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Admittedly, that headline states the obvious. Time and again, market history proves there's substantial risk involved in buying equities of companies with low credit ratings or those heading in that direction.
After all, credit leads equity. Any number of reasons underscore the potential pitfalls of buying shares of companies vulnerable to credit downgrades or those with already deep junk ratings. There's a strong possibility some of these firms will be dividend offenders, assuming the payout still exists. Companies with poor credit grades contend with higher financing costs and the specter of higher, long-term interest costs.
All that capital going out the window for debt diverts from the pool of resources available to reinvest in the in the business, research and development and shareholder rewards.
Still, in a low income world, some clients are tempted to embrace flimsy high dividend fare from companies with slack credit ratings. Fortunately, advisors have avenues for articulating the pitfalls of this strategy and why something that's rated junk is graded that way for a reason.
Unique Index Paints the Picture
There are a dizzying array of equity and fixed income indexes out there. Keeping up with the new introductions is almost a full-time job unto itself.
By sheer happenstance, I recently stumbled upon the S&P 500 Higher Credit-Rating Ex Insurance Equity (HCREIE) Index. Sounds sort of complex, but it's not. In plain English, this benchmark holds S&P 500 stocks with at least an A-/A3 credit rating from one of the three major ratings agencies – S&P Global Ratings, Moody’s, and Fitch. As its name implies, the gauge excludes insurance companies.
Currently, the index isn't linked to an index fund or exchange traded fund, but advisors can use it as a source for unearthing highly rated domestic companies. It's a task, but one worth engaging in. Data confirm as much.
“During the back-testing period from June 30, 2015, to April 30, 2021, the S&P HCREIE Index outperformed the S&P 500 by 10.22%,” according to Dow Jones Indices. “Rebasing the S&P 500 HCREIE Index and the S&P 500 to 100 on June 30, 2015, the S&P 500 HCREIE Index reached 237.7 on April 30, 2021, while the S&P 500 reached 227.4.”
Interestingly, the S&P 500 Higher Credit-Rating Ex Insurance Equity Index proved less volatile than the S&P 500 during the back-test period, meaning its out-performance of its traditional counterpart is all the more a pleasant surprise because lower volatility often implies less upside capture.
Factor Considerations
The S&P 500 Higher Credit-Rating Ex Insurance Equity Index is sector agnostic and the same is true of its factor weights, but focusing on credit grades does tilt the benchmark toward some factors and away from others.
“In comparison with the S&P 500, the S&P 500 HCREIE Index had higher exposures to size, dividend yield, and profitability, and lower exposures to liquidity, growth, and leverage,” notes S&P Dow Jones. “The factor exposure results imply that the constituents in the S&P 500 HCREIE Index tend to be the larger, more mature, and higher quality companies in the S&P 500 universe.”
The dividend and profitability factors turning up in the credit-oriented index aren't surprising because some highly rated companies use cheap debt to fund shareholder rewards and because they're profitable and the interest rates are low, the strategy often pays off. Conversely, non-investment grade companies following suit can be punished as the March 2020 market swoon reminds us.
Putting it all together, the S&P 500 HCREIE Index may require some homework for advisors to use, but the reward of steering clients away from companies vulnerable to negative dividend action and debt downgrades, among other ominous scenarios, will pay off handsomely over the long run.
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