Fixed-income portfolio managers who invest under a constraint based on ratings agency ratings may be tempted to reach for yield by overweighting the securities of financial institutions. The higher yields of such securities, however, are compensation for increased risk.
The authors look at the primary and secondary markets for fixed-income securities issued by financial and nonfinancial institutions. With the exception of the largest financial institutions (which appear to offer a lower yield on the basis of being “too big to fail”), primary market financial institution issues offer a higher yield than nonfinancial institution issues after the authors control for such factors as size, maturity, and the presence of covenants. They use return data from the secondary market to show that these higher yields are fully explained by a standard four-factor bond pricing model. There is no evidence to suggest that reaching for yield within a credit-rating constraint leads to excess risk-adjusted returns—that is, alpha.
How Is This Research Useful to Practitioners?
The potential principal/agent problem identified by the authors is one in which the principal (e.g., a pension plan sponsor) awards a mandate to an investment manager with the constraint that the credit quality of securities not fall below a certain credit rating. In low-interest-rate environments, investment managers may be tempted to reach for yield by investing in higher-yield securities within the same credit rating. But the higher yields are consistent with a risk-based explanation, where the factors are the market risk premium, a default risk premium, the term spread, and liquidity risk.
The authors find that credit ratings remain relatively high (compared with their nonfinancial firm counterparts), even in periods very close to the firms’ default dates. This result might be considered a key aspect of credit assessment in the current market.
How Did the Authors Conduct This Research?
The authors split their analysis in terms of the primary market and the secondary market. Primary bond issues are drawn from the Mergent Fixed Income database and are focused on US corporate debentures and US corporate medium-term notes issued between 1967 and 2012. To test the robustness of their results across different debt instruments, the authors also analyze Dealscan data drawn from the primary syndicated loan market.
After allowing for various issue- and firm-specific controls, they find evidence of higher yields for financial institution issues, except in the largest financial firms, where there appears to be a yield discount owing to these firms being judged by the market as being too big to fail. The authors then test whether these higher yields correspond to alpha in a standard four-factor bond pricing model applied to the secondary bond market. Trade Reporting and Compliance Engine (TRACE) data covering the period of 2002–2012 are used for this exercise, and the results suggest that the four-factor bond model fully captures the returns of financial institutions, with no evidence of excess risk-adjusted returns.
The “reaching for yield” phenomenon is likely to be a problem in the current low-interest-rate environment. When investment managers are given a mandate to invest subject to a ratings agency constraint, they may try to outsmart the system by identifying the riskiest securities within a rating band. Plan sponsors and other principals may wish to design more sophisticated contracts, in which credit rating constraints are combined with ex ante risk factor budgets. Ex post performance measurement techniques could then be used to identify any evidence of style drift.