Search this website. You can use fund codes to locate specific funds

Your Questions Answered by Hermes Multi-Strategy Credit

Your Questions Answered: a quarterly Q&A series featuring the top 10 questions that clients and prospective clients ask our investment teams.

How does Multi-Strategy Credit embody Hermes’ approach to flexible credit? How do we view the credit market at present, and how do we adapt as the credit cycle changes? These are just a couple of the most commonly asked questions about Hermes Multi-Strategy Credit by our clients and prospective investors.

Earlier this month, we sat down with the Credit team as they tackled the most pressing questions about our Multi-Strategy Credit capability.

In the recent past, there has been a profound structural change in debt capital markets and so, credit investors can no longer rely on bonds to deliver strong returns by using only the standard long-only investment approach.

Instead, they need flexible solutions that offer different ways of accessing the markets to optimise their risk-adjusted return. They can achieve this by dynamically investing across the credit spectrum and throughout the capital structures of companies, thereby diversifying their means of identifying opportunities, helping to protect capital and enhancing convexity by investing among cash bonds and derivatives strategies, including credit-default swaps (CDS) and options.

Multi Strategy Credit capability has no official benchmark. We aim to deliver positive performance based on superior security selection, sector and geographical allocation, and by searching for the most attractive debt instruments – bonds, CDS or floating-rate notes – across the capital structures of issuers worldwide that offer the best pay-off profile. In doing so, we provide investors with exposure to our best long-only credit investments, combined with defensive trades – a range of bearish strategies that seek to defend against market volatility and protect our ability to take risk when the opportunities are the greatest.

In addition, our dynamic investment process enables us to respond to changes in the market with greater flexibility . And this approach has not only helped us generate positive returns since the capability’s inception in May 3 (which coincided with the US Federal Reserve’s decision to start tapering its historic asset-purchasing programme) but it has helped us avoid benchmark-related traps and maintain our investment discipline.

Currently, we believe that fundamentals and, importantly, company behaviours continue to support credit markets, especially at the higher end of the ratings spectrum – and that’s despite the fact that accommodative monetary policy is back on the agendas of major central banks (which will likely increase the share of negative-yielding assets beyond the $15bn reported at the time of writing).

Now, more than ever, credit investors need to identify areas of value in the market – and allocate with conviction – while reducing exposure to fully-priced sectors. We currently see good value in emerging markets and corporate hybrids. Within corporate investment-grade and high-yield markets, security selection is increasingly important.

Financial leverage in investment-grade credit has, admittedly, climbed slightly over the year. But highly levered investment-grade corporates are generally using the conditions to their advantage, improving interest-rate coverage ratios by refinancing their debt at a lower cost.

Furthermore, because the cost of refinancing debt should remain low (given the dovish policies among central banks), firms with higher quality credit fundamentals should remain on a sound footing even if their operating cash flow volumes decline modestly.

While a low-growth, low-inflation world is not ideal for high-yield investors, it gives no cause for panic either. Rather, the underlying conditions support our view that investors should not be hunting equity-like credit risk to boost performance in a late-cycle, politically fragile world.

We see better risk-adjusted return potential in investment-grade and the higher rated segment of high-yield credit owing to the slowdown in the global economy. Against this backdrop, we favour credits that are well positioned for macroeconomic weakness and have levers, such as dividend cuts, that can be used to preserve their creditworthiness.

What’s more, with credit curves currently steep, we favour lending for longer to stronger borrowers. This is true in both high yield and investment grade. Negative basis is at the very wides, making cash more attractive than CDS in certain capital structures.

Figure 1. With significant negative basis in the market, we prefer cash over CDS

CDS cash basis

Source: Hermes and Bloomberg as at 13 May 2019.

Convexity in the high-yield market has worsened amid stable fundamentals and a supportive technical backdrop (investor confidence rose in Q2 buoyed by dovish tones from central banks; net supply turned positive in Q2 for the first time since the start of 2018; and credit demand was restrained in Q2 as interest-rate volatility breached multi-year highs). These conditions suggest that high-yield investors increasingly need to allocate capital away from securities demonstrating negative convexity, such as callable bonds.

Figure 2. Convexity in the high-yield market has worsened

Convexity by region (% above call)

Source: BAML as at 30 June 2019.

In addition, corporate bonds rated CCC continued to underperform their expected beta this quarter but remain far from cheap in comparison to B-rated instruments. Despite ongoing spread tightening in the high-yield market, investors should remain wary of lending money to issuers that will struggle in a weaker economic environment.

