1111 Multi-Asset Credit Roundtable

The Future of Credit Investing

June 2019

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Contents

Introduction

Roundtable Sponsors

Roundtable Participants

The Future of Credit Investing

Hermes Investment Management

Investec Asset Management

Royal London Asset Management

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Articles

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The beauty of Multi Asset Credit (MAC) is that there is no one unique approach. The global financial crisis of 2008 changed the landscape for credit in terms of investment behaviour and pricing for credit and liquidity. Additionally, the dispersion of credit quality has increased, both within and across all credit sectors.

MAC managers offer strategies based on their investment strengths and beliefs thus simplifying the choices investors have to make. This delegation of discretion to managers means that one firm is chosen to invest across different credit sectors instead of allocating to individual managers with separate mandates.

MAC managers also have the freedom to invest across the credit fixed income spectrum thereby enhancing value and can avoid being captive to a benchmark. This greater freedom and skill to take advantage of these circumstances, can potentially add greater overall value to a portfolio.

Skill lies in determining how to allocate within a multi-asset fixed income approach, therefore fund managers must analyse and understand current market dynamics and how they could change in the future. The key to this is understanding what’s driving the relationships between asset classes and market volatility.

These strategies are becoming increasingly attractive as investors look to move out of their traditional corporate bond mandates to higher-yielding credit alternatives and CAMRADATA’s Roundtable on Multi Asset Credit investigated further the different approaches being taken within our industry.

A Reminder About Our Aims

Fund managers must analyse and understand current market dynamics and how they could change in the future. The key to this is understanding what’s driving the relationships between asset classes and market volatility

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Hermes Investment Management

Company Profile

Hermes Investment Management provides active investment strategies and stewardship. Our goal is to help people invest better, retire better and create a better society for all. We offer public and private market solutions across equity, fixed income, real estate and alternatives for a global clientele of institutional and wholesale investors. However, we believe that our duty extends beyond achieving clients’ financial outcomes: we must act as stewards of the investments we manage and advise. In 2004 we established Hermes Equity Ownership Services (Hermes EOS), which is now one of the largest stewardship teams in the industry.

Andrew Jackson

Head of Fixed Income

Andrew joined Hermes in April 2017 as Head of Fixed Income. He is responsible for leading the strategic development of Hermes’ credit and direct lending investment teams, and developing a multi-asset credit offering

capable of accessing all areas of the global credit markets for pension funds and other long-term institutional investors.

Andrew joined from Cairn Capital, where he was Chief Investment Officer. In this role, Andrew was responsible for the development of the asset management business, which included designing new products and managing the investment teams, including strategy, portfolio management and research. He has managed assets across the spectrum of global credit and fixed income. He was previously vice president within the European credit structuring team at Bank of America and has held roles with Fitch Ratings and PricewaterhouseCoopers. Andrew holds a BSc degree in Mathematics & Theoretical Physics from Kings College London.

Roundtable

Sponsor

Investec Asset Management Company Profile

Investec Asset Management provides investment products and services to institutions, advisory clients and individuals. Our clients include pension funds, central banks, sovereign wealth funds, insurers, foundations, financial advisers and individual investors. It all began in South Africa in 1991.

We were a small start-up offering domestic strategies in an emerging market. Over two decades of growth later and we’re an international business managing over £111 billion* for clients based all over the world.

*As at 31 March 2019

Garland Hansmann Portfolio Manager

Garland is a portfolio manager responsible for our Multi-Asset Credit, High Yield and Investment Grade Credit funds at Investec Asset Management.

Prior to joining the firm he was Head of High Yield at Intermediate Capital Group, where he was also a member of the investment committee for the firms senior secured loans, high yield bond and direct lending funds. Before that Garland worked at Credit Suisse Asset Management where he was Head of European Credit Research for both European High Yield and Investment Grade, as well as lead portfolio manager for European high Yield and co-manager for Global High Yield strategies.

Prior to this Garland established the Investment Grade Corporate Bond Strategy for Delbruck Asset Management in Frankfurt, and was also a fixed income portfolio manager within Dresdner Bank’s institutional asset management division.

Garland holds a Finance and Capital Markets degree (Diplombetriebswirt) from the Hochschule fuer Bankwirtschaft University in Frankfurt, and is also a CFA Charterholder.

Roundtable

Sponsor

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Richard Tomlinson

Deputy CIO

Richard is Deputy CIO at LPP and has broad responsibility for management and oversight of the investment portfolio and client activity. Richard’s direct responsibilities include asset allocation, macro research, portfolio strategy and

client management.

Richard has over 17 years of investment experience. Prior to joining LPP in 2017, Richard was Head of Portfolio Advisory (EMEA) at Albourne Partners for six years where he advised European investors on alternative investments, portfolio construction and risk management. Earlier in his career, Richard was Head of Multi-Strategy at Old Mutual Asset Managers and prior to this, an analyst at GNI Fund Management. Richard holds a degree and a master degree in Engineering from the University of Cambridge and is a Chartered Alternative Investment Analyst.

