Credit: Doing what it says on the tin?

In the hunt for yield, institutions have become increasingly comfortable with credit. The asset management industry has responded with a plethora of multi-asset products with the flexibility to allocate across the full spectrum of credit markets to enhance duration risk management and capital protection without stretching institutions’ governance budgets. 

Flows into credit funds have been so significant, however, that they are changing the dynamics of the market, particularly in high-yield, where valuations have become increasingly rich. As well as creating opportunities for those willing and able to exploit them, the market dynamics in the high-yield domain underline the importance of selecting funds that can deliver on their promises, and for investors to understand exactly what those promises are.

Multitude

Credit has enjoyed a storming run of flows. By the end of March 2014, inflows into credit funds surpassed those into equity funds in Europe for five weeks in a row, according to Bank of America Merrill Lynch (BAML). Both investment grade (IG) and high-yield (HY) funds attracted over $1bn (€720m) in the last week of March alone, bringing cumulative flows for 2014 into credit funds in Europe to $20bn.

“There is a clear trend among institutions and consultants towards credit,” says Richard Ryan, manager of M&G’s institutional multi-asset credit fund. “Some don’t want to give up all their return potential as they move from equity to fixed income, some want to nudge their overall fixed-income exposure through a complimentary product, others have LDI in place and want to manage their credit risk efficiently without duration generating enough cash flow to cover their LDI swap requirements.”

Asset managers have been responding to increased demand with a huge number of multi-asset credit products. In recent years there have been launches from a multitude of managers, large and small, including M&G, ECM, ING, Muzinich, UBS, Henderson Global investors, BlackRock, AXA, Payden & Rygel and Invesco Perpetul, to name a few. The products, conceived predominantly for institutional investors, have also evolved as investors become increasingly comfortable with investing across the full quality, regional and securities spectrum in credit.

“Two years ago, many of the multi-asset credit offerings were US-based credit opportunity funds that invested in sub-investment grade loans and bonds,” reports Colin Fleury, head of structured credit at Henderson Global Investors. “There has since been a broadening of the range of strategies available, some with a more European flavour taking advantage of the improving macro situation, while banks’ appetite to lend remains constrained.”

The range of potential instruments, although strategy-dependent, has also widened considerably. Some have a focus on extracting attractive credit-risk premiums while seeking to avoid losses from defaults, while others will combine interest rate, currency and emerging market strategies. Most have a long bias, but will seek to hedge out market return volatility and duration risk to differing degrees.

Capital protection

The ability to allocate dynamically is a critical factor in multi-asset credit. The credit cycle creates significant dispersion of returns between asset classes and across geographies.

“Over the last 15 years, no single credit asset class has consistently been the best or worst performer for more than two years in a row, and the spread between them has been 15% per year on average,” says David Newman, senior partner at Rogge Global Partners.

Because multi-asset funds are able to allocate across the credit spectrum, they offer some protection from what many investors believe is an over-valued high-yield sector, without giving up the potential for decent returns.

“By breaking down the silos between geographies and different types of credit, such as high yield and senior secured loans, we can always access credit risk from the best risk-adjusted return perspective,” explains Fraser Lundie, co-head of Hermes Credit. “We aim to achieve the majority of the high-yield upside, but with better capital protection and volatility characteristics. That means largely using high-yield-like instruments, but the best risk-adjusted return might be available through loans or other instruments.”

The less constrained the manager, the greater its opportunity of doing so, but size also plays an important role.

High yield has attracted massive interest in recent years. Figures from data provider Markit show $1.04trn was invested in global high-yield bonds between January 2009 and March 2013. BAML, meanwhile, calculated the size of the total market at the end of March to be $1.2trn. The scale of assets chasing these bonds and their concentration in large funds has fundamentally changed the demand/supply dynamics of the market, making it less attractive.

“There is an over-dependence among the larger buy-side players on the primary market,” Hermes’ Lundie argues. “That means banks are more able to dictate terms of new issuances, which has a knock-on effect on the market.”

Banks naturally try to negotiate the loosest possible covenants, longest non-call periods and lowest possible price for companies. Many large buy-side firms are forced buyers of these bonds because they need the liquidity of the primary market. As a result, deals are becoming increasingly weak because the buy-side has no push-back.

“Multi-asset credit strategies are not held to the primary market and can avoid forced buying,” Lundie reasons. “By avoiding crowded trades, and accessing the maximum breadth of the investment universe, these strategies can provide better risk-adjusted returns and downside protection. The more unconstrained the manager, the better.”

