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Credit markets have developed rapidly over the past two decades as post-financial crisis regulation and the growth of emerging markets have encouraged investors to look at different regions, sectors and instruments. Volatility is also on the rise as late-cycle dynamics, a lack of clarity about the pace of monetary easing and geopolitical turmoil create an atmosphere of uncertainty.
In this world, investors can no longer rely on a standard, long-only approach to generate returns. Absolute-return credit strategies aim to deliver positive returns throughout the cycle, regardless of whether markets rise or fall. These funds look beyond traditional benchmarks and act as a more market-neutral solution – particularly in times of turbulence.
Absolute-return credit strategies are highly responsive to market conditions, while continuously harvesting the income available from the asset class invested in. When markets are weak, investors tend to turn their attention to defensive assets, like government bonds, or use downside-protection strategies to hedge risk. And if markets are buoyant, they can position themselves to capture the upside.
In today’s late-cycle environment, there is more of a need than ever to stay flexible and invest across all credit classes. Absolute-return credit strategies attempt to navigate this uncertainty by employing a go-anywhere, all-weather approach to fixed income.
Investors that allocate capital to absolute-return credit strategies have the potential to benefit from superior risk-adjusted returns. Since its inception, Hermes ARC has delivered higher Sharpe and Sortino ratios1 than corporate and short-dated high-yield bonds (see figure 1).
Figure 1: Performance since inception, June 2015-September 2019
Source: Hermes, as at September 2019. High-yield market performance is that of the ICE BofA Merrill Lynch 0-5 Year US High Yield Constrained Total Return USD Hedged Index. Global corporate-bond performance is that of the Bloomberg Barclays Global Aggregate Total Return USD Hedged Index. Past performance is not a reliable guide to future performance.
ARC has also delivered value more consistently. While high-yield funds have the potential to generate larger returns, ARC has made more frequent gains and delivered positive returns in a greater number of periods since its inception (see figure 2).
Figure 2: A smoother journey
Source: Morningstar, Hermes, as at October 2019. High-yield market performance is that of the ICE BofA Merrill Lynch 0-5 Year US High Yield Constrained Total Return USD Hedged Index. Global corporate-bond performance is that of the Bloomberg Barclays Global Aggregate Total Return USD Hedged Index. Past performance is not a reliable guide to future performance.
Economic growth has slowed and inverted yield curves indicate that a global downturn is a potential risk. Although it could take some time for a sell-off to materialise, we are clearly closer to the end of the macroeconomic cycle than the beginning. And while central banks have resumed their dovish bent, quantitative easing seems increasingly ineffective.
ARC is unconstrained by any benchmark and has the flexibility to allocate capital where we see the best risk-and-return trade-off. In this environment, the lower rated end of the investment-grade market looks the most appealing, and about 65% of the portfolio is invested in BBB-rated credits.
Tilting the strategy towards investment-grade instruments is one way to avoid the risks associated with a slowdown while continuing to seek absolute returns. ARC’s aim to preserve capital does not come at the expense of performance and the overall portfolio demonstrates less volatility than investment grade (see figure 3).
Figure 3: Historically less volatility than investment grade
Source: Hermes, as at October 2019. Past performance is not a reliable guide to future performance.
Much has been written about the risk of BBB-rated instruments turning into ‘fallen angels’. Indeed, fear that these bonds would be downgraded to junk status prompted a sell-off in credit markets last year. But we took the view – which we still hold today – that these fears were overblown. As a result, we benefited from out-of-favour BBB-rated corporates that took measures to de-risk and strengthen their balance sheets.
Hermes Credit firmly believes that security selection is as important as issuer selection. As a result, ARC invests throughout the capital structures of issuers in order to find superior relative value amid a range of instruments. Having the flexibility to invest in a range of assets also means that ARC can take advantage of opportunities provided by the growth of new types of instruments, like hybrids and additional tier 1 securities.
Choosing the right part of the curve is also an important part of generating alpha. Spread curves are steep at the moment and, at the longer end, the ‘fallen angels’ that have descended from investment-grade to high-yield status often trade at very attractive levels compared to shorter dated bonds. Taking a position in these securities can help increase spread duration and offers attractive total-return prospects.
