9 minute read
Pockets of opportunities for investment grade
The investment grade credit environment has become more challenging as spreads and yields have moved back towards historic lows. However, it is still possible to find pockets of opportunities, provided an investor is alert and disciplined.
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By Joost van Mierlo
Tim Winstone, Manager of the European Investment Grade Credit Strategy for Janus Henderson, states that central banks’ quantitative easing intentions are admirable, but that sometimes their asset purchase programmes are directly competing with investors, which can make life difficult for asset managers. But Winstone isn’t complaining. He is absolutely certain that the speedy response to the COVID-19 crisis was crucial and the reason that most markets and sectors have almost returned to normal.
You must have an impossible job, with spreads and volatility at historic lows? ‘It is true that volatility has been relatively low this year, and spreads have tightened considerably. As active managers, our mandate is to outperform the benchmark. That might be easier in periods of high volatility, as volatility is often synonymous with opportunity. But it also means we might get it wrong. We are not necessarily chasing the highest excess returns.
What we are looking for is attractive risk-adjusted returns. Within fixed income we need to pay careful attention to downside risks. Our aim for clients may be to outperform the benchmark by a specified amount, but we treat this as being averaged out over a few years, so that we take risk at times that we believe are appropriate.’
Aren’t you choosing the lower end of investment grade credits at this moment, in order to chase return? ‘That’s not the way we think. A high ‘A’-rated bond might be more attractive than a low ‘BBB’-rated bond trading with a wider spread in basis points from a bottom-up fundamentals perspective. We will also take a judgment on the macroenvironment and the overall portfolio.
Within the corporate credit team, we typically classify bonds into three categories: a high quality bucket with high quality BBB, A and AA bonds; a core stable income area with low BBB to mid BB-rated bonds; and high return potential bonds, often with lower credit ratings. For our Euro investment grade portfolios we would generally invest in bonds that would bucket into the first two categories. The adjustment of our portfolio across these two categories is based on our assessment of the credit cycle.
In the late cycle, where company profits are under pressure and cash flows are peaking or deteriorating, our portfolios would be constructed to hold more of the high quality bonds. In the early cycle, where companies are repairing their balance sheets and cash flows are on a sharply improving trend, we will generally invest more in the high return potential bonds. This establishes an overall framework of where we would like to invest, before engaging in fundamental bottomup credit research to identify the individual securities to include in the portfolio.’
So what is the current assessment? ‘We are ‘constructive’ on the economy, which means it is generally positive. We
think that the current environment of positive economic growth and low defaults will continue for the foreseeable future. Our assessment of the known risks is that they are relatively benign. It’s the unknown risks that cause real turmoil, but by definition it is hard to prepare for unknown risks.’
I understand these are unknown, but what kind of events are you thinking about? ‘There are numerous examples. You can think of terrorist attacks, natural disasters or the epsilon variant of the COVID-19 virus. These are impossible to predict and it is therefore not possible to be completely prepared. It is a matter of reacting well.
Let’s go back to the beginning of last year. We didn’t expect that the outbreak of COVID-19 would turn into a full-blown crisis, but because of our positioning at the time we were able to take advantage of the spread widening that took place. In hindsight we didn’t do enough, but that is what hindsight is for. It is important to be prepared for these opportunities. Experience has taught us that they occur quite frequently, around every twelve to fifteen months.’
You have indicated that you are relatively positive about current market situations. What does that mean for your positioning at the moment? ‘We use a DTS-ratio: Duration Times Spread. We will take on more credit risk when we are more bullish about the market and less when we are cautious. This ratio might be between 175% of the benchmark in the most bullish scenario and 70% when we think we are late in the cycle. At the moment, our DTS-ratio is 112% of the benchmark, which means we are a little long credit risk, but not a whole lot.’
Are there other ways you change your portfolio according to the economic cycle? ‘In most mandates we can invest up to 20% of the portfolio in so-called ‘off benchmark’ investments. For our Euro Investment Grade portfolios this means we will be able to invest in non-investment grade and/or non-Euro bonds. These investments have to be relevant and
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Tim Winstone
appropriate. It is not a way of dressing up the fund with all kinds of extraordinary risk in order to outperform.
