Three steps to avoiding potential BBB risks
Investors are voicing concerns around the BBB market in the US, and the possibility of “negative migration” risk. This is where, under stress, a large portion of this market could be re-categorised to sub-investment grade, potentially causing a mass sell off.
The concerns around BBB exposures in US investment grade (IG) credit markets are, to some extent, justified. The US IG market has doubled in size since 2009, and a large amount of this has been in the BBB space. In fact, the BBB segment of the US IG market is reportedly now larger than the entire US high yield market.
The extent of the growth, and the compositional breakdown, can be seen in this chart:
Value of corporate debt by rating (in $ trillions)
Source: Bloomberg as at December 2018
This growth — combined with the fact that leverage remains elevated, profits and margins appear to have peaked, and the acknowledgment that low default rates can’t last forever — understandably adds to the concern. A significant component of this BBB market is also considered to have credit metrics that are stretched for their rating band, and this is worth watching closely.
The question is how to manage these exposures. Do you simply exclude, or exit this space? If that approach is taken you may be ‘throwing the baby out with the bathwater’ and limiting the return opportunities in the investment grade universe. Is there a better way?
Schroders believes, the trick is to identify which credits are bad and simply don’t invest in them, because not all BBBs are the same and not all are bad. The challenge is how do you pick a winner, and avoid the losers?
Firstly, active management is essential. Fundamental credit research — where individual companies are assessed as to their quality — is key. Simply relying on ratings agencies, in our view, is not sufficient. Outsourcing credit views is prone to challenges and limits the ability of an investor to move quickly as price or risks change. At Schroders we don’t buy anything we haven’t fundamentally researched. This is achievable given our global capability, which has more than 40 credit analysts researching and analysing companies.
Implicit in this approach is to choose active over passive management. When buying a passive portfolio you are buying a range of debt instruments that are weighted in index according to how much debt they issue. That index that provides the most exposure to those companies with the most debt on issue, and there is no reference to the valuation of the company or the risks. By contrast, an actively managed portfolio, backed by fundamental credit research, can identify those companies for which the risk is mispriced. It is important to note that the asymmetric risk profile of credit — limited upside and unlimited downside — means it’s the credit you avoid that makes the difference.
The second element to manage risk is diversification, at not only the stock and sector level but also by geography. Global credit markets are large, and diverse. Having a narrow and/or passive opportunity set impedes an investor’s ability to take advantage of the full range of opportunities and achieve an appropriate level of diversification.
The third element is to manage total risk at the portfolio level. Firstly, that is allocating to assets based on the valuation and where we are in the cycle. The ultimate success or otherwise is determined by how much of an asset you hold, and when you hold it. In addition to when and how much to own, we also need to deploy downside risk management. That is the appropriate use of duration and currency that can assist overall portfolio risk management.
Schroder Absolute Return Income Fund
In the Schroder Absolute Return Income Fund (SARI), our approach is a multi-strategy portfolio that accesses credit, rates and currency markets to deliver an actively managed portfolio that combines top down asset allocation with bottom up fundamental credit research. This approach, combined with a focus in managing downside risk, allows us to manage through different market cycles.
In SARI asset exposures are as follows:
Source: Schroders as at 28 February 2019
When you break down the portfolio by rating band, the total BBB exposures are 37.9%. The country breakdown is Australia at 23.8%, US at 9.3% and Other at 4.8% (as at 28 February 2019).
Overall, the portfolio is defensively positioned and has only 9.3% US BBB exposures. Given our total weighting and our stock and sector selection approach, we believe we are well placed in the event of deterioration in that segment of the market. Should we see some volatility, our active approach puts us in good stead to take advantage of opportunities as they arise.
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