Through ARC, we also take both long and short positions, seeking to achieve positive absolute returns irrespective of the market direction. Our long positions seek to generate income with low volatility and excellent liquidity, while defensive trades respond to specific catalysts by investing short and pairing long and short trades in an issuer’s capital structure. We also take tactical index positions, which allows us to express our views on relative value in different areas of the market.
This focus on positive absolute returns has helped us to consistently deliver a measure of downside protection through ARC since its inception, particularly during periods of turbulence. At -0.71%, the strategy’s maximum drawdown is notably low, compared to -9.37% for short-date high yield and -7.07% for corporate bonds (see figure 4).
Figure 4: Low drawdown
Source: Morningstar, Hermes, as at October 2019. High-yield market performance is that of the ICE BofA Merrill Lynch 0-5 Year US High Yield Constrained Total Return USD Hedged Index. Global corporate-bond performance is that of the Bloomberg Barclays Global Aggregate Total Return USD Hedged Index. Past performance is not a reliable guide to future performance.
Ever since Hermes Credit began in 2010, we have championed a flexible approach to fixed-income investing and look for opportunities across the global credit spectrum, targeting attractive returns throughout market cycles while aiming to preserve capital. We think that flexibility is relevant during each turn of the market cycle – but it makes particular sense in today’s volatile, low-yield and end-of-cycle environment.
There are four characteristics of our flexible approach, all of which are evident in ARC:
Allocation: we invest throughout the global liquid credit spectrum and cover all regions, issuers, instruments and ratings. Through ARC, we favour the lower end of the investment-grade market, but the strategy is unconstrained and therefore has the freedom to invest in high-yield bonds and leveraged loans.
Conviction: we search the capital structures of issuers for attractive relative value. Each security must fight for its place in our portfolio – even in ARC, our most diversified strategy, which holds fewer than 150 positions.
Downside protection: By seeking to preserve capital during sell-offs, our defensive options-based strategies can also help us take risk when the opportunities are greatest. In ARC, we employ outright shorts, curve-trade hedging and pair trades to help defend the portfolio’s performance.
True to mandate: Vigilant of our responsibilities, we aim to ensure that ARC does not become subject to style drift and abides by its risk parameters. We offer investors a high level of visibility into the portfolio and maintain sufficient liquidity by investing predominantly in bonds, credit-default swaps and loans.
Figure 5: The four defining features of Hermes' approach to flexible credit
Source: Hermes, as at October 2019.
Across the global economy, accommodative monetary policy is becoming less potent in stimulating growth. Global credit markets are not immune from these trends and fundamentals have deteriorated in some pockets of the market.
This has resulted in higher default rates, led by the energy and basic-materials sectors, which contain cyclical companies that are directly exposed to a slowdown. Default rates should remain below their long-term average of 3% for the rest of 2019, but Moody’s reckons they could rise from 3%-4% by next May.
Yet company behaviour continues to support credit markets, particularly in the higher end of the ratings spectrum. BBB-rated credit, the lower end of the investment-grade segment, was the subject of acute concern this time last year, but considerable de-risking has taken place since.
Taking all this into consideration, and remaining mindful of continued geopolitical uncertainty, we remain sceptical of chasing equity-like risk in credit markets over the next few months – unless valuations justify doing so.
In the current environment, we believe that overpriced sectors should be avoided and will seek to allocate capital to issuers that are well positioned to weather deteriorating economic conditions. In our portfolios, we often use a barbell approach to combine higher-yielding exposures like collaterised-loan obligation mezzanine and emerging-market credit with higher-quality defensive instruments like investment-grade corporates and structured credit.
Given the current steepness of credit curves, we favour lending for longer periods. Fallen angels at the longer end of the curve often trade at very attractive levels in comparison to shorter-dated bonds and can offer good total-return prospects. Negative basis, where the spread of a credit-default swap (CDS) is narrower than that of the bond it is derived from, is generally at extreme levels, making cash more attractive than CDSs in certain capital structures.
Convexity in the high-yield market has worsened in response to stable fundamentals and a supportive technical backdrop, particularly in Europe and non-cyclical sectors. These conditions suggest that investors may wish to consider allocating capital away from securities with negative convexity, primarily callable bonds.
