Back in the 1970s, the wine business was a sleepy enterprise. It was growing, but mainly in low-grade jug wines. Then in 1978, Robert Parker, Jr., a lawyer turned self-proclaimed critic, decided to rate wines on a scale of 50 to 100. Today, many wine consumers rely heavily on these ratings when choosing wine – and ratings have, in turn, become a strong driver of sales.
For instance, many aficionados have settled on 90 and over as the benchmark for an excellent wine. This number has become so influential that when the Wine Spectator awarded the 2004 Valentin Bianchi Argentine cabernet sauvignon a 90 rather than an 89, sales for that label increased significantly. And it’s not just the sales that can rise: A 2013 report published by the American Association of Wine Economists on the price impact of Bordeaux ratings suggested that a one-point increase in Parker’s scores engendered a price jump of 7% on average. Recognizing these price distortions can create opportunities for savvy value buyers.
The same can be true for savvy investors in the financial markets. Reliance on rating agencies, regulations and benchmarks can lead to some investors paying more for certain securities and – for others – the opportunity to pay less.
Ratings can create distortions in asset prices
Since the credit ratings business began over 100 years ago, the rating of publicly issued debt has become ingrained in the financial markets. Rating requirements for securities are a typical component of most investment manager guidelines or mutual fund prospectuses.
But the extent to which the agencies’ ratings are structurally embedded in the market can create price distortions, particularly around the lowest rated issues of one category, say investment grade, and the highest rated issues in another category, say high yield. Frequently the ratings agencies fail to capture the credit risks with foresight, so we believe independently analyzing an issuer’s forward-looking financial strength is essential to finding value and reducing risk.
For instance, a large North American timber company is rated below investment grade by a ratings agency. Our view, however, has been that the company’s debt is commensurate with investment grade ratings. The company owns over 4 million acres of timberland, which in the remote event of liquidation would likely cover all the existing debt by more than 1x. In addition, it has significant operating leverage to the recovery in the housing market through greater lumber sales revenues, wood products sales and its real-estate business.
Our credit analysis also incorporates both the top-down and bottom-up trends in an industry, which is why, for example, our credit ratings on some tech companies are below investment grade despite those companies having A- ratings with stable outlooks from credit ratings agencies. In those cases, our analysts have incorporated factors such as top-line revenue trends, price elasticity, and the proliferation of tablets at the expense of laptops into their forward-looking financial statements for some time.
The flaws in the way the agencies modeled risk became clear in the aftermath of the crisis. Agencies often put too much stress on the probability of a default rather than the probability of losses in a default. In addition, they’re often influenced by backward-looking perspectives rather than capturing forward-looking balance sheet drivers.
Widespread investing to benchmarks can distort markets and constrain investors
Benchmarks are another source of price dislocation in markets. Trillions of dollars are invested in mutual funds or ETFs that directly track indexes. The investment guidelines of many actively managed mutual funds and investment strategies are measured by their performance against an index with some budget for tracking error.
This creates additional demand for credits and securities in an index, and potentially, artificially high prices. It can also create price dislocations when securities are added to or removed from indexes.
Also, most traditional fixed income indexes are weighted by the proportion of debt outstanding, so investors end up buying more from more-indebted issuers. This means that investors continue to accumulate the debt of countries, institutions or companies that may be issuing too much debt.
While we feel there are better alternatives to traditional indexes to improve capital allocation – like GDP weighting or fundamental weighting – outcome-oriented benchmarks, in which the investment manager makes allocations based on a specific goal or return, are also an alternative solution.
The third rail: increasing government regulation
Regulation is another source of meaningful distortion in the marketplace and the real economy. For example, the unprecedented scale of new bank regulations creates incentives to allocate capital and liquidity in ways that don’t necessarily make economic sense, but help to bolster banks’ regulatory capital and liquidity positions.
Typically, capital requirements for domestic government bonds, as well as for select other government investments, are negligible. In other words, a bank investing in Treasuries does not have to set aside additional equity capital to maintain the same regulatory capital ratio. However, investments secured by collateral such as mortgages, mortgage servicing rights, trade finance and airline and other equipment financing, which could be more productive for the bank as well as for the economy, carry significantly higher capital requirements.
Capital charges apply to other financial institutions as well. While banks, private-deposit taking institutions and insurance companies own the substantial portion of total capital allocated in private markets, the larger group of agency-rating-sensitive institutions may reflect greater than 80% of the $12 trillion corporate bond markets in the U.S., according to the Federal Reserve Flow of Funds data (see Figure). While ratings constraints certainly cause distortions in value, as with non-agency mortgages or certain secured bank loans, regulations also create opportunities for investors that are not subject to capital requirements.
How PIMCO looks to take advantage of these market dislocations and inefficiencies
PIMCO has expanded its resources in credit so it can navigate the global markets with greater depth and recognize the opportunities that these distortions can create. Yet our process has not changed.
Our quarterly cyclical forum is a key part of our approach. These meetings, where we discuss the factors driving growth in the global economy, provide our credit analysts with valuable takeaways that help them identify sectors and companies we feel have relatively attractive growth dynamics. They also add significant value to our analysts’ independent forecasts of the companies’ forward-looking financial statements.
Our investment process begins with the aim for a fundamentally better way to allocate capital, which takes into consideration, among other factors, EBITDA growth and volatility, enterprise value-to-debt trends, as well as the level of earnings visibility, all of which can help drive long-term performance potential. Our proprietary credit analysis is critical because at PIMCO we don’t simply trust the agencies, we take our own view. As part of our due diligence, for example, we gain access to company management to get insight on how they are thinking about their business model and competition. We also meet with regulators and hire external experts, such as geologists, attorneys and other professionals, to further improve our analysis.
Our approach is not tied to a benchmark; it’s driven by finding value and recognizing market distortions. In credit markets today, investors should consider aligning capital allocation with outcome-oriented objectives that aren’t influenced by credit ratings or benchmarks. In other words, investors should take an approach designed to get the best bottle of wine – or bond – for the money.