Recent downgrade of the US government’s credit rating.
The recent downgrade of the US government’s credit rating by Fitch Ratings from AAA to AA+ has caused a stir in the financial world. This decision was influenced by several factors, such as the debt ceiling debate, increasing US government debt, and governance concerns. However, in the days following this announcement, the market barely reacted, reflecting the markets’ forward-looking nature and ability to price in known risks.
Credit ratings assigned by Nationally Recognised Statistical Rating Organisations (NRSROs) like Fitch, S&P, and Moody’s are helpful in assessing an issuer’s creditworthiness. However, these ratings often lag behind market prices, which provide real-time assessments of the credit quality of fixed-income securities.
Dimensional uses a combination of market-based data and stated credit ratings from NRSROs for a more accurate and timely assessment of an issuer’s credit quality. Using price information from the Trade Reporting and Compliance Engine (TRACE), Dimensional can identify if a bond is trading at a price significantly different from its peers with similar stated credit ratings. If the market price implies a lower credit quality than the stated rating, Dimensional may assign that bond a lower internal rating.
This approach enables Dimensional to identify issuers that may no longer fit within a fixed-income strategy’s credit guidelines and avoid such issuers. While index-based fixed-income funds rely on NRSRO ratings to determine eligible issuers, Dimensional’s daily credit monitoring allows portfolio managers to use live market prices for assessing an issuer’s credit rating rather than relying on outdated NRSRO research.
Between 2010 and 2022, Dimensional downgraded 193 bonds from investment grade to high yield, often referred to as “fallen angels”. Of these, 86% were based on Dimensional’s market-based credit monitoring process, while only 14% were in reaction to an NRSRO downgrade. This proactive identification of issuers whose bonds are trading like lower-rated bonds may enable Dimensional to reduce credit risk more effectively in real-time.
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