Hardeep Khangura

Portfolio Manager - Fixed Income

Hardeep Khangura, CFA, is a member of SEI’s Portfolio Management team leading on Emerging Market Debt and supporting Global Fixed Income portfolios. Mr Khangura was previously a member of SEI’s Fixed Income Manager Research

team with coverage of global fixed income manager exposures across EM, credit, sovereign and FX.

Previous to this in addition to operating in a similar capacity as a Fixed Income Manager Researcher at Willis Towers Watson, Mr Khangura also headed the Fees ASK (Area of Specialist Knowledge), leading a team that analyzed, modelled and advised clients on the suitability and competitiveness of their investment manager fees. Mr Khangura joined SEI in 2015.

BSc (Hons) Accounting & Finance, University of Warwick CFA Charterholder, CFA Institute

Roundtable

Participants

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Royal London Asset Management

Company Profile

Royal London Asset Management is one of the UK’s leading investment companies. RLAM has built a strong reputation as an innovative manager, investing across all major asset classes and delivering consistent long term outperformance. RLAM manages over £113 billion of assets (at 31/12/18), split between equities, fixed interest, multi asset investing, property and cash, with a market leading capability in Sustainable Investing. Products include funds and segregated accounts investing in government bonds, investment grade, high yield and unrated credit, equity income and equity growth across global developed markets, as well as UK property and cash and short-term money market instruments.

Azhar Hussain Head of Global High Yield and Multi Asset Credit

Azhar has 17 years direct experience of investing in Global High Yield bonds. With a background as a chartered accountant, he started his investment career at Gulf International Bank as a telecom and media analyst progressing

to managing various funds in the absolute and relative return areas before moving on to Insight Investment Management. Over his career he has invested in an array of bond strategies in the High Yield arena globally. His style is based on his background as a chartered accountant with his belief that fundamental credit analysis is the core to outperformance.

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Sponsor

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André KerrSenior Investment Consultant

André joined XPS’s Investment Consulting practice as a Senior Investment Consultant in 2017, he is based in our Leeds office and provides all aspects of investment advice to UK defined benefit pension schemes. André is the head of

our Fiduciary Management Oversight Service and is a senior member of XPS’s credit research team.

Prior to joining XPS André spent just under 4 years at Willis Towers Watson (WTW) splitting his time equally between providing advice to defined benefit pension schemes on a fiduciary basis and the day-to-day management of WTW’s ‘in house’ funds, including the Alternative Credit Fund. Prior to leaving WTW, André was Assistant Portfolio Manager on the Secure Income Fund was instrumental in its successful launch.

André sits on the committee shaping the industry standard for evaluating the performance of fiduciary management and is a qualified actuary. André previously spent 14 years in the RAF as a fast jet pilot and flying instructor. During that time served three operational tours over Iraq and Afghanistan flying over 50 combat missions.

Brendan MatonFreelance Journalist

A highly experienced financial journalist with an expansive network of contacts in the UK and across Europe. Brendan has written about pension schemes and national welfare systems from Finland to Greece for 18 years and understands the

retirement savings industry in each European country.

Brendan has interviewed EU commissioners and national ministers; central bankers; pension scheme heads; insurance chief executives; chief investment officers; actuaries; union officials; professional and lay trustees.He worked at Financial Times Business for eight years, finally as editor-in-chief of all international pensions titles. Brendan has spent the last ten years as a freelancer for a number of publications, including Financial Times, Responsible Investor, Nordic region pensions news and IPE. He is also Chief webcast host for IPE.

Brendan has acted as conference chair for Financial News, the UK National Association of Pension Funds, Dutch Investment Professionals Association (VBA), Corestone, Insight Investment, Marcus Evans, Robeco Asset Management, Sustainable Asset Management (SAM), Towers Watson.

Roundtable

Participants

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CAMRADATA’s fourth Multi-Asset Credit Strategies roundtable took place in London in early summer, attended by asset owners, fiduciaries, pension fund consultants and MACS managers. Although MACS have been around for more than five years, the roundtable began with some frank challenges about their place and identifying characteristics.

“What should a MACS be? What’s the definition?” asked André Kerr, head of fiduciary oversight at XPS, a pension fund consultancy.

Hardeep Khanghura, portfolio manager at SEI, a fiduciary manager, took a step further back and said that MACS were hard to define uniformly because the opportunity set was so wide and varied. His opening question was: “What is the asset we are talking about here?”

Some orientation is necessary because credit markets have expanded tremendously this century for numerous reasons. One is the improvement in the economic management of Emerging Markets and their subsequent standing as bond issuers. Another is the preference in Developed Markets for debt over equity – or to be precise, private equity and debt over public equity.

