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Your Questions Answered: Unconstrained Credit

20 March 2024 |
Active ESG
Our credit team respond to the key questions that are front of mind for investors at the present time.

What is the argument for using a flexible credit solution at a time when government bonds and higher credits are attractive?

There’s a couple of ways to answer that. The first is that I believe it’s just a better reflection of the marketplace that you’re investing in. If you think about it from the point of view of a company, they are competing with other companies regardless of where they happen to be from or what the rating agency happens to think of them. So, naturally, having that level of flexibility on our side would seem to make sense. Similarly, if you’re a CFO, you want to borrow money in as cheap a form as you can, regardless of whether it happens to be long and short and secured, and again, trying to mirror that on our side, I think just gives us the best ability to access companies in the most flexible way.

Government bonds are attractive right now and so are some of the things that are closely attached to them or have high sensitivity to them. That flexibility allows us to be there right now. But who knows where we’re going to be next quarter or next year, and it may or may not be there. Having the ability to move around as the opportunity set moves around, I think is in the best interest of the clients.

You’ve talked about attaching yourself to subordinated parts of the capital structure of investment grade issuers. What is the ‘Goldilocks’ scenario for this positioning?

First, if you go back ten or even 20 years, there wasn’t even this choice. These layers of cap structure have been invented iteratively by the sales side, and they have provided more of an opportunity for us because they give you different ways of accessing a company.

At the moment, so-called subordinated parts of the structure have been hurt in recent years or so by heightened interest rate volatility. In our view, they’re basically paying too much relative to the more senior parts. The reason we like that is because we do have concerns – bigger picture on growth, on the economy. By attaching ourselves to investment grade companies, we are lowering our sensitivity to the underlying economy because they’re that bit stronger. Ordinarily that wouldn’t pay you very much but at the subordinated level right now, we think that’s an opportunity.

We’ve seen high correlation between government bonds and credit, which presumably causes challenges as a credit specialist. How do you think about government bonds in the context of the Strategy?

The correlation between rates and risk assets is something that is extremely important in terms of the overall risk-adjusted return in fixed income – the Sharpe ratio, Sortino ratio, and so on. In the last couple of years, it has been challenging because they’ve been moving one-for-one and most of the time in the wrong way. To me, this is all about the depth and breadth of your toolkit. In some market environments, government bonds will help you, but not in all. So, if you’re looking to protect yourself but are worried about that correlation, having the choice of things like credit indices or even credit index options to be able to diversify the sources of downside protection in different types of market environments, I think is immensely valuable.

It was quite clear in March and April 2020 that having that access to credit options for a short but very fast sell off can be particularly valuable. In other cases, government bonds will help you. And somewhere in between, you might be able to find pockets of the credit market that are particularly susceptible, and you might want to be able to buy protection on those. So, it’s ‘horses for courses’ in terms of downside protection and I think, again, the added flexibility should play out at the end of the day.

Having the ability to move around as the opportunity set moves around, I think is in the best interest of the clients.

The less ESG-friendly parts of the market have ruled the roost in recent times, notably the energy sector. Do you expect this to continue and, if so, how are you positioned to indirectly capitalise?

I don’t think anybody is good at calling commodities. So, from that perspective, oil, natural gas, can go up, down or sideways from here. But what I would say is that the energy sector going back 50-plus years tends to correlate very highly with global GDP, and people have forgotten about that in the last two or three years because the sector has been dominated by Russia, Ukraine, Covid-19, and so on. That to me I think is a bit of a red flag – I’ve heard the term ‘safe haven’ used by some market participants in the US when they refer to the energy sector. To me, the energy sector will always remain a cyclical part of the market, it just hasn’t really been in the last couple of years.

So, while we’re perfectly happy to play in that space, particularly among the more advanced, Paris-aligned companies in terms of their ambition and progress regarding decarbonisation. At the moment there’s just not enough premium, and so while I do think there’s some interesting cyclicality premium elsewhere – in metals, mining, steel, cement, autos – I think energy right now is a sector to be largely avoided.

Cash and money markets have been king in recent times. Why should clients now be looking along the curve?

I think we are getting increased evidence and narrative from developed market central banks that we are at the end of that hiking cycle. In fact, in some areas, you could argue that we’re at the start of the cutting cycle, if you look at things like UK mortgage rates coming down already, ahead of future cuts by the Bank of England. So, from that perspective, there’s a good argument here to see duration as being something of a tailwind. You’re not going to experience that if you’re in cash. Q4 is a good example of this, where as much as it’s nice to be able to clip 3, 4 or 5%, it’s not going to be more than that because it can’t be more than that, there’s no duration to benefit from.

I think, while further out the curve has clearly had a very tough time in the last couple of years, it absolutely deserves part of a broader multi-asset portfolio for all it brings in terms of overall diversification, de correlation and better risk-adjusted return. I think you’re going to see more and more people starting to eke their way out of that current place in the money market space.

How should clients think about the Strategy alongside allocations to government bonds, which are providing attractive yields and favourable tax treatments for clients investing directly?

It’s hard to argue that there’s not an interesting opportunity right now in direct government bonds for certain types of clients. The one thing I would highlight, though, is in the corporate credit space the cash prices of the bonds are very low indeed right now, because we’re coming off the back of two years of rates widening and to some extent resonating as well. They’re low in government bonds as well. But the key difference I wanted to highlight is government bonds don’t get bought back early – you don’t have the Bank of England buying them back.  Whereas corporate CFOs can be much more opportunistic. 

I think there’s an added kicker to the yield that it says on the tin that is likely to play out over the next year or so, where some of that opportunistic early buyback comes through. And the IRR you get from that tends to be, you know, a fair bit higher than the yields. So, it’s not to say that you shouldn’t be in that for those types of investors. But I think there’s a strong argument to do a bit of both.

 For more information on Unconstrained Credit, please click here

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