We view the inverted US yield curve and slowing economic data, the ongoing US-China trade dispute, continued Brexit-related uncertainty and rising geopolitical tensions between the US, UK and Iran as the biggest tail risks.

The liquid credit space has evolved in recent years with the introduction of regulatory reforms that were designed to respond to pre-crisis shortcomings.

In the lead up to the financial crisis, liquidity buffers were inadequate, and many banks excessively relied on short-date wholesale money to fund long term illiquid assets. Afterwards, tighter regulations, such as Basel III, were introduced to strengthen bank resilience to adverse shocks through stronger capital and liquidity requirements. These reforms led to profound changes in market structure, which in turn impacted liquidity, and resulted in a reduction of bank and dealer activity. At the same, the size of the credit market has increased significantly since the financial crisis.

The accommodative monetary policies introduced by central banks supported a good level of liquidity, compensating for the liquidity lost through the reduction in market-making activity driven by a rise in capital charges and lower risk appetites among banks after the crisis.

But while the liquid credit space as evolved in recent years, we have been – and continue to be – structurally at an advantage.  That’s because we focus on investing through the entire capital structure of global, large-cap credit issuers with ample liquidity (focusing on security selection, rather than issuer selection alone, exploits differences in relative value among bonds, loans and derivatives). And as a consequence of the tighter post-crisis regulations, liquidity tends to cluster in large companies as they are more easily hedged and have less concentrated ownership bases.

More than 90% of our underlying positions in our Multi-Strategy Credit strategy issue equity and the vast majority have a market capitalisation of over $1bn.

Managing liquidity risk

When it comes to our Multi-Strategy Credit capability, we take our responsibilities for managing risk and investor outcomes seriously. For example, liquidity is a key point for the Portfolio Review Committee (PRC)1, who in conjunction with our Investment Office, act as an independent portfolio oversight body, monitoring fund positioning, risk and performance. 

In addition to the oversight from the Investment Office and the PRC, we run stress tests and dynamically manage and monitor our capacity. We also have a dedicated trading resource, comprised of five traders who have the ability to trade multiple products.  We believe it is important for Hermes Multi-Strategy Credit to maintain a strong dialogue between execution teams and portfolio managers to keep abreast of the latest technical developments and to challenge assumptions about future liquidity.

Prior to the financial crisis, investors failed to challenge assumptions across many areas of credit markets but their collective unwillingness to question growing liquidity risks was a major oversight.

Just as we score credit and operating risks and valuations, we also price the ESG risks of individual companies – after all, they impact enterprise value and valuations.

We have a unique collection of ESG resources: the responsibility team consults us on policy and integration and develops tools for analysing ESG; we collaborate with our stewardship business Hermes EOS – a large team skilled in face-to-face engagement with corporate executives and directors; and our internal, proprietary quantitative ESG (QESG) scores generated by Hermes Global Equities, which rank each stock worldwide in accordance with its ESG risk.

We developed our own pricing model to capture the influence of ESG factors on credit spreads by using the QESG scores – 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 3). 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 3. The ESG Credit Curve

The relationship between implied CDS spreads and QESG Scores

Source: Hermes, Bloomberg. For illustrative purposes only.

The pricing model is also an informative screening tool. Issuers with higher QESG Scores have tighter implied credit spreads than those with lower QESG Scores, and we can factor this into our analysis of companies. We believe this is associated with the convexity profile of credit spreads and relates to systematic factors.

What’s more, it helps us to identify mispriced issuers based on their ESG characteristics. Investors should be wary about issuers with low credit spreads and a very poor ESG performance and take a second look at those with high spreads but strong ESG performance.

As with all other scores, we also attempt to price ESG risks on an outright and nominal basis. For example, if we had a choice between two names at similar spread levels but of varying ESG quality, we would choose the one with the better ESG scores.

In addition to the pricing of ESG risks, our ESG analysis is integrated into our investment decisions – and that means we either exclude an issuer or we invest and engage.

If an issuer’s name appears on our exclusion list, we eliminate it from the investment universe. But if it doesn’t, we include it in the investment universe and analyse factors to understand how much the company’s behaviours jeopardise or enhance a company’s enterprise value.

Figure 4. ESG analysis: exclude, or invest and engage

Source: Hermes as at September 2019.

