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9 Questions about credit investing | Question 5
What strategies are used to manage risk?
Investors typically want to be rewarded (preferably over-rewarded) for taking risk. While corporate bonds can be valued attractively for good reasons, value credits often have lower market valuations due to investor fears or behavioral biases. Bonds that exhibit value characteristics in the corporate space tend to have slightly higher volatilities, but also higher returns. This raises the question: how can risk be managed effectively to improve investment outcomes?
Balancing value and risk through active management
We seek to build a portfolio that is sufficiently diversified to minimize the impact of negative credit events and concentrated enough to benefit from active management. To do this we screen global credit markets across various credit classes for overlooked value due to biases ad segmentations. Often, value opportunities can be found in shorter-dated bonds with attractive valuations relative to other corporate bonds, and history shows that these valuation premiums tend to mean revert.
We apply three main principles to effectively manage and control risks:
Diversification: By spreading investments across different issuers, we reduce concentration risk. For example, if the issuing company faces financial distress, bondholders may not receive the full repayment. By creating diversified portfolios investors can limit the impact of credit risks on performance. Consequently, our portfolios are typically diversified across more than 100 different issuers.
Issuer limits: Imposing strict line limits, such as absolute or relative concentration limits based on ratings, protects investors when strategies and/or mandates grow in size. Selling a large amount in an AA-rated corporate is easier than selling the same amount in a lower-rated credit. Liquidity becomes especially relevant when investing in lower-quality credits as the probability of defaults increases disproportionately.
Duration Times Spread (DTS)1: Fundamental bottom-up credit research is important to understand relevant credit risks and avoid the value trap of buying credit that is cheap due to a higher risk of default. Investors should understand how volatility in credit spreads impacts performance, and how a credit portfolio can be constructed to reduce volatility.
Rewarded risks
It is important for investors to distinguish between rewarded and unrewarded risk factors. In our view, rewarded risks are those harvested by taking a contrarian approach, founded on rigorous research. If we believe the F-score2 for an issuer indicates a fundamental improvement overlooked by the market because of recession fears, bad earnings cycles or a slow ratings agency, we perceive this as rewarded risk.
Moreover, subordination risk can also be rewarded. Solid companies with sound fundamentals can issue different types of debt instruments – such as senior, subordinated, first-lien or second-lien debt or payment-in-kind notes. Senior and subordinated debt have the same probability of default, and if an issuer’s default probability is extremely low, it can be beneficial to invest in its subordinated debt. This is particularly true when spreads widen, offering investors attractive entry points.
Unrewarded risks
There are a handful of unrewarded risks, such as idiosyncratic risks, that are more prevalent in certain market segments, including real estate, retail, and leisure. Historically, defaults have been clustered in these industries, however, they remain viable for investment with due caution.
Moving too low in the capital structure can also be unrewarding. Highly indebted companies could face challenges in paying coupons and servicing debt obligations, and weak governance is disadvantageous as it can expose credit investors to material downside risk. Sustainable risks can also be detrimental. For instance, polluting companies are bound to face regulatory pressures as the transition to a low-carbon economy gathers pace.
To manage risks, we primarily focus on market and credit risk for which we believe investors are compensated. To measure and monitor the inherent credit risk in our portfolios we use a proprietary risk management system. This allows our portfolio managers and risk management department to keep an eye on market, sector and company-specific risk. For each of these factors, the risk exposure depends on the weight, spread and duration of individual investments, the product of which translates into an amount of risk points. Whenever the portfolio manager allocates risk to a portfolio holding, the conviction level is expressed by the number of risk points.
Footnotes
1 Read more about how we use DTS to measure credit volatility.
2The Piotroski F-Score is a financial tool developed by Joseph Piotroski that assesses a company's financial strength based on nine criteria covering profitability, leverage, liquidity, and operating efficiency. Scores range from 0 to 9, with higher scores indicating better financial health.
