Multi-asset credit: Adapting across the cycle
Four multi-asset credit managers explain their strategies
• Multi-asset funds can help generate income during different stages of the market cycle.
• Regulatory change and ultra-loose monetary policy are causing dislocations in the capital structure of companies.
• Security selection is becoming a more important factor as the practice of managing multi-asset credit portfolios matures.
Even the most seasoned asset allocators sometimes dream of finding a way to generate income under the varying conditions that arise during market cycles. Multi-asset credit strategies go a long way towards filling that need, but they are not a set-it-and-forget-it solution. Four multi-asset credit managers took IPE on deep dives into their strategies. The results show that plenty of heavy lifting is needed to keep credit portfolios in tune with the times.
At La Française Global Investment Solutions, the credit strategies team led by senior portfolio manager Renaud Champion takes a quantitative approach that focuses on allocating capital to diversified sources of return across the full spectrum of liquid credit instruments. The team limits directional credit exposure to 30% of the risk budget to reduce potential drawdowns, and minimises the portfolio’s sensitivity to interest rate changes by restricting duration risk.
In summary, says Champion, the team emphasises relative value, and credit portfolios – both pure strategies and within broader mandates – are constructed in alignment with the opportunities presented by prevailing market conditions.
“In the context of our credit funds, we like relative value opportunities more than fully directional bets, given how compressed a number of premia are at this time,” says Champion. “The beauty of the current situation is that we have a number of very meaningful dislocations in the credit space,” he adds. “In a number of credit dimensions, those dislocations are major, and we believe the opportunity is that they will normalise over time.”
The main causes of dislocations are regulatory change and ultra-loose monetary policies of the main central banks, Champion explains. These factors are creating significant dislocations in the capital structure, evident in cash-structured credit instruments such as collateralised loan obligation (CLO), as well synthetic securitisations such as tranched indices, tranched iTraxx or tranched credit default swap (CDS). “There is tremendous value in the senior tranches of those securitisations,” Champion says. He says the AA and AAA tranches offer value relative to plain-vanilla credit assets or to the rest of the capital structure. “We believe the main reason those tranches are so wide in spread and so attractively priced is changes in regulation,” Champion says.
Such ‘super senior’ risks are now viewed as ‘systemic assets’, and investors in them, such as insurance companies, are required to hold significant amounts of capital on their balance sheets.
For an investor in the AAA tranche of a CLO, the first 40% of losses would be borne by subordinated investors; in effect, the loan pool would have to suffer losses of more than 40% before affecting the AAA investors, and because the average recovery rate for leveraged loans is about 60%, says Champion, the cushion against losses in the AAA tranche is in practice even larger. “Basically, this tranche has no credit risk,” he says. Despite that risk profile, the capital charge for that asset, a super senior tranche, is 50%, Champion explains. “These assets have been punitively charged and, as such, many investors have deserted them,” Champion says.
That has given rise to an opportunity. “At the end of the day, capital structure arbitrage is a zero-sum game,” Champion says. “When the super senior tranche is very cheap, the rest of the capital structure has to be very expensive.” To capitalise on the dislocation, La Francaise takes a long position in super senior tranches of credit instruments, and shorts junior mezzanine tranches. High demand for higher-yielding assets is a direct effect of loose monetary policies around the world. “The mezzanine is very expensive, particularly those that carry an investment-grade rating, because many investors that are seeking higher yield cannot go lower down the capital structure than BBB-rated instruments,” he explains.
Another approach is to conduct bottom-up research on individual securities and construct a portfolio of well-understood credit risks without trying to position for a change of interest rates or other macro factors. “Our approach is investment by investment from the bottom up, to look at the risks that you run in each individual security,” says Richard Ryan, manager of the institutional multi-asset class credit funds at M&G Investments. “Our edge is to really understand the risks and the individual securities, and ensure we get compensated to take that risk at the point we make the investment, not to invest on the basis that there’s a story behind it and if the story turns out then our valuation premise is justified.”
That approach has two key consequences. First, the team employs an opportunistic methodology, reacting to market events rather than trying to forecast market direction or rate changes. “If you said to me, ‘where do you think 10-year Treasury yields are going’, I would say I have no idea. And furthermore, why do you really care?” Ryan says.
“We’re pretty much agnostic when we look at the individual corporate credits of a company,” he adds. “We want to know what the market is trying to price into those securities, and then we want to know that if we make an investment, that we have a sufficient margin for error within our analysis.” Forecasting has no place in the analysis. “We base the analysis on the facts at hand, and what we know – not on what we think will happen in the future with the help of our crystal ball.”
The second consequence is the need for patience. “If you want to outperform the marketplace, you have to do something different than the market,” Ryan says. “If you can inject a degree of patience into the process, then actually if you are reactive and patient, you can have a much greater degree of success, than if you are trying to forecast the future.”
