Credit where credit’s due

Why is your focus on higher yielding corporate bonds?

Zero is a highly motivating number for investors. Zero or near-zero real yields on core government bonds, is prompting many investors to seek innovative bond strategies. Moreover powerful and unpredictable macro trends provide a disincentive to diversify in govvies. Therefore we think it is more attractive to invest in corporate credit markets, where there is more visibility over the underlying risks for each issuer.

Within the credit space, spreads on investment grade bonds are tight, but high yield offers both attractive yields and low correlation to interest rate movements. Investors always ask about default rates in high yield, which round to an average of 2.5%, but they should also consider high yield issuers as healthy and offering interesting yields: Some have trimmed their debts and re-financed since the financial crisis, meaning outstanding bond obligations are easier to meet.

Does this mean that all high-yield portfolios will outperform?

There was a significant spike in dispersion in the second half of 2014, for instance, partly as a result of poorer-quality issuers entering the market. In a low-growth environment, issuers with high leverage are sometimes unable to meet their debt repayments, and smaller companies struggle to maintain their pricing power. In a downturn, default rates might increase among these types of companies.

As a consequence, in order to sustain the level of returns of recent years, bond picking is likely to become the main driver of performance, as rising dispersion within high yield markets provides opportunities. In other words, alpha will replace beta as the most probable source of portfolio performance going forward.

How does Candriam seek to extract alpha from the high yield market?

Our strategy has three pillars. First, we seek broad coverage of the market, looking across the US and European corporate spectrum. The market is constantly deepening - the Euro corporate high yield segment still only represents about 25% of the US bond market, while the rate of European high yield issuance is outstripping the US, albeit from a lower base. The instruments we consider are also broad, extending beyond high-yield bonds to investment grade bonds, floating rate notes, credit default swaps (CDS) and options.

Second, we actively manage high conviction-driven positions, basing our decisions on fundamental analysis, legal review and quantitative research. Our investment philosophy is to detect the best opportunities within the credit space thanks to our broad coverage, and then, employing our deep expertise, to select the best instruments accordingly (Cash bonds vs. CDS, USD vs. EUR, and so on).

Thirdly, we adopt a conservative approach, managing risks such as liquidity, underlying sovereign risk, tail risk management, interest rate risk, volatility risk and, of course, credit risk. The idea is to be ahead of the curve and employ a strict stop-loss discipline, as well as using asymmetric products, such as options, as a hedge. This implies a focus on only liquid issuers - by liquid, we mean they are rated, have a listed equity, a CDS, a minimum number of marketmakers and minimum thresholds for outstanding issuance.

How do you implement the strategy?

There are two complementary engines of performance, a short duration bucket and an opportunistic bucket.

The first engine invests in short duration bonds from 50% up to 100% of the portfolio. But unlike our competitors, our approach is unique, as we focus on the best opportunities in the market. For example, bonds likely to be recalled, in order to optimise the debt structure of the issuer. It's important to notice that this is not a buy-and-hold strategy: we sell bonds when they've reached their fair value, and in adverse conditions we invest in very short-dated investment grade bonds with money market features.

The other engine of performance is opportunistic, up to 50% of the portfolio. This bucket is designed to capture alpha with a limited number of high conviction positions: long or short positions relating to potential upgrade and downgrades; positions linked to special situations such as M&A, impacting the debt structure; and relative value positions on issuer capital structure, pair trades or curve trades.

Can you explain how an unconstrained approach helps outperformance?

We can look across the traditional rating divides and cross the frontiers of investment grade and high yield bonds, where some funds are focused on only one segment. Hence, we can profit from opportunities between rising stars and fallen angels, for example when ex-investment grade names move back towards investment grade. The additional cost of servicing their debt when risk premia rises has been a strong motivation for many of them to shape up in recent years. Thus, many fallen angels are now rising stars and may be rewarded with an upgrade and a strong price rise.

So our strategy is not only high yield. It may feature mainly high-yield names, but some investment grade as well. Being unconstrained allows us as well to manage dynamically global duration to adapt to different market environments.

What skills are important in executing your strategy?

Understanding key drivers of performance and risk management is crucial, particularly in uncertain times. While a disciplined strategy and strong technical skills are prerequisites, there is no substitute for experience.

Candriam is a pioneer in European high-yield management, with more than 15 years of innovation dating to the creation of the euro. Our team is built around a complementary mix of experience and skills, ranging from proprietary desk trading, to leveraged loans to equity long-short.

Just as important as the credit market expertise is our inhouse legal knowledge of bond contracts and documentation. Sometimes, risks don't lie in credit markets but deep in covenants. Few high-yield managers can offer such integrated capabilities.