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Hermes Unconstrained Credit celebrates one-year anniversary

On 29 May 2018, we launched our Unconstrained Credit Fund. It aims to maximise long-term total returns by combining unconstrained, high-conviction credit selection with a hedge against adverse market conditions. One year on from its launch, we ask: how has Hermes Unconstrained Credit performed?

Key points:

  • We launched Hermes Unconstrained Credit against a backdrop of relatively normal market conditions in late Q2 2018. But in Q4, conditions changed.
  • The options overlay fulfilled its role as a powerful hedge, posting a positive return on a standalone basis over 2018.
  • Since inception, we have achieved a net return of 6.32%1 in what has been a difficult environment for credit investors (see Figure 2). 

A dynamic multi-sector credit solution 

Armed with an impressive track record of outperformance across a suite of flexible credit solutions, Hermes Credit launched its Unconstrained Credit Fund in late May last year.

In its first year, it has delivered a strong performance, providing solutions for investors seeking to outsource their full credit exposure, or enhance their traditional fixed income allocations.

As its name suggests, Hermes Unconstrained Credit invests across the global credit spectrum according to an unconstrained, high-conviction approach. We combine top-down allocations to diverse credit sectors with bottom-up issuer and security selection and – instrumental in the fund’s success since Q4 last year – a dynamic options overlay that we use to mitigate the impact of any broad-based material deterioration in credit markets on our return-seeking investments. Rather than hedging against small market movements, we focus our attention on outsized moves, where permanent loss of capital risk is heightened.

The Hermes Unconstrained Credit Fund could be a great option for investors who are looking to hand over their credit allocation to a trusted credit manager. That’s because as well as deciding on the best credit segments and individual securities to invest in, through the fund’s option overlay we also decide on your behalf how much credit risk to take on.

We aim to deliver a gross return target (USD) LIBOR plus 5%-6% through the cycle – avoiding significant drawdowns during sell-offs while maximising the fund’s participation in rising markets. Investors can choose a distribution share class if they wish to receive an annual payment or an accumulation share class if they’re looking to reinvest any coupon payments to grow their capital as much as possible.

Finally, for investors looking to do good with their money, we integrate ESG throughout the fund’s investment process, ensuring responsibility is embedded in every investment decision we make. We also engage with the companies in our portfolio, urging them to improve their practices where necessary.

At the time we launched the fund, many of our investors were keen to hear how it would be able to achieve its target return considering how tight spreads were and the potential cost of the options overlay that the fund uses. Several of the potential scenarios that we used at the time as examples to show how the fund could prosper in various conditions have in fact played out over recent months.

The story of the year

We have achieved a net return of 6.32%2 since inception in what has been a difficult environment for many of our peers – but what we are really proud of when it comes to our performance is that we avoided the most dangerous parts of the credit markets.

So, how have we delivered what we set out to do?

We launched the fund in what we would call relatively normal market conditions late in Q2 2018. Both investment-grade and high-yield credit were in a steady state, and the fund successfully harvested a combination of income and capital appreciation through this period.

The power of the option overlay 

All this changed in Q4, when the credit markets slumped. At this time the fund’s options overlay fulfilled its role as a powerful hedge: it helped us manage the downside risk during the market sell-off and, by exhibiting lower volatility, we delivered a strong risk-adjusted return. In fact, the overlay posted a positive return on a standalone basis over 2018. But what was really important about the overlay was that it kicked in by significantly reducing the fund’s long positioning throughout November and December, helping to mitigate overall fund losses as well as making money itself.

This was vital as it gave us the chance to spend December and early January buying severely dislocated bonds from around the world at a time when other funds were seeking to reduce risk. And there were lots of attractive opportunities to buy.

Figure 1. The options overlay was instrumental in the success of the Fund in Q4 2018

Source: Hermes Credit as at 31 May 2019. High-yield market performance is that of the ICE BofA Merrill Lynch Global High Yield Constrained USD Hedged Index. Investment-grade market performance is that of the ICE BofA Merrill Lynch Global Broad Market Corporate USD Hedged Index. Note: PnL refers to profit and loss; DTS refers to duration times spread.

