A multi-strategy approach to credit investing
Mihkel Kase, Fund Manager, Fixed Income, discusses how falling cash rates and with the search for yield continuing, we see credit playing an important role in client portfolios. He provides insights into the breadth and diversity within the credit universe and the optimal way to invest. Click the download button below to access the full paper.
Credit is a broad, diverse and multi-faceted asset class that plays an important role in client portfolios. It typically delivers income in a yield constrained world with predictable cash flows and less downside risk than equities. We believe that for many investors the best way to approach the asset class is through an actively managed, diversified, multi-strategy approach. This allows investors to adjust risk exposures and rotate through segments in the asset class to target those with the greatest valuation support and the best prospects to deliver returns. Periods of uncertainty and market volatility further highlight the importance of being active and diversified as opposed to focusing on a single credit strategy.
Broad opportunity set
Credit is an extremely broad opportunity set. The choice of different geographies and currencies, credit qualities, term structures and seniority levels provide investors with a broad range of investment opportunities with varying income and volatility. With such different characteristics, credit instruments can be used to access everything from short dated high quality bonds to low quality subordinated exposures that look and feel more equity like.
Supporting the point on the breadth of the credit opportunity, the analytics in the table below show the differing characteristics of key elements of the asset class.
Figure 1: Characteristics of different Fixed Income asset classes - June 2002 to June 2016
A multi-strategy approach
We don’t believe only targeting a specific individual class of credit or using concentrated portfolios is appropriate in credit markets. It appears counterintuitive that one segment of such a broad asset class will always provide the best opportunities for investors and in fact unnecessarily locks investors into the beta of one investment market without regard for valuation, cycle or liquidity. For example in the lead up to the GFC, Global High Yield as an asset class was, in our view, extremely expensive with elevated valuation. Post the sell-off despite the extreme volatility, the risk in the asset class was at decade lows. Had an investor held a single strategy approach across this time they would not have been able to manage the market beta through this period. Having a one way bet on a cyclical asset class can be a risky approach to say the least.
One way to visualise the advantages of a multi-strategy approach is to consider different optimised portfolios in comparison to single asset classes. Using historic returns and correlations we can model an efficient frontier representing a range of optimised portfolios for a series of risk and return outcomes using different combinations of assets.
Figure 2: Optimised multi-strategy portfolios
Source: Schroders, Datastream, Bloomberg, data period June 2002-2016 as at 30 June 2016
In Figure 2 we use historic returns and correlations from June 2002 to June 2016. The major credit asset classes are marked as blue dots with the orange line showing the range of optimised portfolios. By combining different assets we vary the characteristics of the portfolios and can achieve a better risk and reward payoff than compared to holding a single asset class.
Importance of stock selection
We also believe stock selection is important. The asymmetric risk profile of credit instruments results in unlimited downside with limited upside in the return profile. Hence minimising the downside by avoiding issuers likely to default is essential. This is in contrast to an index approach that fails to consider security level fundamentals and relies on market capitalisation weight based rules to derive benchmark composition.
The Global High Yield market provides clear evidence of the importance of active stock selection as opposed to a passive benchmark approach. Each year in the Global High Yield market there are at least one and often multiple industries that suffer high default rates. Even when overall default rates are low as was the case in 2015 at 1.8%, the Metals and Mining sector suffered a 14.95% default rate. Avoiding such defaults through stock and sector selection adds value and manages the downside risk across market cycles.
With falling cash rates and the search for yield continuing, we see credit as an asset class that can provide investors with a source of income without the risk and volatility of equities. As a broad, diverse and multi-faceted asset class it plays an important role in client portfolios.
We believe the best way to approach credit is through an actively managed diversified multi-strategy approach. This allows investors to adjust risk exposures through time and rotate through segments in the asset class to target those that have the greatest valuation support and hence give the best chance to deliver. Periods of uncertainty and volatility, such as in the case of the oil price weakness that induced a risk off period in the months leading up to February this year, in our view further highlights the importance of a multi-strategy approach as opposed to a single strategy.
It is important to note we are not suggesting that credit is a risk free asset class. Rather we see particular segments as providing adequate compensation for the level of risk. We also strongly believe the best way to invest in credit is through an active and diversified approach. More specifically active management through top down asset allocation with a focus on valuation to ensure you are in the right markets at the right time, combined with bottom up stock selection based on fundamental credit research with a focus on avoiding default, is vital.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.