Rated bonds have been assessed for a fee by a credit rating agency (Fitch, S&P or Moody’s), and the agency issues a rating based on the likelihood of a bond’s default. Unrated bonds are simply bonds which have not been through this process and do not appear in benchmark indices.
Many companies, particularly large multinational firms, have both rated and unrated debt in issue; they may just choose not to pay a ratings agency to analyse a particular bond.
This can be for a number of reasons, including the size of the debt issuance, the cost of obtaining a rating, the need (or lack of) for visibility, and the level of complexity of the issue. Unrated bonds do not necessarily mean less liquid, for example, The Kingdom of Spain government bonds are highly liquid, but not rated. The sovereign (i.e. the country as a whole) is rated but not each bond.
Active bond managers are able to identify market inefficiencies between two similar bonds, one rated and the other unrated. The rated bond will often command a higher price, without necessarily offering better security or value, purely on account of being rated by one of the rating agencies (the enhancement of the rating).
By investing in unrated bonds, investment managers can increase the diversification of their portfolios, enabling them to better manage risks and enhance yield.
We prefer investment managers which can make full use of their credit research skills and investment universe by allocating to unrated bonds and build portfolios that are designed to achieve superior long-term returns.