When to Choose A Single Over A Double
Credit Risk Comparison between AA and A-Rated Corporate Bonds
The ratio of roughly 3 to 1 single-A vs. double-A issuers suggests a liquid market sector and potential for better risk diversification.
Average one-year default probability by a single-A corporate issuer was 0.1% in the last 10 years. Investing in single-A securities would have incurred cumulative credit losses of 1.1% over a five-year span based on data tracing back 33 years. Such benign data includes the periods of the dot com era of 1999-2003 and financial crisis of 2007-2008.
Forty five years of historical data reveals better ratings upgrade potential by single-A bonds (2.4 %) than double-A’s (0.9 %) in any given year. Favorable ratings migration is often associated with better potential for principal value appreciation.
The bond market rewarded investors of single-A bonds with an additional 1.35% a year in total return over double-A corporate bonds in the 6 years since the financial crisis.
Although corporate treasurers often consider potential yield pickup as the deciding factor of selecting a single-A investment policy mandate, a stronger argument for them can be made in their better risk diversification benefits and more investment choices. Due to limited supply of AA corporate bonds, investors may be better served by adding fundamentally sound single-A securities to their corporate cash portfolio.
Investment-grade corporate bonds are widely viewed as a core fixed income asset class for the vast majority of investors that desire attractive yield, dependable income, safety, diversity and market liquidity. Among corporate treasury accounts managed by Capital Advisors Group, about 82% permit corporate bonds in their portfolios, and 71% view bonds rated A or better as eligible investments in their investment guidelines .
In this article, we provide a comparison of risk characteristics and portfolio considerations between corporate bonds rated single-A and those rated AA by the major rating agencies (refer to the Appendix for ratings definitions). It is our belief that a portfolio including A-rated corporate bonds would achieve better risk diversification and better yield potential without compromising a conservative credit bias essential to today’s treasury management functions.
For data analysis, we use corporate securities in the Merrill Lynch 1-3 Year Corporate Index as of June 30, 2015, which resembles typical corporate holdings in a cash management account. In our experience, the results are applicable to accounts with shorter maturities.