While taking on more risk may lead to better returns, it might not always deliver consistent outperformance in the corporate bond space, according to BlackRock’s Ben Edwards, who believes managing risk should always be a fund manager’s starting point.
Edwards was appointed manager of the five FE Crown-rated BlackRock Corporate Bond fund in May 2012, following a review of the strategy during the third quarter of 2011 with the aim of offering something “sensible and differentiated” from the 80-plus funds in the corporate bond sector at the time.
The fund’s starting point of building a portfolio based on risk minimisation sets it apart from its peers, he said.
“We know that very broadly risk equals return: the more risk you take the more likely you are to generate return,” the manager explained. “But it sits at odds with everything we tell investors we do as active fund managers.
“Our job should be trying to deliver the highest return we can for a given level of risk or vice versa and deliver the lowest level of risk for the highest return.”
As the chart below shows, the BlackRock Corporate Bond fund has delivered a return greater than the IA Sterling Corporate Bond sector average while displaying less annualised volatility over the past six years.
Performance/annualised volatility chart of sector over 6yrs
Source: FE Analytics
Edwards said the low-risk, disciplined approach to portfolio construction informs everything the team behind the fund does and affords it greater flexibility than fund managers focused on outperforming benchmarks.
“It’s more important than the outlook or my view of where the Fed is going because you never know when the market is going to turn: no-one ever knows with certainty what is going to happen tomorrow,” said the FE Alpha Manager.
“The biggest mistake that fund managers can make is to believe that their ability to predict the market is better than a) the market, and b) their clients, because it’s not true.
“Hopefully where our skill lies and our value add is is in building portfolios that are flexible so tomorrow when the unexpected comes where in position to deal with that.”
Its benchmark-agnostic approach prevents it from becoming skewed to companies and sectors that have outsized amount of securities denominated in sterling, said Edwards.
“We strongly believe that tying ourselves to benchmarks is not the right thing in the long-term and leads to all types of risk-taking,” he said.
“It also leads to problems of weighting based on the most weighted debt in sterling. Why should we have more exposure to companies like EDF just because they have a lot of long-dated sterling debt?
“It’s a fluke of market structure more than anything else.”
The BlackRock Corporate Bond fund manager said that instead he takes a more bottom-up approach to security selection, eschewing more traditional approaches to corporate bond analysis.
“I am a true believer that trying to analyse the last quarter’s earnings tells you very little about the state of the companies and the likelihood they are improving or deteriorating over next 12 months,” he said. “It tells you very little about where spreads might go.”
What is more important, he said, is asking what incentives are in place for chief financial officers and treasurers in maintaining strong balance sheets.
This has become more important in recent years the trend of leveraging up – particularly in the US – has strengthened while debt remains cheap, boosting earnings per share figures and fuelling the rise of stock markets at the expense of credit ratings.
As such the ‘BBB’ part of the market – which sits just above high yield – has boomed and become a cause for concern for policymakers.
While the threat of higher debt service payments has fallen after the Fed announced it would reconsider its approach to normalising interest rates, it remains enough of a worry for some investors.
“The fear seems to be that were the global economy to go into downturn as we saw priced in last year and move into softer economic period and recession a similar proportion of ‘BBB’ that were dumped in the last recession would see a larger amount of bonds transition to high yield,” said Edwards.
Despite the concerns over the rise in lower-rated debt, BlackRock’s Edwards remains convinced that his process can identify the higher quality companies that can continue to prosper, but has also added some more defensive assets.
“We’re happy to own ‘BBB’ as long as they are quality [issues] and we’re being paid for that risk,” the FE Alpha Manager explained. “We also have pretty large holding in gilts, not because we like gilts at 1.3 per cent but because we tend not to like very high quality corporate bonds that don’t pay much more.”
While the growing ‘BBB’ space has stocked fears, Edwards said that the size of the market is not a problem in itself but an indicator of how big it will be when it comes. He said that large ‘BBB’ issuers will likely come under pressure to act and it is likely that equity holders will likely also suffer.
“It’s fair to say that some of the larger companies just simply can’t fund themselves as high yield companies,” the manager explained. “Some of the US telecoms companies have over $100bn in debt that is unfundable in the high yield market. Were they to have to fund at those levels their businesses would be broken and costs too high.
“If it looks like they need to sustain that ‘BBB’ rating they will have to do that by cutting dividends, stopping buybacks and selling assets. Who ultimately has to bear the pain is the shareholder and the share price will suffer as they deleverage.
“Our job is to work out which can deleverage which have sustainable business good management teams and credit ratings will have to protect rather than fall in to high yield.”
Performance of fund vs sector & benchmark under Edwards
Source: FE Analytics
Since Edwards took over the BlackRock Corporate Bond fund it has made a total return of 49.57 per cent, roughly in line with the ICE BofAML Sterling Corporate & Collateralized index benchmark return of 49.88 per cent and well in excess of the average IA Sterling Corporate bond peer’s 38.84 per cent gain.
The fund has an ongoing charges figure (OCF) of 0.57 per cent and a yield of 2.88 per cent.