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How does Unconstrained Credit differ from other flexible credit solutions? How much/little risk do we take? Why do we use options? These are just a couple of the most commonly asked questions about our Unconstrained Credit strategy by our clients and prospective investors.
Earlier this month, we sat down with our Fixed Income team as they tackled the most pressing questions about our Unconstrained Credit capability.
With a combined experience of over 40 years, the strategy’s portfolio managers Andrew Jackson, Head of Fixed Income, and Fraser Lundie, Head of Credit, have managed a spectrum of funds during downturns and crises. Together, their vast experience alongside the diversity of our fixed income team acts as a key differentiator, enabling us to offer investors a dynamic credit-allocation solution that captures value from credit markets as investment conditions change and targets a gross return of the risk-free rate plus 5-6% per annum1. Although our specialist portfolio managers (such as EM, loans and ABS) and credit analysts provide views and trade ideas, final investment decisions and portfolio implementation are made by Lundie and Jackson.
Other notable differentiators include:
Bottom-up skill: through fundamental credit analysis, we identify issuers that drive returns in each credit market before searching their capital structures for the most attractive instruments.
Top-down oversight: we apply expertise from across the credit spectrum as well as insight from other asset classes. The Multi-Asset Credit Investment Committee (MACIC) drives our appetite for risk, steers the strategic asset allocation across credit classes based on their relative value, and determines what hedges are appropriate for the prevailing market environment.
Full spectrum: unrestricted by security type or geographical silos, we seek to exploit opportunities in developed and emerging markets for investment grade and high-yield corporate bonds, credit default swaps, loans, asset-backed securities and government securities.
Our best ideas: the strategy selects from our team’s best long-only credit ideas, which, combined with a dynamic asset allocation framework, offers the potential to enhance our team’s ability to achieve positive absolute returns through the cycle.
Downside defence: optimal convexity is achieved by a dynamic options overlay that aims to provide a measure of protection against large market and macro risks and acts as a hedge for our high-conviction credit strategy in times of market disruption. There will be instances where this approach is complemented by very material increases or reductions in risk on the long side as dictated by our risk appetite. This combination enables the strategy to manage through periods of stress to capture opportunities and significantly dampen volatility and has been instrumental in driving performance to date.
ESG advantage: we price ESG risks within fundamental credit selection combined with market-leading company engagement alongside our stewardship services team, EOS at Federated Hermes.
Structured with independent risk management: we operate with the flexibility of a boutique, while enjoying the support and resources of a major asset management firm, including independent risk oversight provided by the Federated Hermes Investment Office.
Our Unconstrained Credit strategy enables investors to outsource their credit allocation to our trusted and vastly
experienced managers Andrew Jackson, Head of Fixed Income, and Fraser Lundie, CFA, Head of Credit. As well as deciding on the best credit segments and individual securities to invest in, they also decide how much credit risk to take on through both the strategy’s best long ideas and the derivative overlay. With over four decades of experience combined, Jackson and Lundie have managed credit risk in all its forms, having managed a spectrum of credit funds (including but not limited to absolute return and benchmark tracking funds) through a number of crises. Together, their combined skillset and vast experience offers a dynamic solution for investors seeking to outsource their full credit exposure or enhance their traditional fixed income allocations.
The strategy necessitates increasing or decreasing risk appetite within the prevailing market environment as Jackson and Lundie have demonstrated by delivering annualised returns of 9.83% since the strategy’s
inception(2). Overall risk appetite is governed by the monthly Multi Asset Credit Investment Committee (MACIC), chaired by Andrew Jackson. The MACIC seeks to garner input from all aspects of the fixed income universe and outside fixed income with the aim of delivering an appetite for risk that is in tune with risks
in the economy and markets at large.
The primary outputs of MACIC are: 1) to overall assess risk appetite (both gross and net); 2) determine the need for (and value of) tail risk hedges; 3) provide top-down guidance on asset allocation primarily validating overall risk positioning.
A key input into this meeting is the bi-monthly Credit Strategy Meeting (CSM) which provides a forward-looking overall score for credit risk appetite (through a numeric and documented consistent process that evaluates macro,
fundamentals, credit quality, sentiment, technical and tail risk). In addition, the CSM drives the broad sector positioning of the portfolio’s credit allocation (geography, credit quality and curve positioning) and, within these broad sectors, which specific industries the team favours. The team also holds relative-value meetings to affirm sector valuation views, which play an important role in issuer and security-selection decisions from a bottom-up perspective.
