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When determining the quality of high-yield bonds, you shouldn’t rely solely on their assigned credit ratings.

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This is the case for two reasons, says Andrew Zimcik, a member of the fundamental equity team at Connor, Clark & Lunn Investment Management. His firm manages the Renaissance High Income Fund.

“The first is that rating agencies tend to lag the market quite significantly,” he explains. “Oftentimes, we see the market reflect changes in [a bond’s] credit quality weeks or months before the rating agencies do. You can either make or lose a lot of money in that time.”

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Secondly, he says, agencies rate companies over a cycle, especially when it comes to more volatile companies. “This means you can go years where a company’s credit rating is far worse or far better than its official credit rating.”

Read: Why companies issue high-yield bonds

By performing deeper analysis, says Zimcik, “We avoid bonds that have triple-C problems despite [having] a double-B rating or higher,” for example.

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Rather than rely on a bond’s credit rating, Zimcik and his team analyze the credit of companies independently. “We look at things like total leverage, [and] we look for the amount of liquidity on a company’s balance sheet. We also look at the resiliency of a company’s cash flow.”

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One example of a time when Zimcik disagreed with credit rating agencies was when Yellow Media’s bonds were rated single-B in 2012. “The story of the [company’s] restructuring was well-publicized and probably didn’t come as a huge surprise.” He notes there was a decline in that business as well as decreased use of Yellow Pages’ phone book.

But, “if you rewind to 2012, that company’s bonds were rated single-B by the rating agencies. It made no sense to us [because] the balance sheet was highly levered and the company was facing a liquidity crisis with no end in sight.”

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So he didn’t own the bonds. Then, “Yellow Media’s bonds were downgraded to triple-C,” and that was when the company restructured.

If investors had waited for that downgrade to happen, says Zimcik, “they’d have lost about half the value of their investments, since the bonds were already trading at $0.50 on the dollar.”

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But the opposite can also occur, he adds. “Some of the best performing high-yield bonds we have in the portfolio are ones we think [have] far higher credit quality than rating agency labels. These are the ones we really look for and are the ones that typically generate good returns for clients.”

Read: Should you judge a bond by its label?

Originally published on Advisor.ca

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