Seeking return from fixed income: credit where credit’s due

September 6, 2016 Categories: Investment, Markets

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Investors are struggling. High valuations and low interest rates make both equities and government bonds prospectively riskier and less rewarding. The search is on for alternative approaches and more flexible outcome-oriented strategies. Credit can play an important role in this search, but investors need to understand the characteristics of credit risk and where it fits in terms of their own risk/reward profile.

In today’s world of ultra-low government bond yields, credit bonds offer investors a significant yield premium. That premium comes with a risk of default by the borrower, potentially resulting in a partial or total loss of capital and interest for the investor. But our research demonstrates that default events are typically less frequent and severe than the markets expect, and that taking credit risk will normally pay off. Investors can access credit risk across a wide spectrum of fixed income issues – for instance High Yield (HY), Loans and Structured Asset Backed Securities (ABS), and these ‘extended’ sectors have different performance characteristics with different performance cycles and risk/reward profiles. These factors mean that extended credit sectors tend to offer very strong risk-adjusted returns, and make good total return instruments; they can also be combined to create an efficient asset mix in a multi-asset credit portfolio.

Yet while credit may provide a significant return premium over government bonds, and can deliver it with reasonable certainty, it has some properties that make it difficult for some investors to hold. In particular, on a mark-to-market basis credit can suffer tail-risks with sharp drawdowns, and be fairly sensitive to market events.

graph-1

Source: Bank of America Merrill Lynch High Yield Index. Historical data from Dec 1999 to May 2015.

Drawdowns illustrate the extent of each fall from the previous highest closing value.

Furthermore, short term correlations to equity markets can be high, which means on a mark-to-market basis a portfolio’s return drivers can dip at the same time. This drawdown risk and equity sensitivity is, in many cases, a temporary phenomenon. In other words, credit investments are going to return to their face value (be ‘pulled to par’) as they approach maturity unless they do actually suffer a default. That makes credit risk more about whether investors can stomach the journey than whether they will arrive safely. Nonetheless, not all investors have the luxury of waiting out a drawdown.

Thus investors can choose from two main fixed income multi-strategy approaches. They can focus on harvesting as much of the credit risk premium as possible across a wide spectrum, and allow the maturity profile of the asset class to manage their risk (the multi-asset credit approach). This works for investors seeking higher returns, and with a longer timescale and tolerance for risk (say, LIBOR + 4% pa on a minimum five year timescale). Alternatively, they can seek to focus on mitigating the drawdown risk by targeting their exposures to credit more selectively, by concentrating on shorter duration bonds, and by diversifying their credit portfolio through tactical switches into cash, Treasuries, and less correlated return-generating strategies. We characterise this second approach as unconstrained fixed income investing. This approach works for investors seeking somewhat lower returns and with a shorter time-horizon (say, up to LIBOR +3% over a minimum 3 year period).

In Russell Investments’ own unconstrained fixed income strategy, we use a focused credit book targeted on the best risk adjusted points of the credit market to reap the benefits of the credit risk premium. We combine this core exposure with diversifying strategies to mitigate the volatility and potential drawdowns, and with higher-risk actively managed bond strategies that we include opportunistically to enhance returns during favourable points in the credit cycle. There is a return cost to smoothing the return stream in this way, but we expect our unconstrained strategy will deliver Libor +3% over a 3 year horizon. Our strategy focuses on higher- quality HY bonds with shorter durations to do the heavy lifting in generating returns. These are complemented by dynamic management of cash levels and by targeted alpha strategies that offer strong diversification properties versus credit.

We explore all these points in a longer piece, Return-seeking strategies in fixed income: adopting the right approach for your portfolio. It’s worth taking a look at the charts and graphs even if you don’t have time to read the detailed text.

Next up – our White Paper on unconstrained fixed income. This will be available shortly, so watch this space.

Adam Smears, Head of Fixed Income Research

 

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