Since we launched our strategy, there have been times when we have taken more risk than would have been achieved through an investment into a Global High Yield index and on other occasions significantly less. Our Unconstrained Credit offering is designed to capture value within markets and, as such, it is likely to take less risk during periods where spreads are very tight. This approach, along with the options overlay and the dynamic risk appetite management, have been the primary reasons for our strong performance through some of the most turbulent periods of the last three years, including the coronavirus crisis (see question three and four for more
information about how we fared during these periods).
Figure 1. Historical Strategy Duration Times Spread (DTS) by Overall CSM Score
Source: Federated Hermes
Figure 2. Unconstrained Credit Strategy: Rolling performance (%)
Past performance is not a reliable indicator of future returns.
1 Performance shown is the strategy in USD gross of fees. Subscription and redemption fees are not included in the performance figures. Data is supplementary to GIPS® compliant information at the end of the document. Source: Federated Hermes, as at 30 June 2021.
We make use of a dynamic derivative overlay made up of credit default swap (CDS) index and options that enables us to tactically adjust the risk profile of the portfolio for the prevailing market environment. In term of options, we buy out-of-the-money payer options in order to profit if credit spreads widen significantly from a market sell-off. The size and composition of the hedges employed will vary depending on the team’s risk appetite and the risk exposure of the long book. This provides us with an effective hedge, with losses limited to the upfront cost of the option.
Figure 3. Portfolio allocation: exposures since inception
Source: Federated Hermes, as at May 2021
We believe that this process of incorporating options into the Unconstrained Credit strategy is essential to outperforming in both bull and bear markets.
Since the strategy’s inception, the use of options within the derivative overlay has helped provide a level of downside protection and enabled us to have higher conviction in our credit selection and maintain risk during market sell-offs. This means we can participate in rebounds as markets rally, and avoid having to sell bonds at the worst time. This was well demonstrated during the Q4 2018 sell-off, when our options protection gave us the confidence to maintain a higher DTS exposure3 and, in turn, benefited us in Q1 2019 when a v-shaped recovery occurred (see Figure 4).
Figure 4. The options overlay was instrumental in the success of the strategy during the Q4 2018 sell-off
Source: Federated Hermes, as at 30 June 2019.
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.
The team’s view at the time was that the sell-off in Q4 2018 did not reflect the fundamentals in the market, and a sharp recovery in spreads would likely occur once sentiment turned. Here the inclusion of the options in the portfolio gave the portfolio managers comfort in materially increasing the risk on the long side into the sell-off, 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.
In advance of the crisis, our view had been that markets offered little value and, as a result, we entered the crisis with less risk than at any time since the launch of the strategy. From 24 February and into March 2020, credit markets sold off heavily as a dispute over oil production between Russia and Saudi Arabia rattled investors fearing a coronavirus-driven global recession. During this time, we actively adjusted the options overlay as the market moved downwards. This enabled us to take profit on positions and ensure that our Unconstrained Credit strategy remained protected should the market continue to sell off.
As risk increased at the end of February, our team quickly scaled up options exposure – reaching a peak of 147% of net asset value (NAV) in notional terms on 3 March 2020.
Figure 5. Scaling-up our options exposure in response to Covid-19
Source: Federated Hermes, Bloomberg, as at 31 March 2020.
Figure 6. Options overlay: seeking downside protection through the sell off
Average strike of European options v iTraxx Crossover level
Past performance is not a reliable indicator of future returns.
Source: Federated Hermes, Bloomberg, as at 31 March 2020. Performance shown of Hermes Unconstrained Credit Strategy in USD, gross of fees. Xover level represents the level of the IHS Markit iTraxx Crossover CDS index. Hedge PnL represents the aggregate performance of the options book and index hedges within the strategy, including but not limited to contracts on the iTraxx Crossover index. Please refer to Figure 1 for the rolling performance of the Unconstrained Credit Strategy.
By actively managing the options book during this period of tumult, this enabled us to crystallise option profit and loss, while at the same time maintaining convexity and protection. The total contribution of options to the performance of our Unconstrained Credit Strategy from 24 February to 31 March was 9.35% – this compares to the Global High Yield index which fell by 14.38%4 (Note: the Unconstrained Credit Strategy does not have a benchmark; the comparison demonstrates the return that would have been achieved by investing into a Global High Yield benchmark during this time).