In addition, we also capture ESG trends – that is, we look at whether or not a company’s ESG behaviours are improving and if it demonstrates an earnest desire to improve. In this way, companies that optically score poorly on retrospective ESG metrics could be investment opportunities.

We have long embraced the concept of ‘flexible credit’ – and such an approach will always make sense in our view, but in today’s perverse market where investors face the challenge of negative yields, it is particularly pertinent.

The Multi-Strategy Credit capability demonstrates our flexible ethos in four ways:

  • Allocation: the strategy is unconstrained and so, it invests globally across credit sectors, industries, ratings and liquidity profiles throughout market cycles.
  • Conviction: Through high-conviction, relative-value investing throughout the capital structures of issuers worldwide, we seek to generate strong capital returns and an attractive level of income in all market conditions. We provide investors with our best long-only investments in corporate bonds and derivatives comprising two-thirds of the portfolio. In addition, our proprietary ESG analysis and company engagements strengthen our views.
  • Downside protection: By preserving capital during market sell-offs, defensive options strategies also help to protect our ability to take risk when the opportunities are greatest. A third of the portfolio is comprised of a collection of trades that in their totality have a bearish bias. Our dynamic management of rates and credit duration also aims to safeguard our portfolios.
  • True to mandate: Vigilant of our commitments and responsibilities to investors, we aim to prevent style drift and abide by our agreed risk parameters.

 Figure 5. Our flexible credit ethos

Source: Hermes as at September 2019.

An all-weather solution

Since we launched the strategy six years ago, we have successfully navigated periods of tumult thanks to our flexible approach to credit. These challenging periods included the 2013 taper tantrum, the bund market shock, the China slowdown in 2015, monetary policy normalisation by the US Federal Reserve, and periods of geopolitical uncertainty, such as the Brexit vote, the election of Donald Trump as US President and, more recently, US-China trade tensions.

During this time, there have also been more typical sell offs, like the 2014-2015 oil-price slide and the contagion into the US high-yield market. Again, we were able to preserve capital by leaning on some of the defensive trades that we had at the end in the low end of the US market. Importantly, this also enabled us to capture upside when opportunities arose.

Figure 6. The bund shock: downside protection in times of market stress

Past performance is not a reliable indicator of future returns.  Inception date: 31 May 2013.  Performance as at 30 June 2019 in USD, gross of fees. Source: Hermes Credit Team and Bloomberg. Performance over the rate drop between April 2016 and September 2016.

When credit markets slumped in Q4 2018, the defensive bucket – which includes outright short, curve, capital-structure, event-driven and relative-value pair trades – defended the portfolio. This, alongside our large-cap bias, meant we had the liquidity available to be able to capture attractive opportunities in late December and early January when bond valuations were severely dislocated.

This demonstrates how global, high-conviction, long-only positions combined with defensive trades can help to generate outperformance while minimising risk. Indeed, our dynamic approach gives us the ability to respond to market changes with greater flexibility and security.

In addition, our concentrated portfolio which comprises the most attractive instruments across the capital structures of issuers worldwide maximises the potential for outperformance. Such a high level of conviction is quite rare in this market.

As we’ve already mentioned, one of the key pillars of our approach to flexible credit is downside protection. We dynamically allocate risk as we understand that a long-only exposure to bonds cannot continue to deliver the strong returns of recent years. For that reason, we aim to protect capital and enhance convexity through options-based strategies, such as defensive overlays and synthetic exposures to otherwise callable bonds. Approximately a third of our portfolio is comprised of bearish credit trades at both single name- and index-level.

Another way in which we aim to preserve capital is through our ability to access a broad spectrum of liquid credit. This allows us to leverage our credit view across all debt instruments, gives us the ability to diversify our sources of alpha generation, and respond to changes in the market. We exploit relative value through high-conviction name- and security-selection.  We also believe in active management predicated upon bottom-up, fundamental stock picking within a top-down framework. The discipline of assessing and pricing credit, ESG and liquidity risks is deeply ingrained in our investment process.

Our dynamic management of rates and credit duration also aims to safeguard the Multi-Strategy Credit portfolio during major drawdowns (for more information on duration see Q8).

In addition, we seek a comprehensive view of risk, focusing on security-specific metrics, such as the default risk of an issuer, to portfolio-wide measures, such as overall duration.

We have been concerned for several years about the point when monetary authorities admit defeat on their string-pushing strategies and bring out the traditional rate-tightening artillery.

