‘Fishermen know the sea is dangerous and the storm terrible, but they never found these dangers sufficient reason for remaining ashore’. So once remarked Vincent Van Gogh, and the same could be said of experienced fixed income investors, as they face an increasingly treacherous juncture for bond markets.
The reality is we are facing the unwinding of the most unprecedented synchronised action by central banks in history. While opportunities exist in both liquid and illiquid credit, investors should be heeded to fit a guardrail, as stormier conditions loom on the horizon. From accessing the illiquidity premium to applying overlays to global liquid credit, Andrew Jackson, Head of Fixed Income at Hermes Investment Management, outlines how to plot a successful course though choppier bond markets.
Harvesting the illiquidity premium in private debt
As we move into the final stage of this economic cycle, accessing the entire spectrum of private debt can enhance portfolio returns, but also provide a rich seam of income. However, investors must be discerning to navigate the approaching headwinds.
By applying a selective approach, private debt can exhibit more defensive characteristics than public debt and is relatively conservatively underwritten. Leverage and operational gearing is also lower. Long-term investors don’t only have to view illiquidity through the prism of risk, but as an additional dimension to the risk-reward dynamic.
By accessing private debt markets, investors are rewarded with enhanced incremental yield or a significant illiquidity premium for holding such assets. The question is: what level of illiquidity premium should an investor demand as compensation? This can be difficult to calibrate, as what looks too good to be true, often is. Investors must tread carefully when accessing high-octane offerings promising double-digit returns. This type of strategy may pay off over a year – but the reality is we are deep in the cycle, and when the music stops, we may see levels of distress in the market.
Focus on quality control in direct lending
Direct lending is a relatively defensive asset class where consultants, institutions and allocators can generate strong streams of uncorrelated diversified income. We view senior-secured direct lending – with strong underwriting, conservative pricing and secure terms – as the most compelling opportunity for yield capture in bearish markets. Indeed, if approached conservatively, the asset class should continue to generate income, even in a downturn.
A successful long-term defensive strategy demands particular expertise. Strong origination is key. For example, through our exclusive co-lending partnership in the UK mid-market, we are provided with a consistent flow of the highest-quality loans. We apply a further selective lens to rigorously filter optimum opportunities. Only a small proportion of loans pass our direct lending screen.
Experience through cycles is also important. A direct lending team must be able to successfully structure, execute and monitor loans. They must forge strong relationships with underlying borrowers; have the capability to undertake detailed credit underwriting; and, if the worst comes to the worst, be in a strong position to renegotiate through restructuring.
The market has provided stable returns close to LIBOR plus 6 per cent since the financial crisis. It is also growing, attracting more institutional investment and benefiting from government initiatives to strengthen the SME sector. These positive fundamentals, combined with the security afforded by senior loans’ position at the top of borrowers’ capital structures and investors' ability to negotiate protective covenants, underpin the enduring appeal of direct lending strategies in a low-yield world.
Applying true alpha tools to manage risk in liquid credit as beta retreats
The recent spike in volatility was reminiscent of the taper tantrum in 2013; it delivered a sobering wake-up call to complacent investors. The impact on government debt, particularly Treasuries, will continue to be felt and it has implications for duration and the shapes of curves in credit land. But this was a technical adjustment and not driven by a fear of rising rates. We are not yet in the frozen depths of bear market winter.
In global liquid credit, fundamentals are still positive and the recent market volatility flare-up did have one positive effect: it has recalibrated the market, opening up some investment opportunities. The pull back in spreads has also brought welcome repricing in debt markets. Being conservatively positioned in liquid markets during a volatile period allowed us to take advantage of price swings to add to existing conviction positions. As part of our investment process, we also regularly take a step back to consider the level of risk in underlying portfolios – as the environment changes, we view portfolio overlays and hedges as more important to our portfolio construction.
In terms of selection, a number of individual securities provide compelling opportunities, particularly in the financial sector, where we are using overlays to manage risk. The market tends to gravitate to consensus positions the longer a cycle goes on, so we prefer to seek non-consensual opportunities today.
As we enter a phase that will see the unwinding of the greatest financial experiment in history, fixed income investors need to tread carefully. Accessing the entire credit spectrum, in both illiquid and liquid markets, can help investors broaden and diversify their sources of stable income. Undertaking an extra layer of risk management on individual security selection can help insulate portfolios against spikes in volatility and a longer term strategic risk management mindset can mitigate, or potentially profit, from the second order correction that is likely to occur when this cycle ends.