Figure 7. Cumulative performance of Long book v overlay
Source: Federated Hermes, Bloomberg, as at 31 May 2021.
With bonds having enjoyed a significant bull run over the last few decades, leaving global interest rates near record lows, duration risks plus the spectre of rising inflation are at the top of many investors’ minds. Our unconstrained approach to credit investing means we have many levers we can pull to manage these risks within the portfolio, and generally we look to manage duration to within 2 to 6 years, depending on our view.
Firstly, our freedom to allocate between high yield and investment grade gives us the ability to look to more spread driven parts of the market when we see fit. From a sector perspective we can look for opportunities in areas of the market that may benefit from rising interest rates or inflation, such as financials and metals and mining. We also have the ability to look to floating rate instruments such as bank loans or Asset Backed Securities where we have a specialist team searching for the best opportunities in European structured finance. In terms of security selection, where it makes sense to do so, we are also able to hold Credit Default Swaps instead of cash bonds, further reducing the portfolio’s exposure to interest rates given CDS only represent pure credit risk.
Finally, on a macro level we manage the overall fund duration using interest rate futures.
Figure 8 documents the liquidity profile of the portfolio. For example, 33.70% can be liquidated in one day, 56.24% on day two and 98.11% by day 10.
Figure 8. The liquidity profile of the portfolio
Source: Federated Hermes, as at May 2021. Note: this analysis excludes the structured credit portion of the portfolio (circa 8%).
In addition, normal waterfall is based on mitigating any deviation from normal market impact when trading, and so assumes 25% of a security’s average daily trading volume (ADTV). As such, the securities that take longer to sell are a result of our holding size rather than being illiquid in nature.
Our Unconstrained Credit strategy aims to generate capital growth and a high level of income over time. To achieve this, we adopt an unconstrained, high-conviction approach to investing across the global liquid credit spectrum, with the goal of capturing superior relative value as investment conditions change through instruments such as developed and emerging market investment grade and high yield corporate bonds, loans, government securities, asset-backed securities, convertible bonds, preferred stocks, credit default swaps, credit index options, interest rate instruments and other credit derivatives.
Based on the top down views of the desk, the team dynamically assess how much and what type of risk to take.
In managing this, the strategy also incorporates a dynamic derivative overlay, which aims to provide a defensive hedge against down markets, while also performing rebalancing and risk management functions. We believe that this process is essential to outperforming in both bull and bear markets.
In addition, the prior experience of our team underlies its confidence in investing across traditional and alternative credit classes through the entire capital structure. The team’s diversity in terms of specialist portfolio managers (such as emerging markets, loans and ABS) and credit analysts provides the lead portfolio managers with views and trade ideas that can be leveraged across credit strategies and products.
Because we believe that non-fundamental factors are inexorably linked to credit risk, we integrate ESG factors into our investment decisions and analysts assign ESG scores to all credits covered. Our ESG assessment focuses on the impact that issuers’ ESG policies and behaviours have on cash flows and, thus, enterprise value. To generate our ESG scores of 1-5, our analysis draws upon both internal and external sources. Our ability to assess and price ESG risks is enhanced by the significant resources within the broader Federated Hermes International business. In addition to the team’s ESG score, issuers that are taken through credit committee are reviewed against the criteria of the team’s proprietary sustainability scores, including sustainable development goals, Climate Change Impact and Sustainability Leaders.
These scores are owned by the Sustainable Fixed Income team (SFI) and can provide further insight to the portfolio managers about the sustainable characteristics of a company when making investment decisions.
Engagement efforts led by our in-house stewardship team EOS and SFI engagers are a critical element of the team’s integration of ESG considerations into our investment process. Credit analysts work closely with engagers; share views and opinions; and attend company meetings together with engagers. This allows the analysts to develop a much better real-time understanding of management’s thinking, culture and processes around sustainable business practices as well provides an opportunity to encourage further progress, improvements and pursuit of best practices. The credit team believes that improved ESG behaviours ultimately lead to lower risks and volatility and thus better investment decisions. The credit team also uses Federated Hermes International proprietary quantitative ESG (QESG) scores as one of several inputs into our analysis. The QESG scores combine internal analysis with external sources, such as Sustainalytics, MSCI and Trucost to score company’s behaviours on a scale from 1 to a 100. FHI’s firmwide proprietary ESG dashboard is also integrated into our ESG assessments. In addition, analysts have access to proprietary firmwide Carbon Tool allowing them to assess company’s carbon footprint and Climate Change Database developed by the SFI team, allowing access to climate and sustainability-related information of the credit universe. These proprietary tools allow for sophisticated comparison of companies against peers and sectors with respect to a range of ESG considerations.
