After a difficult end to 2018, investors may now be well-positioned to take advantage of a more favourable environment and fresh opportunities in the credit market, according to Hermes Investment Management’s Fraser Lundie.
Although there has been less issuance in the credit markets so far this year, Lundie – manager of the £844.5m Hermes Multi Strategy Credit fund – said this has not been particularly problematic for him.
“As much as new issuance is great news if you’re a banker, it’s not particularly good news if you’re the guy who’s trying to manage supply and demand,” said the Hermes manager. “If anything, supply is disappointing so far this year, which is good news.
“The reason it’s disappointing on an aggregate basis is because companies that have already been so pre-emptive and opportunistic in re-buying and churning out debt.”
Corporate debt issuance over 2yrs
Source: SIFMA
The low-rate, post-financial crisis environment has encouraged companies to repurchase existing debt and reissue at lower rates in recent years, which has changed the dynamic of the market somewhat.
“Companies have made very good use of the fact that the capital markets have been so open for so long and they have reduced their cost of financing and termed-out their liability structures in an impressive way,” said Lundie.
“It’s partly why you can be a bit more constructive on the market because of the balance sheet health. As much as leverage levels might look on the high side and typical for late-cycle, interest coverage on the other hand looks extremely strong because rates are still low.”
Like all asset classes, the final quarter of the year was a challenging one for credit as fears about a potential US recession built on growing concerns over the Federal Reserve’s rate-hiking programme and the escalating US-China trade dispute.
Yet the pausing of the Fed’s rate-hiking programme in January has made conditions more favourable for credit markets than last year and the attractiveness of the asset class to allocators has significantly increased.
“You’ve got central banks across the world in pretty accommodating shape here,” the Hermes manager said. “It’s a very different picture to six months ago.”
Lundie said the relative value of credit has also greatly improved compared with other asset classes and is one thing that is often being overlooked by the market.
“We think that the average cash price phenomenon is something that people don’t focus on enough,” said the Hermes co-head of credit. “People tend to focus on spreads when they talk about credit, but cash prices are really low.”
Cash prices have fallen for a range of reasons, said Lundie, including reissuing at lower rates for the longer–term and credit spread tightening, with securities now trading at or significantly below par value.
“One of the areas most important for this is in the corporate hybrid market which is securities typically of investment-grade companies right at the bottom of the debt capital structure,” the Hermes Multi Strategy Credit manager said. “They are more complicated to appraise in the sense that they have some equity characteristics and some debt characteristics.”
He said that the securities carry a lot of risks if you own them above par value but currently they are trading “significantly below par”.
“We’ve been materially increasing our exposure to corporate hybrid bonds both in Europe and the US and would expect them to be a major driver of returns this year,” he added.
Another area where the phenomenon has been seen is in the high yield market, where debt is currently trading below par value.
Performance of index YTD
Source: FE Analytics
“For example, global high yield yields something like 6.5 per cent in dollar terms,” Lundie explained. “That is combined with the average cash price of the bonds that you’re buying being relatively low something like 95-96 cents on the dollar.
“Which means that there is nothing, from a bond market perspective, to stop it from going up and up and up.”
The combination of high yields and the potential for cash price appreciation makes for a compelling investment argument, according to the manager.
“Sometimes in the high yield market what you’ll find is that the yield might be attractive, but the convexity profile of the asset class is challenged by call options which become more of an issue if the cash price is higher,” he said. “That’s not a risk right now.”
The manager said what is likely to transpire this year – as the late market cycle continues – is a differentiation of companies at an earnings level and pressure on more challenged sectors, such as car manufacturers and retailers, which could support the asset class further.
“Companies have spent the last few years being pretty equity-friendly with regard to share buybacks and dividends they are now having to make a bit more of a choice because earnings and the macro have turned a little bit,” he said.
“The choice is ‘do I allow the balance sheet to deteriorate and take the ratings downgrade that will be associated with that or do I turn off the tap on the share buyback programme or dividend in order to preserve the balance sheet health and the ratings’?”
As such, the board and management of companies in challenged sectors are questioning whether they want to risk a rating downgrade.
“That is going to involve equity dividends being questioned more than they have in recent times and I think that will be part of the constructive story for high yield from here,” the Hermes manager said.
Lundie has managed the Hermes Multi Strategy Credit fund since launch in May 2014 and said he follows a more considered approach to portfolio construction, rather than simply picking companies.
“What binds it all together is our belief in security selection not just company selection,” he said. “So, [we’re] trying to emphasise the importance of how you access a company not just what company, which I think is often underappreciated in the asset class.
“To contrast that with equities, if you like a stock you buy the stock. If you like a company in credit you can buy it in dollars, euro, sterling, three-year, 10-year, 30-year, loans. bonds, secured, unsecured, hybrid, and so on.”
In addition, the Hermes manager said he often disregards where a company happens to be headquartered or what the rating agencies think about them.
“Often, you’ll have a situation where companies compete with one another globally where one is emerging market and [the other] developed market, or one is high yield and [the other] investment grade, and, therefore, the peer groups that people in asset management look at are nothing like the peer groups that people look at in the real world,” the manager explained.
Performance of fund vs sector since launch
Source: FE Analytics
Since launch in May 2014, Hermes Multi Strategy Credit has made a total return of 13.47 per cent compared with the average IA Sterling Strategic peer’s 15.35 per cent gain.
The fund has an ongoing charge figure (OCF) of 0.8 per cent.