One area of focus is companies whose debt was downgraded because of the pandemic. For some of these companies, their difficulties might be short-term. They might have been able to access appropriate funding and they might have been less impacted by the pandemic than first thought. So their sub-investment grade rating is lapsing in our eyes. We believe these credits are really investment grade, but the market has not yet adjusted.
Of course we are not the only ones who realise this. Back in February this year, JPMorgan estimated there were 280 billion dollars of high yield bonds that could move back up into investment grade by the end of 2022. Most of these will be dollar denominated, as it is the largest market in the world, but a large part of them are appropriate for us and we are trying to capture a fraction of it.’
Tim Winstone is a Corporate Credit Portfolio Manager at Janus Henderson Investors, a position he has held since joining Henderson in 2015. He co-manages the European Investment Grade, Global Investment Grade, European High Yield and Global High Yield Strategies. Previously, he was an Executive Director, Senior Fixed Income Portfolio Manager and part of the Global Credit Team at UBS Global Asset Management. He began his career as a Portfolio Assistant at Thesis Asset Management.
What percentage of your current investments are ‘off benchmark’? ‘At the moment (30 September 2021, ed.) it’s around 18%. It is probably as high as we’ll ever go. We need to have some cash for collateral and margin calls and we will always keep some powder dry for oppor- >
tunities that we want to take advantage of. But the fact that the percentage is so high reflects that we are constructive on credit risk.
We are at a situation where valuations are rich again. Some of us think that we might be back at the period of 2005-2007, with low spreads and low volatility persisting. It’s a time when there’s not a whole lot of carry to be earned, so one has to be creative in these times.’
What about sectors that were hit relatively hard by the crisis, like Travel and Leisure. Do they offer opportunities? ‘In the past twelve months these sectors have definitely been attractive. It was important to assess which companies could stay liquid with the doors shut and the lights turned off. This was true for the airline industry, for example. But we are seeing that industry opening again, most recently with the return of a busier transatlantic flight schedule.
Spreads have been normalising. But that does not mean there aren’t any opportunities. For example, there was a 2028 bond from a European budget airline which looked completely mispriced in our eyes, compared to similar companies. This company has a stable outlook, but we were able to get a 30-40 basis points spread on this investment. So, yes we pocketed that opportunity. But most of that has played out in the past months.’
You were still able to outperform the benchmark, you indicated. Part of it is spread risk, I assume, and part of it are off-benchmark investments. Are there other attractive parts in the market? ‘We see some opportunities around the so-called legacy bonds. These are bonds issued years ago by banks. However, these bonds will lose their regulatory approval as a specific form of bank capital and therefore won’t serve the purpose they were meant to serve. There are two kinds of plays around these bonds. They might be mispriced, because they are very particular and each one is different from the other. They are not like the current Additional Tier One vintage, which is very homogenous.
This plays into our hands because it needs in-depth knowledge of the particular details of the bond.
The other thing is that there is an infection risk. If these bonds get reclassified, it might have a cascade effect on other eligible capital instruments in a lower category. Banks are encouraged to retire these bonds, but there might be particular reasons why they wait. Again, this asks for careful analysis. The technicality of these securities can potentially work to our advantage.’
Green bonds seem to be the flavour of the day. What do you think of it? ‘The ESG approach is integral to our way of investing. It is at the core of our investment process. It is what our investors are demanding and it is something we believe in.
We are looking at companies that might be a liability because they don’t adjust fast enough when it comes to climate change. We won’t invest in those companies. But on the other hand, there might be companies that are not issuing green bonds, but do exactly the right things that are needed, not only for the climate side, but also for social and governance issues. To us, it’s not so much about slapping a green label on bonds. We’re looking for the companies that are really taking change, ESG-change, seriously. In fact, we would argue that some of the best returns for investors are likely to come from those companies that are on an improving ESG trajectory.’
SUMMARY
The corporate environment is improving, credit rating downgrades are giving way to upgrades.
Major market disruptions are common – we have come to expect one practically every 12 to 15 months.
Legacy Tier 1 debt of banks offers interesting potential at the moment.