Drawing on the QESG scores, we developed our own pricing model to capture the influence of ESG factors on credit spreads – as they provided a numeric value to represent ESG risks (for many years, we had assessed these qualitatively). By regressing these values against the spreads of credit default swaps (CDS) instruments – which provide the purest reflection of credit risk – we were able to determine the nature and strength of the relationship between the ESG risks captured by the QESG scores and credit spreads. Our analysis showed a convincing relationship between ESG risk and credit spreads, manifesting as an ESG-risk curve (see figure 9). This enables us to calculate the marginal price for ESG risks of companies and anticipate the change in valuations as a company moves along the ESG Credit Curve.
Figure 9. ESG risk pricing model: implied CDS spreads and corresponding QESG scores, 2012-202
Source: Federated Hermes, as at 31 December 2020. Note: The QESG Scores, generated by our Global Equities at the international business of Federated Hermes, rank each stock worldwide in accordance with its ESG risk.
There is no doubt that our approach to sustainable investment within Fixed Income will continue to evolve, as will our approach within the strategy. Federated Hermes remains at the vanguard of engagement, ESG analysis and responsible investment. We expect that as companies and governments improve disclosure, measurement and awareness this will continue to grow as an input to our management approach.
Having enjoyed one of the most successful launches that the international business of Federated Hermes has ever seen, we believe the strategy is a good complement to other flexible strategies because it offers investors a dynamic, high conviction exposure to global credit alpha, that aim to protect in down markets whilst also outperforming in a market rally. Unlike other strategic bond funds, we use credit index options to provide a level of downside protection rather than government bonds. The incorporation of options within our dynamic derivative overlay acts like a form of insurance, helping mitigate risks within the prevailing market environment by providing cover for our bottom-up, high-conviction positions against adverse market moves. We see this as being a highly effective tool for providing downside protection for our portfolio, especially considering the current market environment of low government bond yields. What’s more, we have managed to deliver our target return since inception (see question 10 for performance information) during which time markets have experienced two of the most volatile periods in the last decade.
Past performance is not a reliable indicator of future returns.
We launched our strategy in July 2018, communicating our aim to deliver a gross return target of the risk-free rate plus 5-6% per annum through the cycle. Unsurprisingly, many investors were keen to hear how our strategy would be able to achieve this target return considering how tight spreads were at the time and the potential cost of the options overlay that the strategy uses. Several of the potential scenarios that we used at the time as examples to show how the strategy could prosper in various conditions have in fact played out: indeed, since we launched our strategy, markets have experienced two of the most volatile periods in the last decade and the strategy has comfortably delivered its return target.
Targets cannot be guaranteed.
In 2020 we were able to take profits on our options positions as markets sold off in Q1, leaving us in a strong position to generate returns as the market recovered. We continue to see plenty of opportunities for alpha within credit markets and have options in place to provide a level of protection should the unexpected occur. Because of this we remain confident in our ability to deliver on our objective going forward, despite low market yields. Indeed, our strategy has outperformed the average performance for the global unconstrained fixed income universe (see figure 11).
Figure 10. Our Unconstrained Credit Strategy has generated annualised returns of 9.8% since inception
Past performance is not a indicator of future returns.
Data is supplemental to the the GIPS® compliant information that follows. 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. Any investment overseas may be affected by currency exchange rates. 1 Cumulative return since strategy’s inception in USD. Inception date: 1 July 2018. Performance as at 30 April 2021 in USD, gross of fees. Source: Northern Trust.
Figure 11. Unconstrained Credit Strategy performance: one-year v peers
Past performance is not a reliable indicator of future returns.
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1Hermes Unconstrained Credit Strategy does not have a benchmark for performance purposes. The risk-free rate – currently Libor – is given for illustrative purposes only.
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