Garland Hansmann, co-manager of Investec Asset Management’s MAC, pointed out that “A MAC should be a solution based approach to help investors achieve their investment goals. While what goes into a MAC is of course important, more important is what it delivers. Most investors require a L+4% type return with low volatility, fixed income like. A global-aggregate style portfolio or a high-return-seeking portfolio don’t really solve the bigger issues investors face today.”

“Markets have changed hugely since I first started out,” said Azhar Hussain, head of credit at Royal London Asset Management. “The industry is much more professional and the opportunities much broader. The duration of Investment Grade has lengthened. There is also much more passive money in High Yield thanks to the likes of ETFs.”

Addressing Kerr’s opening questions, Andrew Jackson, head of fixed income at Hermes, said the lack of rigid definitions for MACS in this expanding universe was a boon, not a hindrance. “That’s the best thing about MACS – it allows us to have conversations with clients. Together we can discover and identify what they want.”

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Some orientation is necessary because credit markets have expanded tremendously this century for numerous reasons

Multi-Asset Credit

The Future of Credit Investing

Kerr said that XPS has guidelines for different types of MACS based around the characteristics they bring to the overall portfolio in terms of return target and liquidity. Libor +2-3% is the safest version, with a material allocation to Investment Grade. The popular middle category targets Libor +3-5%. Then there is a racy Libor +6-10% which is likely to be less liquid. These broad categorisations are also heard from other pension fund consultancies. Kerr said: “Personally, irrespective of the return requirement of the portfolio, I would have 15-30% invested credit in return-seeking credit to benefit from the contractual cashflows.”

Given this belief, why his initial concern about MACS definition? The problem for UK pension fund trustees, as Kerr sees it, is that return-seeking credit has not been well explained to them. When Liability-Driven Investing first took hold, pension fund trustees were led to identify credit as sitting in the matching portfolio [which is also understandable given that the new corporate accounting standards worked off an AA-swap curve]. That portrays credit as a single homogeneous asset that is a little harder-working than gilts but not risky and certainly not containing some areas that could be comparable with equities over in the growth portfolio in terms of some characteristics such as expected return.

Richard J Tomlinson, deputy CIO of Local Pensions Partnership, a new pool for £17bn in UK local authority pension savings, solves this particular problem of definition by distinguishing matching-side debt as fixed income: “Our fixed income fund is low-duration, daily liquidity; closer to cash than risky credit,” he said.

But Kerr wasn’t sure that others on the buy-side, notably trustees of smaller pension schemes, were comfortable with this distinction: “Many trustees don’t want to hear about credit in the growth portfolio,” Kerr said. “When we were at Willis Towers Watson - a global pension fund consultancy - it was easier to sell Diversifying Strategies - which had all sorts of non-traditional strategies with low correlations to equites in there - than the Alternative Credit fund. Scheme consultants reported back to us that the Diversifying Strategies were easier to explain and recommend to trustees.”

Whilst the accessibility of a much broader range of credit has improved for smaller pension schemes, the long-held view that credit is a matching asset may be hard to shift.

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Whilst the accessibility of a much broader range of credit has improved for smaller pension schemes, the long-held view that credit is a matching asset may be hard to shift

Hansmann reminded the CAMRADATA panel that for many folk ‘credit’ retained untrustworthy connotations. “There is still a stigma attached to credit in the mind of ordinary people since the Global Financial Crisis. Any three-letter acronym starting with a ‘C’, e.g. CLOs, is even worse. People still think of them as toxic waste.”

The irony of this overly cautious mentality to MACS managers is that their Libor +4-5% strategies were created to produce the kind of returns that used to be delivered by blue-chip Investment Grade bonds. “MACS is what a Global Aggregate Bond fund used to be,” remarked Hussain. He qualified that in today’s environment Libor +4-5% is more a High-Yield-like return but MACS such as Royal London’s crucially target lower risk than a High Yield index.

Kerr feels that consultants have not done great job educating their pension fund clients about this shift in credit markets. Not enough sovereigns or blue-chip corporates issue coupons at the generous levels of yesteryear, so going further out along the risk spectrum is necessary. This is the price one pays for a multi-decade bull run in fixed income.

Where the panel fell to argument was when to travel and how far along that spectrum. “It all starts with expectations,” said Tomlinson. “How are companies financing themselves? How credible are past default rates? We look at long-run returns for risk assets and work from there. That is how you build strategic allocations.”

Local Pensions Partnerships is a sophisticated investor. In a previous job, Tomlinson himself worked as a multi-asset portfolio manager at a fund manager. His take on the three broad categorisations outlined by Kerr was thus: “Libor +2% is not interesting to us because it won’t meet our liabilities. Libor +12% is not realistic. But Libor +3-4% is a healthy risk premium to target. We don’t need all the upside.”

