Investors may come to remember 2011 as the year we lost the risk-free rate of interest. The debt-ceiling episode of the summer raised the possibility that the US might not make a coupon payment, and Standard and Poor’s (S&P) downgrade showed that ratings agencies could regard this as more than a temporary hiccup. Several other very highly rated sovereigns were put on watch or downgraded. Given that AAA or AA sovereign ratings were regarded as unimpeachable only a few years ago, this came as quite a shock.

 

Rethinking strategic asset allocation

Investment guidelines are often written in terms of credit ratings, a prominent example being a restriction on some central bank reserve portfolios to hold debt rated no lower than AA-. Restrictions to high ratings effectively spell sovereign rather than corporate credit exposure, which, can have the unintended consequence of increasing rather than decreasing risk. The main culprit is the practice of thinking about credit risk on an entity-by-entity basis, rather than in the context of a portfolio.

While it is hard to dispute the notion that a single AA-rated obligor has less chance of default than a single BBB-rated one, it does not follow from this that restricting investments to AA or better securities lowers portfolio risk.

There are three related reasons for this. First, the number of highly rated entities is quite small so the opportunities for diversification of their credit risk are limited. Second, again because there are so few highly rated entities, the experience we have of these ratings is consistent with an extremely wide margin of error relative to their low expected default rates. This is to be contrasted with A and BBB-rated corporates, whose expected default rates are much higher, but is measured much more precisely, because we have experience involving thousands of them. Third, the rating agencies’ frameworks for sovereigns, which dominate the high-rating categories, are necessarily more subjective and less quantitative than the corporate framework.

Of course, all of this was true before 2011, but the events of that year opened the door to thinking about sovereign risk as a species of credit risk, and this raises the chance of an eventual tilt from sovereign risk to corporate credit risk. Our goal here is to lay out the logic that might inform such a move, on which we believe all investors should have a grip. While many do not have sovereign exposure to divest, they will surely be affected by even a small shift in this direction. For example, any defined-benefit (DB) pension plan that reports under US or international accounting standards discounts their liabilities using a corporate yield and so, if unhedged, would be on the losing end of an increased demand for corporate bonds.

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