But, if anything, we seem further away from the point of reckoning than we were at the start of the year. That is why markets find themselves in such unusual territory. In our Economic Outlook published earlier this year, we considered how an abundance of cheap money is leading to the ‘Japanification’ of the world economy.

In the fixed-income space, the technical onslaught of this vast and sustained injection of liquidity is nigh on impossible to fight. We’ve seen further evidence of this in recent short squeezes and the ease with which syndicate desks are closing deals that would have been borderline even 12 months ago.

None of this is new or particularly insightful. But at times like this it is worth contemplating a few home truths:

  • Central banks do not inject vast amounts of liquidity into markets and inflate their balance sheets to historically high levels when everything is fine;
  • $14trn worth of assets don’t have a negative yield in most market conditions;
  • Investors will be very hard-pressed to find a yield above 1% from European investment-grade corporate bonds. Less than 4% of all investment-grade corporate bonds trade with a yield greater than 2% and more than 28% trade with a negative yield.

But there are some strategic opportunities as these forces gather. Here are a few rather less-negative thoughts:  

  • Credit markets are certainly not poor value relative to other asset classes, despite being closest to the assets that are being hoovered up by central banks. US equity markets, for example, continue to regularly touch new highs, while credit looks cheap versus cash on a multi-year basis;
  • In keeping with the ‘bad is good’ theme, it would appear there is a very low probability of this grand monetary experiment slowing down anytime soon – in fact, we may see an acceleration of rate cuts before we see a concerted slowdown;
  • There are still signs of good lender discipline in a number of credit market sectors, suggesting the rally has not yet arrived at the ‘get back in there at once and sell’ stage.

One of the obvious effects of central bank activity through zero interest-rate policy (ZIRP) and quantitative easing (QE) has been to drag the yield and credit spreads of fixed-income assets tighter. Currently, almost 40% of European covered bonds trade at a more negative yield than the European Central Bank’s deposit rate. Recently, we have seen a raft of headlines highlighting the slew of ‘high yield’ European bonds trading with a negative rate.

Notably, some of the bonds quoted as generating a negative yield do so only because of the nature of the instruments (most being callable). However, a few do appear to fit the description.

Some discipline remains in the ranks

But fear-mongering commentators are probably overstating the extent of market distortion caused by the influx of loose credit.

Indeed, there are some companies for which even the central-bank gravitational pull – now at almost black-hole conditions – is not enough to tighten their credit spreads. These firms exist at the outer limits of the credit universe and tend to have either incredibly high levels of leverage, inhabit a sector that is undergoing major stress, or have an idiosyncratic story that makes them almost un-investable (in Europe, several in the latter category are based in the UK).

Quite possibly, many of the companies that lie outside the influence of central banks could soon escape the atmosphere, perhaps floating off into space to be salvaged by distressed-debt funds.

We have seen an increasing number of these names hurtling towards credit events where recoveries have been well below historical averages. In our view, the rising number of corporate failures is a strong sign that investor discipline is still alive and well; a similar story explains the performance of CCC-rated credits in the US this year.

In the European investment-grade space, the credit-correction effect is slightly less pronounced but, nonetheless, remains apparent with a very small number of corporate bonds generating a disproportionately large amount of the total average yield.

The average yield of European investment grade corporates is approximately 0.4%. Removing the highest yielding 1.3% of that index would leave the average yield as a negative number (see figure 7).

Figure 7. Dispersion of European investment-grade corporate-bond yields

Source: Hermes and Bloomberg as at August 2019.

Overall, our top-down view is that most markets appear rather expensive. We also worry about the perception that ‘bad is good’ and the recent actions of central banks.

We dynamically manage duration – both rates duration (a measure of interest-rate risk) and credit duration. 

Our flexible, global credit approach allows for multiple lines of defence. It allows the team to rotate out of regions that it considers to be overvalued, thereby exploiting valuation anomalies across currencies, debt instruments and through the capital structures of issuers worldwide.

Since inception, we have dedicated a third of our portfolio to defensive strategies, which include outright short, curve and capital structure trades (as we mentioned already) – and which seek to limit risk.

Every day, we review our portfolio hedges using a proprietary dynamic duration-management tool that calculates the suggested hedge by currency and part of the curve based on current positioning, market environment, shape of the interest rates curve and correlations. We subsequently review the results and adjust the hedge as appropriate.

Overall, we have benefitted from the income characteristic of duration risk and, at the same, we have been able to successfully manage the downside in times of duration pain, including the 2013 taper tantrum, the bund market shock, the China slowdown in 2015 and the election of Donald Trump as US President as we’ve already mentioned (see question five for more information).