The bottom line is that the future is unknowable, but clients still expect results. “You can explain why your forecasts are incorrect,” Ryan says, “but from a portfolio management perspective, if we have to deliver performance to our clients, we need to get investment decisions right, and not only do we need to get it right, we need to get it right consistently year after year after year.” Ryan contends that a realistic approach to what multi-asset portfolios can deliver leads to a pragmatic style. “I just don’t think you can do that by trying to forecast decisions as binary as where 10-year Treasury yields are going to go.”
Another way of doing things differently is in portfolio construction. Ryan’s team manages just under €10bn in multi-asset credit strategies, the flagship being the M&G Alpha Opportunities fund. In general, strategies target LIBOR-plus 3-5%. Using a LIBOR target, rather than an all-in yield, allows greater flexibility to invest in different assets, including fixed and floating-rate instruments, as well as property securities or private markets. Reflecting the concentration on security analysis, the portfolio hedges out duration risk.
In practice, Ryan says, the M&G team has a “natural home bias”, in contrast to many multi-asset funds that focus heavily on US markets. “There are significant opportunities to be had in Europe, which many US buyers tend to overlook,” he says.
Broad approach to securities selection
The ability to nimbly adjust allocations between asset classes and credit ratings remains a basic requirement for success in the multi-asset sector. However, security selection is becoming a more important factor as the practice of managing multi-asset credit portfolios matures. “One of the things that’s important in managing these strategies is not only the ability to asset allocate, which is the main driver of returns, but the ability to express particular themes across industries and geographies and then to really security-select within your allocations,” says Jeffrey Cucunato, head of the US investment grade credit team at BlackRock.
“We’re seeing more and more opportunities to add value with regard to security selection,” he adds. “So from a risk budget standpoint the top-down allocation has become a little less exciting, and it’s probably valuable to be spending a bit more time on industry and security selection.”
“If you said to me, ‘where do you think 10-year Treasury yields are going’, I would say I have no idea. And furthermore, why do you really care?”
That view is being put into practice at BlackRock. “We’re spending more time on the next level down of asset allocation, in terms of implementing some of the themes we’ve liked,” Cucunato says. “From a top-down standpoint, we’ve favoured high yield on loans, but from a more thematic standpoint we’ve liked financials, particularly subordinated financials,” he adds.“So we’ve been spending more time looking across the different geographies and sourcing some of the industry and thematic traits that we like.”
That translates into a large active-management team comprised of nearly 70 research analysts focused on bottom-up security selection within corporate credit, which serves as a first line of defence as economic and financial factors evolve. “Once you start to get into a more stressed or challenged environment, there is idiosyncratic risk and avoiding problematic stories can be very beneficial,” Cucunato says.
Currently, Cucunato says, BlackRock is constructive on the outlook for credit assets. The team has close to two-thirds of the capital it manages allocated to sub-investment-grade securities, and continues to adjust allocations; the allocation to floating-rate loans declined to the high-20% range in 2017 after being more than 50% in the fourth quarter of 2016, for example. The geographical allocation has also changed substantially, with the US allocation declining from about 85-90% to two-thirds of assets, with the allocation to the rest of the world rising accordingly. That top-down view is expressed, for instance, by investing in subordinated credit to financial institutions, mainly large banks in both the US and Europe.
The opportunity stems from the improved capital strength and better liquidity that many banks have achieved, Cucunato says. Tighter regulations have helped to some degree, he adds, and the sector is also somewhat overlooked because it is not included in high-yield or investment-grade indices. “There’s not a natural index buyer of subordinated financials,” he says. “The space has done very well this year, and while the relative value is not as compelling, we believe there are still some interesting opportunities there.
Assessing and managing risks are the core of the multi-asset credit approach at Franklin Templeton Fixed Income Group. The Franklin Multi Sector Credit Income fund targets relatively high total returns from corporate assets while maintaining relatively low correlation to interest rates. The fund is designed to be a ‘best ideas’ type of portfolio, says David Yuen, senior vice-president and director of quantitative strategy and risk. The strategy emphasises bottom-up company and industry-level research to capture higher yields offered by corporate and structured credit. The fund “will not invest in a sector where we do not have an experienced team in place that has managed the relevant sector successfully over time,” Yuen says, “particularly since the sectors we focus on carry a relatively high degree of credit risk.”
Franklin’s portfolio construction approach combines top-down country and sector analysis and bottom-up security selection. The positioning resulting from the process includes selective exposure to energy companies, including some that have been restructured after 2015, a light weighting in Europe compared with the US, and a preference for high-yield debt over bank loans, although that differential is decreasing. The fund has “opportunistically increased allocations” to CLOs and other structured credit, Yuen says, such as credit risk transfer securities (CRTs), which benefit from a strong US housing market and offer floating yields and other structurally-driven diversification benefits to the portfolio.