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% 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 return. 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
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
||Market weight (%)
|BB and above
Source: Hermes as at 31 March 2019.
As already mentioned, the performance of the Fund year-to-date is outstanding, at 11.18% net of fees (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.