Against a backdrop of a growing stock of global negative-yielding debt (it recently reached $16tn) and as central banks scramble to react to a slowing economy, we believe yield will remain scarce. 

We do not target investments primarily for yield reasons. That said, our strategy offers a powerful yield enhancement in comparison to traditional portfolios. That’s because attractive yields can be best gained by dynamically investing across the credit spectrum and capital structure. What’s more, our tactical use of long-only and market-neutral trades provides more opportunities to seek strong risk-adjusted returns through the cycle.

As a consequence of our focus on security selection, our flexible approach delivers a strategy with a consistently optimised yield profile without having to target low-quality companies to boost yield. The current portfolio yield2 is 4.93% relative to its average yield since inception of 5.22%. The yield for the portfolio since inception has ranged from a low of 3.70% to a high of 6.62%.

Since the launch of our Multi-Strategy Credit capability in May 2013, the strategy’s flexibility has enabled us to deliver on our mandate – that is, to generate strong capital returns and an attractive level of income through the cycle – despite experiencing a number of challenging periods. Examples of periods of tumult included:

  • The taper test (2013): In Q2 2013, when the Fed 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 companies instead to gain a similar short-duration exposure.
  • Tapping the good oil (2014): 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 credit 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.
  • Fundamental focus (2016): Through intensive bottom-up research, we executed contrarian trades such as our investments in the global mining sector in early 2016, which was still experiencing a cyclical downturn. Anticipating creditor-friendly moves by stronger companies to bolster their balance sheets by cutting dividends, reducing capital expenditure and selling assets, we increased our exposure to the sector. Throughout 2016, our exposure to mining companies contributed strongly to our overall return, showing the benefit of favouring fundamentals instead of prevailing sentiment.

It was our dynamic investment approach that enabled us to respond to these changes in the market with greater flexibility and express our conviction. As a result, we have enjoyed an impressive track record through market cycles since inception.

Figure 8. Relative strategy performance since inception

8a. Performance analysis by ratings

Past performance is not a reliable indicator of future returns. Inception date: 31 May 2013. Performance as at 30 June 2019 in USD, gross of fees. Source: Hermes Credit Team. The figure at the top of the columns is the sum of the positive and negative contributions.

8b. Performance analysis by geography

Past performance is not a reliable indicator of future returns. Inception date: 31 May 2013. Performance as at 30 June 2019 in USD, gross of fees. Source: Hermes Credit Team. The figure at the top of the columns is the sum of the positive and negative contributions.

Figure 9. Hermes Multi-Strategy Credit has generated attractive returns since inception  

Rolling year performance (%)

  30/06/18 to 30/06/19 30/06/17 to 30/06/18 30/06/16 to 30/06/17 30/06/15 to 30/06/16 30/06/14 to 30/06/15
Multi-Strategy Credit 7.78 1.10 9.43 2.35 1.79

Past performance is not a reliable indicator of future returns. Inception date: 31 May 2013. Performance as at 30 June 2019 in USD, gross of fees. Source: Hermes Credit Team.

  1. 1The Portfolio Review Committee comprises the Head of Investment, Head of Investment Risk, Head of Performance, Head of Risk, Head of Trading and Strategic Risk and Compliance Director.
  2. 2Note: Past performance is not a reliable indicator of future results.
Risk profile
  • Past performance is not a reliable indicator of future results.
  • 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.
  • Targets cannot be guaranteed.
  • It should be noted that any investments overseas may be affected by currency exchange rates.
  • This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
  • Where the strategy invests in debt instruments (such as bonds) there is a risk that the entity who issues the contract will not be able to repay the debt or to pay the interest on the debt. If this happens then the value of the strategy may vary sharply and may result in loss. The strategy makes extensive use of Financial Derivative Instruments (FDIs), the value of which depends on the performance of an underlying asset. Small changes in the price of that asset may cause larger changes in the value of the FDIs, increasing either potential gain or loss.

More Insights

Views from the credit desk: Bullish and Bearish Cases
In our latest Credit Pulse we consider the case for bullishness and bearishness about corporate conditions and the global economy, and suggest ways that credit investors can act on either sentiment.
Looking below the surface: 360°, Q2 2021
What is our current view of fixed income markets? And where do we see the best relative value?
The Circular
The Circular cuts to the heart of the issues that matter in the second ESG quarterly update for 2021...