Fundamental analysis identifies contrarian opportunities for Q1 

For starters, around this time investment-grade credit in aggregate was trading below par cash price for the first time since the financial crisis. But it seemed like most other investors didn’t recognise this as they were focusing their attention on spreads.

At the same time, much of the media attention was focused on the risk of several high-profile companies – the likes of General Electric and General Motors – being downgraded to high-yield status. As a result, these firms’ bonds were trading at deep discounts – in some cases, as if they already had a ‘B’ rating. Many other investors sold these companies at a loss. But we conducted in-depth fundamental analysis on these names that suggested there was little risk of them falling to junk-bond status. And, as a result, we invested in them.

The fund fell by about 1.07% in December last year, but this loss was largely due to our purchases of undervalued names, which went on to rise sharply in the first five months of 2019. If we hadn’t bought them, the fund would not have achieved its 11.18% year-to-date net return3. This period of strong performance has been vital in enabling us to meet our return target since the fund’s inception.

Figure 2. Unconstrained Credit Fund: rolling performance (net)

31/05/2018 to 31/05/2019 31/05/2017 to 31/05/2018 31/05/2016 to 31/05/2017 31/05/2015 to 31/05/2016 31/05/2014 to 31/05/2015
6.38%

Source: Hermes as at 31 May 2019. Performance shown is in USD, net of fees. Past performance is not a reliable guide to future performance.

A quality focus

Since inception, our exposure to CCC-rated bonds – the riskiest investments at the very bottom of the credit spectrum – has been very low (see Figure 3). Indeed, these pockets of the credit market are the most vulnerable to a correction, when it occurs.

We are more comfortable with our positioning in the credit rating spectrum: our exposure to higher-rated credits (BB and above) stands at 95.93% (by market weight) and we continue to find value in less-leveraged parts of the credit market.

Figure 3.  A quality focus: our unconstrained credit fund has very little exposure to the riskiest parts of the market           

Credit Rating DTS (%) Market weight (%)
AAA 0.28 -1.06
BB and above 90.33 95.93
B 8.56 4.66
CCC 0.00 0.00
CC 0.00 0.00
C 0.00 0.00
D 0.00 0.00
Not rated 0.83 0.47

Source: Hermes as at 31 March 20194.

As already mentioned, the performance of the Fund year-to-date is outstanding, at 11.18% net of fees5 (as at 30 June 2019). Our current positioning finds us very cautious about markets from here, with material tail risk seemingly not being priced in as markets react to the wave of dovishness sweeping over the world’s central banks.

Risk profile
  • Past performance is not a reliable indicator of future results.

  • The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

  • Targets cannot be guaranteed.

  • It should be noted that any investments overseas may be affected by currency exchange rates.

  • This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

  • Where the strategy invests in debt instruments (such as bonds) there is a risk that the entity who issues the contract will not be able to repay the debt or to pay the interest on the debt. If this happens then the value of the strategy may vary sharply and may result in loss. The strategy makes extensive use of Financial Derivative Instruments (FDIs), the value of which depends on the performance of an underlying asset. Small changes in the price of that asset may cause larger changes in the value of the FDIs, increasing either potential gain or loss.

  1. 1Source: Hermes Investment Management as at 31 May 2019. Performance is in USD, annualised and net of all costs and management fees. Subscription and redemption fees are not included.
  2. 2Past performance is not a reliable guide to future performance. Source: Hermes Investment Management as at 31 May 2019. Performance is in USD, annualised and net of all costs and management fees. Subscription and redemption fees are not included.
  3. 3Source: Hermes Investment Management as at 30 June 2019. Performance is in USD, annualised and net of all costs and management fees. Subscription and redemption fees are not included.
  4. 4Note: Duration times spread (DTS): recognises that bonds with a longer duration or wider spread – or both – have a higher beta and therefore greater contribution to index returns
  5. 5Past performance is not a reliable guide to future performance. Source: Hermes Investment Management as at 30 June 2019. Performance is in USD, annualised and net of all costs and management fees. Subscription and redemption fees are not included.

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