Absolute return credit – it’s the big picture that counts

October, 2011 Print



When reviewing the investment mandate of a pension scheme, trustees need to focus on a longterm investment horizon. As such, it is important to consider the fundamental attractions of different asset classes and what they can bring to an investment portfolio, and not to be distracted by the short-term noise and volatility – even when that noise seems to be approaching fever-pitch.

Macro noise

We are clearly in such an environment at the moment with markets being driven by big macro issues from the sovereign debt crisis in the eurozone to the US budget deficit and slow economic growth. This has seen indiscriminate swings in the value of credit and high yield credit in particular, irrespective of the underlying investment fundamentals. The result seems to be that many investors have been swept up in the risk-on/risk-off trading patterns we have seen for much of 2011.

Focus on the fundamentals

From a trustee and scheme member’s point of view, focus needs to be on the fundamental attractions of particular assets, and ideally those with solid long-term drivers that can help underpin asset values. But at the same time, in the current climate, this approach can identify significant value where individual credits look to have been unjustly penalised. The potential opportunity available is illustrated by the chart below, which shows the spread over the risk-free rate of investment grade and high yield bonds. As we can see, the last time spreads were at their current level was back in 2009 as the global economy was emerging from recession.

Absolute return credit – it's the big picture that counts

Does credit fit the bill?

We believe that there is a clear longterm structural demand for credit assets, and while we have said that trustees should be looking through the short-term noise, some of the issues currently being discussed also serve to underpin this argument.

Demographic demand

In the developed economies of the West, along with China, Japan and Brazil, there are aging populations, which is likely to mean a shift in patterns of investment. As these postwar baby-boom generations reach retirement age, their investment focus is likely to shift from capital growth to generating an income in retirement.

We believe therefore, that we will see a natural shift in allocation towards assets capable of delivering a strong and sustainable level of income.

State support

The current debate over sovereign finances, not only within the eurozone but in the developed economies generally, only serves to highlight the long-term structural pressures on government finances with the proportion of taxpayers falling relative to the percentage of the population in retirement. This is likely to mean that for the foreseeable future anything more than basic support for pensioners in retirement is highly unlikely. As a result, individuals, via their pension schemes, will increasingly have to provide for themselves in retirement if they want to have a reasonable standard of living, which means further structural demand for incomeproducing assets looking well beyond the dependency figures on the chart in Figure 2.

Sluggish growth

With government austerity measures starting to bite, economic growth in the developed economies looks set to be sluggish at best for a number of years. A knock-on consequence of this is that interest rates are likely to remain at, or close to, their historically low levels for a considerable period, indeed much longer than was thought when the developed economies first started emerging from recession. This is also good news for credit investors as an environment of sluggish growth and low interest rates provides an optimum opportunity for investmentgrade credit and a similar argument can be made for high yield bonds.

Defaults to remain low

A slow growth, low interest rate environment is also usually good news in terms of keeping defaults low. So while we do expect to see an increase in default rates over the next year or so, we believe they will remain below their long-term averages. Figure 3 shows the extent of the potential opportunity currently available across credit markets for those with a long–term investment horizon.

We can see from Figure 3 that the market is currently implying a 14.5% default rate for investment grade credit in Europe over the next five years – more that 14 times the long-term average, while in the high yield market the figure for Europe is double the long-term average. In the high yield market it’s also important to note that defaults tend to be skewed towards the lower-rated CCC credits rather than the better quality BB rated issues, where according to Moody’s, the average default rate is just 0.73%. When looking at credit defaults, trustees need to remember that a default does not mean losing everything. The chart figures assume a recovery rate of 40% of the par value of any defaulting credit, while in 2010 the actual rate was 62% for senior secured bonds. One of the key reasons we believe that defaults will be much lower than the market is currently suggesting is that corporate balance sheets are in a much healthier position today than they were during the credit crisis in 2008.

Disintermediation of the banking sector

The latest concerns over the solvency of European banks are likely to increase this process, which involves banks cutting back on the provision of shortterm lending and overdraft facilities to companies to strengthen their own balance sheets. As a result, more and more companies, most in robust health, are coming to the credit markets for debt finance. This is good news for investors as it provides a flow of opportunities and further breadth and depth to the credit market as a whole.

Absolute return credit – it's the big picture that counts

Absolute return credit – it's the big picture that counts

Smoothing returns

For most trustees the key attraction of absolute return funds is the potential for reducing volatility in a portfolio by smoothing the peaks and troughs of markets. And this is as true for credit markets as any other asset class. They aim to do this by capturing the bulk of the upside credit investment, while aiming to mitigate a significant proportion of the downside risk, effectively looking to protect capital rather than eliminate risk. Absolute return funds look to do this through a long/short strategy made possible by access to the full range of investment tools, something not available with traditional funds. This enables the managers to undertake a range of hedging strategies designed to help protect the fund in periods of declining markets.

Strategies typically include hedging single country risk via credit default swaps, and using derivatives based on a basket of credits to hedge broad market risk. Interestingly, with high yield credit performance more akin to that of equities than fixed income, equity market derivatives can be used to help hedge a fund’s high yield exposure. More traditionally, currency risks can be hedged back to a fund’s base currency.

An absolute return mindset

Managing an absolute return fund requires a different mindset from that employed by traditional funds. It means the managers have as much focus on not losing money for investors as they employ in trying to make money. This is quite different from a traditional fund, where the focus is normally on beating a specific benchmark and is why absolute return managers need to have the full range of investment tools at their disposal. Bringing such a mindset into an investment portfolio will also have the added benefit of increasing diversification.

Absolute return credit – it's the big picture that counts

Resource and expertise
At F&C, through our Thames River arm, we have a 13-
strong team dedicated to the management of absolute return credit funds. The team is headed up by Stephen Drew, who manages the range in conjunction with Mehrdad Noorani. Between them they share over forty year’s industry experience, so have invested across the range of market conditions and cycles. They are supported by a dedicated economist and team of credit analysts, as well as specialists in fixed income trading. We are therefore able offer a fund range that covers the entire credit spectrum from a focus on investment grade credit to high yielding bonds and also exposure to emerging market credit. And can provide trustees with a range of potential investment solutions to meet their individual goals for their schemes.

Julian Lyne
UK Institutional Business
F&C Asset Management

“We are clearly in such an environment at the moment with markets being driven by big macro issues from the sovereign debt crisis in the eurozone to the US budget deficit and slow economic growth.”


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