Fraser Lundie, Co-Head of Credit at Hermes Investment Management, explains how the 16.8% return of Hermes Multi Strategy Credit since its May 2013 inception has been achieved by implementing the team’s global, unconstrained approach.
Hermes Credit aim to generate strong gains from our best credit ideas while dedicating part of our portfolio to defensive, short-biased strategies to minimise downside risk1. Importantly, our return incurred far less volatility than the global high-yield market in a period characterised by economic and market shocks.
Figure 1. Ahead from the start: Hermes Multi Strategy Credit v the global high-yield market
Inception date: 31 May 2013. Performance as at 31 May 2016, cumulative, in USD and gross of fees. Source: Hermes Credit Team. Benchmark: Merrill Lynch Global High Yield Index (hedged USD).
Past performance is not a reliable indicator of future results and targets are not guaranteed. 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.
Hitting the mark
The aim of Hermes Multi Strategy Credit is to deliver high-yield-like returns with lower volatility throughout market cycles. Seeking this outcome, we combine high-conviction investments with defensive trades by searching throughout the capital structures of issuers worldwide to identify which bonds, derivatives and loans offer superior return prospects or can be used to effectively mitigate risk. Since the launch of the strategy, we have invested throughout the taper tantrum, China slowdown, global high-yield sell-offs and the recent rise in corporate debt defaults to achieve our performance target. Our flexible approach has enabled us to capture opportunities while preserving capital throughout market shocks.
The taper test
In Q2 2013, when the Federal Reserve first indicated that it would reduce quantitative easing after almost five years of running the bond-buying programme, the market’s acute sensitivity to changes in US interest rates became clear. Fear of a rate hike had already caused overcrowding in short-duration bonds, and this strong demand allowed issuers to introduce looser covenants and shorter non-call periods. We were unwilling to accept the consequent risks – high valuations, weaker investor protections and diminished upside – and invested in credit default swaps of the companies instead to gain a similar short-duration exposure. We avoided two-thirds of the drawdown, returning -0.95% compared to the high-yield market’s -2.76%2 in June 2013, the first month that the strategy was live.
Tapping the good oil
In October 2014, oil prices began to fall precipitously after OPEC refused to halt production despite global oversupply. This adverse impact on the US shale market, where many producers were highly leveraged due to higher operational costs, would soon be felt in the high-yield market. Two months before oil prices began to slide, we cautioned that investors should be particularly selective in the North America shale oil and gas market as it featured many entrants with uncertain long-term prospects. We avoided these stressed companies and exploited the breadth of our universe by investing in more mature commodity businesses with proven operations and reserves, and in undervalued but robust oil companies in the politically-beleaguered Russian market.
Figure 2. Smooth delivery: portfolio exhibits less volatility than the high-yield market
Source: Hermes Credit Team as at June 2016.
Avoiding the lows of high yield
In Q4 2015, amid growing certainty that the Fed would raise rates for the first time in almost a decade, liquidity fears spurred a global high-yield sell off that drove the market -0.7% lower for the quarter. It ultimately returned -2.0% by the end of the year3. In the preceding months, we increased our combined investment-grade credit and leveraged loan allocation to 30% of the portfolio, and this exposure to higher quality and more secure assets preserved capital during the drawdown and drove our 1% return for 20154.
Focus on fundamentals
Through intensive bottom-up research, we have executed contrarian trades such as our investments in the global mining sector in Q1 this year, which was still experiencing a cyclical downturn. Anticipating creditor-friendly moves by stronger companies to bolster their balance sheets through cutting dividends, reducing capital expenditure and selling assets, we increased our exposure to the sector from 12.8% to 19.1% between Q3 2015 and Q1 this year5. Among the issuers we invested in were Vale and BHP Billiton, which benefited from strong asset quality and conservative financial policies. In the year to date, our exposure to mining companies contributed 1% to our overall return, showing the benefit of favouring fundamentals instead of prevailing sentiment6.
Our flexible investment approach has driven the strong risk-adjusted returns of Hermes Multi Strategy Credit in its first three years, as evidenced by its Sharpe Ratio of 1.5 per annum for the period, despite macroeconomic and technical market shocks7. Amid the current risks – from Brexit, a potential US rate hike to the political turmoil in Brazil – we continue to find opportunities to generate attractive returns and preserve capital.
- 1 Source: Hermes as at June 2016. Performance shown is gross of fees and on a cumulative basis and denominated in US dollars.
- 2 Source: Hermes as at June 2016.
- 3 Source: Bank of America Merrill Lynch Global High Yield Index as at June 2016.
- 4 Source: Hermes as at June 2016.
- 5 Source: Hermes as at June 2016.
- 6 Source: Hermes as at June 2016.
- 7 Source: Hermes as at June 2016.
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