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Impact Investing

IPE special report May 2018

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Changing rules of the credit game

More than 25 years’ experience of fixed-income investment has made us increasingly aware of how much the credit landscape has changed. The changes have been particularly rapid in the past couple of years, posing a continuous challenge to investors. As one of our fund managers put it: “Each time I thought I knew how to play the game, someone came along and changed the rules.”
This article presents the themes that have been dominating the credit market, and looks at whether they have impacted the rules of the game.
Having identified the way the rules have changed, we will see if the old approach to playing the game still works – in other words, does traditional or fundamental credit research still work?

We conclude with a description of our credit approach, showing how we analyse credits, and discuss one of our newest tools that help us select bonds with potential upside.
Until a few years ago, most medium-sized companies went to the banks for their funding needs. Nowadays, more and more of these companies have to go to the bond or equity markets to raise capital. This shift has been triggered by the changing role of banks: rather than acting as lenders, banks now increasingly operate as intermediaries. In fact, an increasing proportion of their income is generated from fees rather than from margins on loans.
Having more numerous corporate issuers in the bond market is, of course, a positive development for credit investors. However, there are also many more companies active in the equity markets. This has resulted in a dilemma for debtors as the two markets have different requirements.
In particular, the key words shareholders are looking for are: dynamic management, high leverage, new products, higher but more uncertain cash flows.
In contrast, the bondholder’s view is different: closed environments with ‘predictable’ cash flows that are known up front. Management influence should be limited.
There are similarities – both are looking for a good track record and sound economic environment – but the difference is striking.
This debtors’ dilemma has had a clear impact on the credit market. If we look at the credit market, the ABS/CLO sector comes closest to the preferred bondholder’s view; it is very predictable and it involves limited event risk. Given the increasing volatility and increased event risk among corporate issuers, the demand for this sector has risen considerably and is expected to continue to do so.
In contrast to the ABS/CLO sector, the vast majority of corporates focus on shareholder value. This is not surprising, as shareholders control the company. However, for many corporates in Europe this is a relatively new situation. They faced different priorities in the past, such as employment, national importance, etc.
The shift to shareholder value has caused three major changes to materialise: increased leverage, introduction of hybrid capital and more frequent share buybacks. Share buybacks benefit shareholders, as the objective of the buy back is to increase the return on the remaining shares.
For bond investors a share buyback is not a preferred management tool, as it is often financed from the company’s cash reserves.
A share buyback only works in an environment where the return on an asset is higher than the cost of capital. As the cost of capital has risen significantly and the availability of bond capital has fallen, the incidence of buybacks is leveling off (Figure 1).
The stronger focus on shareholder value has already resulted in some unpleasant effects for bond holders. Companies generally considered to be rock solid for many years have fallen from their pedestal. We can illustrate this with some statistics from the credit markets.
Apart from some exceptions like European financials, average credit quality has declined in the last few years: there have been two downgrades for every upgrade (Figure 2).
Driven by factors such as deteriorating credit quality and share buybacks, credit spreads are at their highest levels since the early 1990s (see table).
Besides shareholder value, there have been other themes that affected the credit market, such as the government bond yield curve. However, unlike shareholder value, this has always been part of the game.
The changing theme in credit markets has led to some unpleasant surprises. The question is, does traditional or fundamental research still work?
We strongly believe in the value of fundamental research, and therefore put a lot of effort into debtor analysis. Although the rules of the game may have changed, we still feel that fundamental research is a key factor in understanding the credit market.

The main challenge a credit analyst faces is to find companies with a positive credit story and an attractive spread. This type of bond will outperform other bonds with a similar rating. So far, the situation is similar to that of an equity investor. For a credit investor however, the risk profile is totally different: it is not symmetrical. To put it simply, the upside is limited as spreads can tighten until they reach the same yield as government bonds of the same maturity, but no further. The downside is that a debtor will default and the investor will only regain the recovery value.
This asymmetric risk profile means that picking winners is only part of the story, avoiding losers is at least as important. This was particularly the case in 2000, when the credit markets only focused on the negative factors. Good news was mostly ignored, while any piece of bad news led to severe punishment – that is, a wider spread. Mean reversion of spreads was clearly not a theme last year.
Given the problem of one-sided focus, we still believe that credit fundamentals will be the main driver of credit quality and credit spreads over the longer term.
So what investment strategy should one pursue, in view of these ongoing changes in the credit landscape? Our answer is given in Figure 3, which summarises our global investment approach. This approach is based on a research study we carried out with Lehman Brothers1. The study was based on ‘perfect foresight’, and shows that debtor selection in a corporate portfolio is a superior way to achieve steady outperformance per unit of risk, and far more effective than sector or rating rotation. An investment approach should also focus on risk management. This can be achieved by diversifying the portfolio across sectors and rating classes as much as possible.
Many commentators say the credit market has structurally changed. We do not fully agree. We believe rather that the credit market is in a process of evolution. Certainly, there are several themes which are likely to recur and cause temporary disruptions, but in our view credit quality and fundamental credit analysis remain the key elements when investing in credits. As a consequence, issuer selection based on fundamental credit analysis is and remains the cornerstone of our investment process.

To support our decision-making process, we have recently developed a new quantitative bond selection model that helps us select the most promising bonds. Interestingly, the model has strong similarities to filter models which have been shown to add value in the equity world. Based on both bond variables such as spread valuation, and equity variables such as stock revisions by analysts, the model selects the most and least promising (avoid the losers!) bonds2. The selections for several rating/sector combinations are very useful, as the filters provide a guideline in an extensive global universe of more than 10,000 issues. Moreover, the model uses an underlying database which is unique, as we managed to link bond data at individual issuer level with the relevant equity data. This linked database is very useful, as it appears that equity data contain valuable information for credit investors as well.
Klaas Smits is head of the credit team and Olaf van Thull is senior portfolio manager and member of the credit team at Robeco in Rotterdam
1 The study, ‘Value of Security Selection versus Asset Allocation in Credit Markets’, was published in The Journal of Portfolio Management, summer 1999
2 More details are given in the working paper, ‘Can we find successful factors to select outperforming corporate bonds?’ by J Hottinga, E van Leeuwen and J van IJserloo

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