The devil is in the credit details, Interview

THE DEVIL IS IN THE CREDIT DETAILS

‘European credit markets still remain attractive, offering long-term value while taking into account default risk and potential losses.’ Marc Rovers, Head of Euro Credit at Legal & General Investment Management, answers a number of questions related to European credit markets.

WHAT HAVE BEEN THE MAIN PERFORMANCE DRIVERS THIS YEAR?

‘Identifying a single performance driver is difficult since our portfolio has changed many times over the past couple of years, mainly driven by economic and monetary conditions. The year 2020 has obviously been a real roller-coaster for the credit markets with the COVID-19 pandemic. We’ve navigated the storm through employing a dynamic combination of top-down and bottom-up research.

Being defensively overweight in utilities has helped this year as the strong market conditions in January, which weakened through February, were followed by the sell-off in March as the pandemic hit Europe. Since the second quarter, we have become more positive on the back of low valuations and historic levels of monetary and fiscal support. Furthermore, companies have been issuing large amounts of debt to ensure sufficient liquidity and their survival. We used this opportunity to add risk, including companies that may have been impacted by the pandemic but which we believe will come out the other side, at the same time hopefully avoiding names that may not survive the crisis.

Looking further back, 2018 started out positively, but as the year progressed we became increasingly concerned about valuations. The opposite was true of 2019, with the year starting weak and then turning bullish. As a result we increased beta and ran long on hybrids, which contributed to our performance, but not everything worked out and being overweight in utilities detracted from returns last year.’

WHICH POSITIONS HAVE PROVED BENEFICIAL?

‘Higher conviction investment ideas in certain sectors, or names, often work well. For example, we’ve successfully navigated the automotive sector on the back of good analyst coverage, trying to identify the winners and losers and adding those that we believe will remain investment grade.

Within financials, some of our long term holdings are select Italian banks which we believe have stronger fundamentals as compared to their Italian peers and banks in other markets across Europe. With all the turmoil, we believe that a focus on quality is imperative.’

With all the turmoil, we believe that a focus on quality is imperative.

The European credit market still looks relatively attractive and offers long-term value, taking account of default risk and potential losses.

COULD YOU OUTLINE YOUR CURRENT INVESTMENT THEMES?

‘Electricity is the fuel of the future, so we have a long-term view on sectors and companies that are focused on electrical power. Within the auto sector, for example, sales of electric cars are rising while combustion engine vehicle sales decline. That is going to be a very powerful trend driving our investment choices.

This theme also plays a part in our positive view on utilities, especially those whose revenues come from regulated network exposure, which reinforces this group’s defensive characteristics. This means that we maintain a general exposure to the sector.

We have been long-time proponents of select real estate sub-sectors, preferring regulated residential, logistics and data centre names, where COVID-19 has magnified performance differences.

We have also moved in and out of the energy sector, adding companies such as Shell, Total and BP when the oil price was low and because we felt values were compelling. Some of those valuations have now compressed as the oil price has normalised and we have become more critical given the uncertain longer-term outlook for the sector.’

WHAT IS YOUR OUTLOOK FOR THE NEARBY FUTURE?

‘The European credit market still looks relatively attractive and offers longterm value, taking account of default risk and potential losses. We have a neutral view for the rest of the year, given how far valuations have come and the near term uncertainty.

We have already seen a strong beginning to the economic recovery, but there remains a great deal of uncertainty around its shape. Governments across the world are still grappling with how to respond to virus case loads as the scientific community works on a vaccine. The challenge is to identify how holdings will perform under different scenarios. Important questions are how the various factors wil affect the balance sheets of these companies and what could be done by them to improve their prospects.

We believe it’s all about stress testing. These are the issues we discuss with our credit analysts and is why we continue to be underweight in names that we feel are structurally challenged. When the vaccine is generally distributed within the next twelve months, this will benefit companies in some of the hardest hit sectors like travel and leisure, so we see opportunities for the better names here.

At the same time, we mustn’t lose sight of geopolitical risks. The US election has just taken place and the Brexit looms on the immediate horizon. Issues such as US-China relations will remain very fragile despite the arrival of the new administration of Joe Biden in the new year. With trade globalisation threatening to go into retreat and monetary policy being deployed at, or close to, the maximum, with burgeoning government fiscal deficits, it’s very hard to be positive on world growth. We have to bear this in mind when analysing companies.’

WHAT ARE THE KEYS TO YOUR INVESTMENT POLICY?

‘Market conditions are evolving dynamically, so it’s important not to become complacent. We have to be nimble when it comes to managing the portfolio. Due to the current uncertainty, we want to make sure that we have enough flexibility in our fund, which is why it’s important to also have relatively liquid holdings, including cash and German Bunds.

The last few months have been particularly challenging because things have been moving so quickly and you have to keep your eye on everything. It’s important to have a strong team with extensive analyst support. It is essential to capture market turns while continuing to be disciplined in scaling risk and assessing valuations.

We obviously couldn’t predict the extent of the pandemic, but at the start of the year we felt that markets were not properly pricing the defensive characteristics of some sectors (like utilities), as compared with more cyclical names. In the future, making these calls while realising positions as valuations become stretched either way, will be key.’ «

• The year 2020 has been a roller-coaster for credit markets. • Higher conviction investment ideas look the most promising under the current circumstances. • Our investment policy currently focuses on electrical power and select real estate sub-sectors. • The path to post-COVID-19 recovery is unclear, but the

European credit markets still look relatively attractive. • Market conditions remain volatile, so vigilance is warranted.

Important Information: Past performance is no guarantee of future results. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.