Fundamental credit analysis enables an active investor to determine whether a company's characteristics - the strength of its operations, balance sheet, enterprise value, cash flow, leadership and management of environmental, social and governance (ESG) risks - make it a leading candidate for investment.
An investor must then look beyond the business and focus on how they can best invest. An active investor's ultimate judgement - the outcome of top-down allocation and bottom-up analyses - is their conviction.
- Curve: vertical limit
Credit curves depict the market's interpretation about the riskiness of an issuer's instruments. Generally, risk and reward increase as the curve progresses towards maturity - although curves can steepen dramatically or invert to reflect investors' expectations about the prospectors of a particular issuer.
For active investors, identifying the section of the curve offering the most attractive risk-return prospects is crucial, because focusing only on the headline yield neglects the roll-down, or the capital return realised as a maturing bond converges to par. Targeting yield alone, therefore, is not always conducive to striking the right balance between risk and return in across their portfolios.
- Convexity: a question of balancing the upside and downside
The call feature embedded in many bond structures, which enables the issuer to call the bond at a predetermined date and price, create additional complexity for investors. It benefits the business that can lower the cost of funding if market conditions are favourable but can be challenging for investors because it effectively caps the extent to which a bond can appreciate in value. This performance-limiting phenomenon is known as negative convexity.
Credit fund managers need to monitor the percentage of bonds trading above call prices in order to improve the convexity profile of their portfolio. This can be enhanced by analysing the differences between the yield-to-maturity and yield-to-worst of instruments according to region, rating and sector.
- CDS: all about that basis
Selling a CDS on an issuer, a derivative insuring the buyer from the risk of a company defaulting, can provide a number of advantages.
- First, a CDS is a purer representation of an issuer's credit risk because the instrument is immune to interest-rate movements.
- Second, a CDS does not have embedded call features, enabling investors to avoid negative convexity among bonds in rallying markets.
- Third, investors in CDSs can pick and choose the points on an issuer's credit curve that seem to be the most attractive.
Analysing the risk-return trade-offs among instruments in an issuer's capital structure is core to our flexible approach to credit investing: choosing which securities are superior is our expression of conviction.
- Instruments: hybrids strike a popular chord
The market for corporate hybrids, securities with equity and bond characteristics that are subordinate to senior bonds in a capital structure, has grown quickly in the past five years.
For issuers, hybrids help to diversify their sources of funding, optimise their weighted average cost of capital, and improve balance-sheet strength and flexibility. For investors, hybrids provide an opportunity to gain exposure to attractive corporate fundamentals and earn a return exceeding what is offered through senior bonds.
In the later parts of a credit cycle, amid rising defaults, some investors prefer to select instruments further down the capital structures of stronger issuers rather than invest in more senior securities of weaker companies at risk of not repaying their debt. Investors in the subordinated instruments need to understand both the risks endemic in adverse market conditions, as well as the incentives that serve to mitigate them.
- Sizing: balancing conviction
To fully express conviction in a credit instrument, the size of the position in a portfolio must be determined. To do this, we consider a range of factors, such as credit quality, country-risk premia, sectoral cyclicality, and the liquidity and expected volatility of the security. Our objective is for the investment to help diversify the sources of alpha in our portfolio and therefore minimise the risk of any particular security causing too much volatility on day-to-day basis.
To size a position, we use a metric called duration times spread, which gauges the volatility contribution of a particular security to the portfolios overall volatility. This can then be used to assess the volatility contribution from the top-down exposures like regions, ratings, sectors, types of securities, curve points to make sure that no single risk factor is impacting portfolio to an outsized degree, diversifying the sources of alpha.
- Sustainability: giving credit to ESG
We have written extensively on the correlation between the cost of funding (spreads) and ESG factors in credit[1]. In summary, we found the relationship statistically significant and saw the relationship strengthen in recent years as ESG integration became more mainstream in the last 18 months. ESG score is assigned by our credit analysts and impacts which security we own within the capital structure, for example, it impacts what we view as attractive steepness from the credit curve's perspective. Additionally, when valuing securities, we adjust the spread on the bond using our proprietary ESG pricing matrix, which is based on the relationship we calculated in the paper.
The fixed-income universe is increasing in size and complexity, necessitating a flexible approach to investment. Following credit-allocation decisions to determine which markets offer the most attractive opportunities, it is the bottom up, high-conviction security selection which really comes to the fore.
Andrey Kuznetsov, CFA, Senior Portfolio Manager
Andrey joined Hermes in January 2013 and is co-portfolio manager on Hermes' range of credit strategies. He joined Hermes from C-Quadrat Asset Management, where he managed the multi-strategy credit fund and generated investment ideas for a range of absolute return credit funds. Andrey holds an undergraduate degree in Economics from State University - Higher School of Economics in Moscow, where he majored in Financial Engineering and Mandarin Chinese, and a graduate degree from London Business School. Prior to moving to London he worked in various roles in Russia and China. In 2019, Andrey was named in the Financial News' ‘Top 25 Rising Stars under 40 in European Asset Management' and has been selected to join the leadership team of Next Generation Fixed Income Portfolio Managers network, a CFA UK initiative to bring together the leading portfolio managers in the UK. Andrey is a native Russian speaker and CFA charterholder.
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