The benefits of diversification are demonstrated, for example, in the differential between the European high-yield bonds and their relatively similar cousin, senior secured loans. Spreads are tighter on the bonds because of the fund flows into the space, but also because of the disappearance of some traditional buyers of loans. Historically around 70% of demand came from banks, and CLOs largely made up the remaining 30%. Tighter regulation has forced down demand from banks and reduced new CLO issuance to replace post-crisis CLOs reaching the end of their reinvestment period. Meanwhile, unlike high yield, which enjoys enormous popularity in the UCITS arena, loans are not UCITS-eligible and do not attract much retail demand.

“The reduction in buyers of senior secured loans presents an opportunity for institutions to get in at a good price,” says Craig Scordellis, senior portfolio manager at CQS. “Allowing a manager to invest more broadly, be more selective and manage valuation risk is a key benefit to multi-asset credit. Opening up the universe to allow a manager to allocate to floating rate instruments also reduces duration risk, [which] is very prevalent for institutions today.”

The majority of multi-asset credit strategies are duration-neutral or LIBOR-based, as investors generally appear keen to separate their credit and interest-rate risk. However, some take a more active approach, using duration as an alpha-generation tool.

“Some flexibility is beneficial, given the opportunity to earn roll-down from steep yield curves, or to buy duration as a hedge in ‘risk off’ markets,” Rogge’s Newman argues. Few, however, are genuinely short duration, given the high cost of carry and considerable complexity and skill associated with short positions in fixed income markets. 

De-risking

So far, investors are viewing multi-asset credit strategies as complimentary portfolios, either to existing credit exposures or to help cover the cost of holding swaps in LDI portfolios.

“Some multi-asset credit strategies can be viewed as ‘completion’ funds to wrap around existing investment grade credit portfolios, given their predominant exposure to non-investment grade credit,” says Peter Martin, head of manager research at JLT Employee Benefits. “Others are using them as a cash-kicker in LDI strategies as part of the holistic question of how to manage duration risk in de-risking. Investment grade bonds used to be enough to provide sensible, sufficient returns to meet long-term liabilities. Perhaps not now. As spreads have compressed and investors have become more comfortable with broader credit markets, they have followed a natural journey through the credit spectrum. What used to be a relatively easy decision now requires considerable governance to allocate nimbly between the plethora of opportunities. Multi-asset credit, if done properly, is a way to generate returns over sovereign bonds, and delegating the allocation decisions is very attractive because it puts the decision-making where it is most appropriate.”

Despite this, consultants generally report taking a cautious approach to multi-asset credit, selecting only from a handful of managers they believe genuinely have the breadth of skill required to cover all the markets, corporates and instruments available to an unconstrained manager.

Given the variety of strategies included under the banner, which differ in terms of return objective, basic strategy (top-down or bottom-up, say), duration-risk hedging, ability to short either physically or through CDS and the extent to which they are constrained, investors need to conduct considerable due diligence when selecting managers, to ensure they understand the fund and that it will behave as expected.

“We see a lot of mediocre stuff,” Martin warns. “Managers need to have considerable skill across a range of areas that can be brought seamlessly together, not just bolted on.”

In the past year there has been some interesting market movements to test the ability of these strategies to deliver on their promises. During the ‘taper tantrum’ of 2013, for example, many areas of the fixed-income market fell in unison. A broad range of benchmark indices simultaneously posted declines during May, June and August, including BAML’s Global Broad Corporate and Global High Yield indexes, Barclays Global Aggregate, and JPM’s EMBI Global Composite and GBI-Emerging Markets Composite. A fund promising absolute returns would, therefore, have little option other than being short, but few have proven willing or able to do so.

“Look at their thought process,” Martin urges. “Look at how managers reacted and whether they did what they said on the tin.  During the taper tantrum loans did better than high yield, so a manager able to invest in both should have been more in loans, or should be able to explain the reasons for not being. That explanation and discussion is as important as what people actually did. Be absolutely clear what a manager is promising, that they are behaving in accordance with that and, if not, make sure there is a serious discussion about why.”

Multi-asset credit funds have, in recent years, enjoyed a surge in popularity from investors seeking to de-risk from equities but retain return-generating potential, or to separate the credit and interest-rate risk premiums within their fixed-income portfolios. The range of strategies on offer has increased greatly and investors need to exercise care in selecting managers with a good chance of meeting expectations.