Market Comment 15/03/2018
Staying Ahead of the Credit Markets
Ewan Millar, Senior Investment Manager at Cornelian Asset Managers, explores opportunities for unlocking investment potential.
Corporate credit markets are vast and varied and offer a huge range of opportunities depending on risk tolerance and return objectives.
Even for the very biggest active corporate bond managers opportunities abound for generating above benchmark total returns. Identifying corporate bonds whose credit ratings are likely to improve is one of the main sources of alpha. If the issuer - the corporate borrower behind the security – becomes a more robust business and their default risk lessens, then they are likely to be upgraded by the rating agencies. When this happens, the price of the bond usually rises and, therefore, the yield on the debt falls. Credit rating agencies – S&P, Fitch and Moodys – are notoriously slow and therefore alert active bond managers can stay a step ahead of the agencies and over time earn returns ahead of the benchmark. Investments via Exchange Traded Funds and Passive funds are now approaching 20% of the US fixed income market (source: BIS). In addition, there are huge swathes of capital in insurance and pension funds that blindly follow benchmarks. This ensures active opportunities persist for diligent managers.
The reality is that around half of corporate bond investors are not ‘profit maximisers’ and simply follow benchmark allocations regardless of how appropriate or otherwise those allocations may be. Unlocking those shackles completely opens up the opportunity set for benchmark indifferent corporate bond managers. Such managers can earn a premium from simply owning bonds that are not in the benchmark or that are not rated by the agencies. Also, where a long-term time horizon can be afforded, further premiums can be earned from owning slightly less liquid bonds.
Within the corporate credit market, well resourced, skilled corporate credit research teams can earn a complexity premium by dedicating time and resource to niche areas of the market where others cannot. Asset backed securities are one such example. Here loans are grouped into special purpose vehicles (SPVs) and are backed by a book of assets such as mortgages, credit card loans or borrowings backed by a hard asset such as property or machinery. The additional skill and due diligence required in this area earns a complexity premium compared to a traditional corporate bond with the same level of credit risk. Although ABS’s can sound ‘risky’ they are constructed in such a manner that the senior debt in the SPV is of a very high credit quality and has a very low risk of any capital loss.
specialist credit funds which use closed ended investment trusts to lend to both social and economic infrastructure projects can offer very attractive risk reward returns.
Lastly, specialist credit funds which use closed ended investment trusts to lend to both social and economic infrastructure projects can offer very attractive risk reward returns. These structures are backed by, for example, a 25-year commitment by a government body to pay an agreed amount every year for the construction and operational management of a hospital, or the rights to the toll revenues from a toll road for an agreed period of time following its construction and subsequent maintenance. Specialist credit funds return higher yields owing to the particular expertise required to operate in this area and the illiquidity of the investment compared to a large corporate bond issuance with the same credit risk.
An appropriate blend of all of these credit strategies can earn an attractive yield and maintain adequate liquidity whilst ensuring the preservation of client’s capital. After all, a focus on through the cycle returns and capital preservation is the real goal, not the outperformance of an arbitrarily constructed benchmark.
Senior Investment Manager