Agility should be the watchword in the new bond environment, according to Hermes Credit’s Mitch Reznick and Fraser Lundie
There have been gradual but profound structural changes to the credit markets since the financial crisis. It is imperative credit managers recognise the world has changed and find ways to manage the new and rising risks.
Although there is less systemic default risk and lower volatility within credit markets, the structural changes have opened up new risks to performance: liquidity, evolving bond structure, duration and idiosyncratic risks. To better manage these risks brought on by this structural change and to deliver outperformance, managers will need flexibility and to lean more heavily on a broader set of fixed income skills.
The problem is that many credit fund managers must manage their funds according to narrow mandates and therefore lack the ability to access the pockets of relative value that emerge on a global basis, that more flexible investment mandates permit. Agility should be the watchword in the new bond environment.
One of the risks in today’s low-volatility, rising-rate-concerned market is the crowded trade at the front of the credit curve, where one finds short duration and shortening maturity. Predicated on these rate rise fears, investors have heavily allocated to short-duration credit, allowing the pendulum to swing in the issuers’ favour.
In the high-yield market, this ‘demand pull’ to feed these mandates has led to a surge in issuance of shorter-maturity, short-call bonds. Many of these have come from smaller companies that were once the province of the loan-market, but, because of bank deleveraging and demand, they have refinanced loans in the bond market.
However, with more securities subject to shorter non-call periods, achieving long-term, equity-like returns with less volatility is more difficult. In addition, whatever idiosyncratic risks may exist in these names could be magnified given the paucity of trading liquidity compared with pre-crisis levels. Unexpected bad news could really catch some investors out. Managers must be more vigilant than ever of credit risks and deal structure.
As for the risk of rising rates, making use of a broader set of debt instruments can mitigate these risks. For example, by hedging or using CDS, one can effectively manage for rising rates without having to enter what are potentially risky positions.
Finally, because the dearth of liquidity will magnify any sell-off, we have managed the compression in the spreads between low and high-quality names by shifting to better credit quality, as one is not adequately compensated for the additional credit and liquidity risks. An effective way to compensate for not trading down in credit risk for yield is to manage on a global basis and look to emerging markets for opportunities.
We have found that one can find spread-equivalent securities in higher-quality global emerging market names. These tend to be globally diversified, high-quality, double-BB, large-cap names, with revenue in US dollars. In the first part of the year, this has worked out very well. We have bought in India, Brazil and Russia – but the common defining characteristic is the robustness and global nature of the individual companies. We still see relative value here. There is, of course, some inherent emerging market risk, but this is compensated by the high quality of the companies to which we are gaining exposure.
Cocos have been receiving much interest of late. And, while we appreciate their merits, their inherent structure raises some concerns for us, and we are not convinced many of these securities are priced appropriately. For the moment, we prefer more credit-friendly legacy capital securities, and US preference shares are an alternative.
For US banks, preference shares perform a similar role to cocos and are favoured by the Federal Reserve as a means of building capital buffers. The securities are typically callable after 10 years, have non-cumulative coupons, and are issued out of the holding companies overseeing banking groups. As relative-value investors, we compared the dollar Wells Fargo 5.85% perpetual preference share, which is callable in 2023, with the BBVA 9% dollar perpetual coco, callable in 2018.
The securities displayed similar valuations, but the Wells Fargo preference share has more bondholder-friendly terms. It offers less capital appreciation, but is less volatile and generates a higher Sharpe Ratio in both price and yield terms and should therefore deliver a better risk-adjusted return.
Mitch Reznick and Fraser Lundie are co-heads of Hermes Credit