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Navigating credit risk for better gains

Exploiting inefficiencies

Our core value approach is aimed at exploiting what we see as inefficient markets, with the aim of maximising returns for a given level of credit risk.

We do this in part through a relative value process that allows us to avoid those countries and companies that are overvalued and most susceptible to a downturn in the credit cycle, as well as investing in value opportunities that have an in-built cushion for downgrade risk associated with a negative turn in financial conditions.

Macro factors drive beta

From an allocation perspective, we believe macro factors such as overall credit risk drive the majority of directional moves or ‘beta’. Basically, we aim to upgrade or downgrade the quality of our credit portfolio to take advantage of cyclical conditions, but use security selection to enhance returns for that target level of credit risk appropriate to the prevailing stage of the cycle.

The relative value model allows us to exploit the value/dispersion dynamic throughout the cycle whatever the target credit quality.

Maximising target beta

When credit spreads are relatively tight, this approach can be particularly relevant. Simply moving down the credit-risk spectrum may generate higher income returns from increased beta exposure.

However, it is important to understand that the downside risks associated with lower quality credits are asymmetric with any increase in cyclical risk, especially when overall coupon income is low (see Boosting capital returns in a low-yield world).

A good example of this is the correlation of high yield and investment-grade spreads. When compared with investment grade over the past three or four years, high yield has been approximately four times more volatile in terms of credit-spread movements.

In essence, assuming no change in government yields, junk bond yields would exhibit much larger moves in price for equivalent duration as investment-grade debt. Put another way, investors have to run a quarter of the duration in high yield to assume a similar level of price sensitivity to move in credit spreads as investment-grade bonds.

This means that when spreads widen out, what typically happens is the average spread for each rating group widens as well so, for instance, the gap between BBB and BB names expands.

Understanding how credit spreads move in relationship to each other and the macro environment is vital

A value strategy can also be advantageous in this instance, as bonds retain their discount to their credit rating, rather than necessarily moving as much as lower grade credit. In this respect ‘value’ investing can act as a more defensive way of gaining yield without taking additional credit risk.

Credit risk and portfolio construction

In summary, it is critical to assess the top-down allocation to credit risk, this is an asset allocation decision factored into portfolio construction. The decision can be enhanced through the value process, which not only delivers excess returns against a positive economic backdrop but also has defensive qualities relative to moving down the credit spectrum in a more negative economic environment.

Links to fund pages

Further reading

For more information on the relationship between duration and relative value, read our whitepaper A Theory of Relativity.

 

 

 

Part of the Bonhill Group.