Fraser Lundie, Co-head of Credit at Hermes Investment Management, explains why security selection is a crucial element of his investment approach.
We look at credit in a different way to the majority of our peer group. Within the credit world, there is a sense that if you get the company right and avoid default you will have done your job as a bond investor. While this is a neat premise, we believe it is a gross oversimplification of the asset class.
By only focusing on the quality of a company you have only dealt with the equity risk – not the fixed income risk. You haven’t tackled convexity, duration, illiquidity or volatility by getting the company right.
For us, it is crucial to drill down deeper and get the security right within the company. Hence, we will do our bottom-up analysis like everybody else, but as important for us is - what is the most appropriate risk-adjusted way of accessing that company’s risk? Is it through bonds, loan or CDS. Is it through dollars, euros or sterling? Is it through 3-year, ten-year or 30-year issues? By emphasizing this part of the decision making process, we think investors can mitigate the fixed income risk attached to the company.
For example, if we look at the gold sector, we prefer issuers that are positioned lower on the cost curve, are less exposed to geopolitical risk and have demonstrated a strong track record amid lower gold prices. Taking these factors into account, we believe Barrick Gold is the most attractive opportunity in the sector.
However, when we analyse a company, we like to apply a different lens and look at the capital structure from a bondholder’s perspective. In the case of Barrick Gold, it is attractive due to its liquid capital structure which includes a CDS contract. We think that shorter maturities are expensive, given the market expectation that they will be redeemed at some point in near future. The very long end looks expensive as well. So instead we like CDS due to the limited debt owing between now and the current five-year CDS expiry date, and Barrick’s strategy to buyback short-end bonds to lower interest expense and gross debt.
Furthermore, Barrick has engaged in activities which favour bondholders over shareholders, a tendency which should prove helpful in preserving value for lenders in volatile times: it has a history of raising equity, tendering for bonds and selling assets to reduce debt.
Taking this approach requires a wide mandate. The reality is that many portfolios do not allow the breadth of flexibility required if an investor wants to find different ways of accessing the capital structure. It also means having the ability to invest across geographies and across the yield curve. It is this unconstrained and flexible philosophy that we employ across our absolute return, global high yield and multi strategy credit vehicles.
The need for flexibility is vital at a time where a lot of money is trapped in narrow mandates. This is exacerbated by our point in history: a post-financial crisis world where valuation and liquidity have had profound structural changes. We now live in world where so much of mispricing in credit is down to other people’s inflexibility: the relative value between loans and bonds or CDS and bonds, or euros and dollars, or between Europe and US.
When you ask deeper questions you often find you need unforeseen flexibility. We have always believed in unconstrained investing and don’t believe you can optimise fixed income credit investing by taking a narrow approach.
The above information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments. Stock names were chosen for illustrative purposes and are in no way a recommendation to purchase. Past performance is not a reliable indicator of future results.
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