Speaking directly from home, Tom Ross, Credit Portfolio Manager, explains how in an unprecedented crisis the Corporate Credit Team are remaining true to their process within high yield investing but recognise that some things need to be done differently.
- The team are sticking to their tried and tested investment process but are upping communication so that portfolio managers and analysts can more swiftly assess the changing environment.
- They have adapted their trading to take into account shifting liquidity, expanding the number of smaller line items to diversify execution risk and maintain desired risk profiles across the portfolios.
- While currently cautious the team are seeing deep value emerging within high yield and believe that fallen angels can offer selective opportunities for both high yield and investment grade investors.
This video was filmed in late March 2020.
Beta: The sensitivity of the portfolio to market movements.
DTS: Duration times spread. This is a measure of expected credit volatility in portfolios.
Firstly, we acknowledge the unprecedented uncertainty you are currently facing right now both at a professional but also on a personal level. So, we wish you all the best through these difficult times.
What are we doing within the portfolios?
Now for a high-level update on the high yield portfolios. Looking at beta, we have been relatively cautious on the market and have been keeping the beta of all of our high yield portfolios around the low 90 percent in terms of beta or the duration times spread (DTS) ratio. Generally, what we have been doing is maintaining liquidity within the fund, i.e. higher cash balances than usual. But also looking to reduce some areas of risk in some of those areas of the market we believe to be a little bit more affected. So, if we take sectors such as the energy sector and also the gaming sector, those are two areas where we have been looking to reduce a little bit of risk just through this difficult time. This is because we have two impacts at the moment: firstly, we have the coronavirus; but we also have the oil price war that is going on as well. So, this crisis is slightly different from usual, in that we have two relatively exogenous factors that are impacting our market.
What are we watching right now?
So, what are we watching right now? Well, it is the case with the virus that we need to be seeing hopefully a peak in the infection rates, especially in some of the more developed countries. Clearly, we have already started to see that in areas such as China, but I think we are going to need to see that in the broader developed markets and more broadly globally before the market can really get comfortable with how the virus is going to pan out before we get into the summer months. It is also the case that because the oil price has had such a significant impact on the market any recovery in the oil price or a situation that helps out on the price war that clearly would also be positive. The third factor would probably be valuations. At some stage. there is a chance that outflows could cause valuations to get to such a level that they are pricing in so much of the downside risk. However, we are not quite so sure that is just at the current stage. I guess the final factor is the steps being taken by the various governments and also the monetary stimulus that has been coming through. That is also potentially an impact. But at the moment it is going to be tough for those to really grip on the economy given the social distancing that is going on. But it will certainly have an impact when we start to get through some of the impacts of that social distancing from the virus.
The near term outlook
So, with regard to the outlook, as we say, we remain a little bit cautious. And the one key risk is potentially further outflows. That is why we are maintaining liquidity within the funds, maintaining a higher cash balance, and ensuring that where we do have any outflows that we would be maintaining that diversity within the funds, trading pro rata slices across the portfolios to maintain the same risk levels as before.
What are we doing the same?
Now one thing we absolutely have been doing is maintaining our philosophy that we continue to believe in: that this should be a really great time for active managers to exploit the inefficiencies within the market. And absolutely sticking to our process that has seen us through so many crises in the past.
What are we doing differently?
But what are we doing differently? Well, clearly these are slightly different times. I am currently doing a video from home for the first time and we are having to use the business continuity and a split-site working plan to ensure that we can continue to be as efficient in our business-as-usual activities as we can possibly be. That is absolutely the case and through testing of that type of split-site working we have been able to see through this period with people still being able to do their day-to-day roles and ensuring the portfolio has the appropriate amount of risk.
Well, one thing we have been doing is upping communication. It is at times like these when more communication is even more important, even despite the challenge of many more conference calls as opposed to day-to-day meetings. So, for example, our usually monthly top-down beta positioning meeting with all of the portfolio managers within the corporate credit team. That is usually monthly; we have been having those three times a week to ensure that everyone globally is all tied in, all of the views are together, to work out what are those signposts to potentially see a change in the market. That is hugely important right now. And we are also upping the communication between the portfolio managers and analysts as well. And we have had more sector reviews, mini sector reviews across a large number of sectors in recent days and in recent weeks as we again believe that almost over-communication is really important at this time.
How are we managing liquidity?
The other thing that is really important is liquidity. And, clearly, we can fully understand that is a major concern that clients have at this time.
So, what are we doing about liquidity? Well, the first point to note is that even when we do face outflows we are ensuring that our portfolios have the same risk profile and we are trading across a large number of line items to maintain liquidity and cash. Also, diversification, but also those risk levels as well. Also, trading costs have gone up. So, we are actually reducing the amount of trading that we are doing, to just stick to the really essential trading and maintaining those risk levels at where we want to be. And to give an example of that we are trading in smaller size across a larger number of trades. This has two really key benefits. Firstly, by doing that and trading in smaller size you get better execution, you are getting better levels to trade at because the cost of trading in larger size is one of the big impacts of the drop in liquidity that we have seen recently. But the other advantage is that it also reduces execution risk and by that we mean the chance that you hit a price that might not be the best price. And if you did that on one single large trade that can have a potentially negative impact on the portfolio. But when you do it across a larger number of trades across more line items that risk is diminished as you diversify that potential execution risk.
Are fallen angels a risk or opportunity?
Fallen angel risk has come back on the agenda again as the slowdown in growth potentially could impact in a more systematic way than we have seen in the past the downgrade of some BBB bonds into the high yield market. One thing we have to consider about this recession is it is probably likely to be different from ones we have seen in the past in that actually it potentially could be quite a bit deeper. But it is also going to be a little… it could also be quite a bit shorter than we have seen with previous recessions. The reason for that is the virus is a purely exogenous shock and once it does get through we believe the bounce back will be quite great.
Now the interesting thing will be to what extent do the rating agencies give some companies the ability to look through that period and look through that uncertainty before they take the action to downgrade them from investment grade to high yield. But we absolutely acknowledge that this is a risk, especially for areas such as the energy sector within the US where there are a large proportion of BBB that could get downgraded into the high yield market. But, again, we often see fallen angels, potentially not all but some of them, as an opportunity to add risk. And the other important factor right now is that the levels of valuation that we are starting to see within the market will mean that some of those fallen angels are going to create really great opportunities to be buying not just for high yield funds but also for investment grade funds going forward.