bank lending.

Retail investors were attracted by coupons paying 7%, but reportedly suffered heavy losses and complained about a lack of disclosure over the true risk of investing in the unrated bonds.

McAlpine says it takes a sophisticated investor to invest in the asset class, but it can give an advantage to those who know what they are doing. ‘We’re a reasonably small team of analysts and portfolio managers, but the thing is we’ve been looking at this area for a long time.

‘Historically, we’ve talked about having a unique approach to credit management and that incorporates unrated bonds.’

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Lesley Dunn
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