Seeking downside protection is an essential part of our flexible approach to credit investing. We dynamically allocate risk, aiming to protect capital and enhance convexity through options-based strategies like defensive overlays or synthetic exposures to bonds which help us avoid call features. Approximately one third of the ARC portfolio is comprised of bearish credit trades.
ARC also uses dynamic duration management (DDM) to mitigate the impact of any broad-based, material deterioration in credit markets. Correlations change as the contribution of spreads to overall yield evolves, which impacts the portfolio’s interest-rate exposure. We use a proprietary DDM tool that calculates ARC’s suggested hedge on a daily basis by currency and curve exposure, based on current positioning, market environment, shape of the interest-rate curve and correlations.
In ARC, we successfully used downside-protection strategies to our advantage in Q4 2018, when credit markets sold off. The defensive bucket – which includes outright shorts, curve, capital-structure, event-driven and relative-value pair trades – insulated the portfolio from the volatility. This, alongside our large-cap bias, meant we had the liquidity available to capture attractive opportunities in late December and early January, when bond valuations were severely dislocated.
For example, we saw an opportunity to invest in Rothesay and PIC, two investment-grade bulk-annuity providers. These companies had attractive long-term growth prospects, but their bonds were trading below par because of the market turbulence and Brexit-related worries. Because we were able to invest when many others were unable to or too fearful, we gained exposure to the firms’ discounted bonds.
The liquid-credit space has evolved over the past decade as tighter regulations were imposed to strengthen the liquidity buffers of financial institutions. While these reforms were intended to improve the banking industry’s resilience to shocks, they also profoundly changed the structure of the market.
Reduced bank and dealer activity has in turn impacted liquidity, and corporate-bond inventories have shrunk to the lowest level in a decade, as institutions have been forced to lessen the risk on their books. At the same time, the global credit market has mushroomed in response to investors’ long-running demand for yield. But because yields are currently lower, investors are no longer at a liberty to pay a premium for the ability to exit a position quickly.
While liquidity has not completely deserted credit markets, it is in short supply. What remains is pooling in larger issuers with global operations and complex capital structures. Although liquidity has become a flashpoint, our ability to invest throughout the capital structure provides an advantage.
Moreover, ARC – and indeed all our credit strategies – has an up-in-quality and large-cap bias. We seek value in less-leveraged parts of the market and aim to benefit from the generally more diverse ownership bases of large issuers. Nearly 90% of the underlying companies in the ARC portfolio issue equity and the vast majority have a market capitalisation of more than $5bn.
We run stress tests and dynamically manage and monitor our capacity. In addition, our two dedicated fixed-income and currency traders and three additional multi-asset traders have the ability to execute in a range of instruments.
Hermes Credit believes that in order to have the best possible chance of delivering consistent and positive long-term absolute returns, it must accurately price the environmental, social and governance (ESG) risks of individual issuers. Although our research shows that credit risk is the primary driver of spreads, poor ESG behaviour can weaken operating or financial strength.
We have developed our own pricing model to determine the influence of ESG behaviours on credit spreads. By regressing our proprietary quantitative ESG (QESG) scores against the spreads of credit-default swap instruments, we have found a convincing relationship between ESG risk and credit spreads (see figure 6).
Figure 6: The ESG credit curve
Source: Hermes, as at October 2019.
This pricing model helps us screen issuers, as those with higher QESG scores have tighter implied credit spreads than those with lower scores. It also helps us identify mispriced issuers, like those with very high spreads but strong ESG performance.
The ARC portfolio has positions in different regions and sectors, executed through a range of instruments. In order to express the portfolio’s ESG convictions effectively, we assess an issuers’ QESG risk within the context of its sector. In other words, we consider the fact that certain businesses, such as energy producers, are more prone to specific ESG risks due to the nature of the work they undertake.
To do this, we measure how much an issuer’s ESG behaviours will jeopardise or enhance its performance in relation to the sector it sits in. For example, a basic-materials issuer may score lower on environmental behaviours than a consumer-goods company but could perform well relative to its sector peers.
The change in an issuer’s ESG-risk exposure over time is also important. Regardless of the sector, our main priority it to ascertain if an issuer’s ESG score is improving and whether or not it demonstrates an earnest desire to keep improving.
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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.
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