This sounded like good news to the ears of Hansmann and Hussain: both Investec and Royal London target this kind of return over the cycle while Hermes offers low, medium and high-return versions of its MACS, in accordance with client objectives.But expected returns is only the beginning of the story. The three managers have different styles and strengths.

For Hermes’ high-return version to meet expectations, Jackson was clear that his team needed to include distressed opportunities. Tomlinson described distressed as capital strategies, where a company is saved from peril and - when things go according to plan - those investors are rewarded by a deep discount on the bonds turning into a smaller discount.

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How are companies financing themselves? How credible are past default rates? We look at long-run returns for risk assets and work from there. That is how you build strategic allocations

Income Credit, in contrast, Tomlinson defined as performing instruments.The first argument was whether distressed has a place in strategies targeting Libor +3-5%.

Hussain reckoned there were lots of opportunities nearer to home, in the likes of Asset-Backed Securities and Leveraged Loans. “We asked our clients what they wanted and the answer we got back was High-Yield-like returns over the cycle,” he said. “Illiquids are out on the far right of the spectrum. There is a place for everything but introducing distressed debt into my MACS would make the whole fund’s success dependent on skills in timing whereas the tools we use are relatively liquid. When the markets are down, as in 2018, that means we can protect capital.”

Hansmann argued that the Investec MAC, targeting Libor +4-6%, can include capital-return strategies, ie they are neither the preserve of the more racy, double-digit versions nor earned solely from distressed situations. Like Hussain, he also believed that medium returns best suited pension fund clients.

“Jeff Boswell and I used to run a 8-10% strategy. But the more we spoke to clients, that wasn’t what they wanted for the challenge they faced. It was risk-constrained Libor +4% to make up for what government bonds and Investment Grade were no longer supplying.”

Jackson made the point that once categorisations are established, the asset management industry starts to think in terms of silos, which do more bad than good, preventing portfolio managers from pursuing best ideas. “I don’t understand why a lower-risk strategy can’t put in some 10-year duration or Leveraged Loans where appropriate,” he said.

He added that Hermes clients typically want its highest-return MACS run on a segregated basis. These investors wanted to have the conversation with Hermes about what they needed and how the manager achieved those objectives. So they were free from siloed thinking. He added that US pension funds were very enthusiastic for 8-12% returns. But what about the rest?

The CAMRADATA panel noted several dangers with current attitudes to credit by UK institutional investors. They might remain fearful of credit in the ‘A’ to ‘BB’ range but seem to have fewer qualms lending to more illiquid, private equity buy-outs. Jackson noted that illiquidity and high risk had become conflated. “There is plenty of paper out there that is low-risk, low-liquidity like infrastructure debt,” he said.

Once categorisations are established, the asset management industry starts to think in terms of silos, which do more bad than good, preventing portfolio managers from pursuing best ideas

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“There is high underwriting quality written into the contracts but you can’t liquidate it readily.”

So not all illiquids are the same. Hussain said that the illiquidity premium in private debt had diminished in recent years because of the weight of pension fund money being shoved into this area. He suspected that the next major financial crisis’s epicentre could be triple-B debt, especially in Europe, an area which has ballooned in size due to quantitative easing.

Tomlinson agreed with Jackson that there was a misassumption about the constancy of returns from illiquids. “The simplistic notion that the illiquidity premium is always positive– that’s the excess reward for the illiquidity – is naïve,” said Tomlinson. “They are time-variant and not consistent across asset classes.” He suggested pension schemes need to be run more like a balance-sheet, with each line on the asset and liability side being understood in a holistic context.

LPP itself is currently mulling how to best capture opportunities across the credit spectrum. Tomlinson said the pool may have agreements with specialist managers that enable it to appoint them at very short notice to act on its behalf. These could be mandates not funded before the point of active deployment. But herein lie structural difficulties even for large asset owners. LPP uses Authorised Contractual Schemes for some vehicles but not for credit due to liquidity mismatch concerns (ACSs require daily dealing, which does not suit many illiquid investments). Border to Coast, another local authority pension pool, also uses ACSs. John Harrison, adviser to Border to Coast, via a telephone interview, made the additional point that at least two of its institutional clients had to stick with an ACS to keep it open. In the broad world of credit, with time-varying returns from each sub-sector, deciding where to open a sub-fund thus becomes a balance between practicality and diversification. Harrison estimated that it takes a year to get a vehicle up and running and two years to close it down. This highlights the key importance of investment vehicle and pool management structure – what Tomlinson suggests is only possible with the right fund and governance structures in place.

The MACS managers would argue that they offer a ready alternative. In terms of vehicle structure, this might be true but the scrutiny then turns to the breadth of their capabilities. Khangura said that each different sector of credit requires different skill sets. “Everyone has a starting-point. Ten years ago most MACS were a High Yield team, that then went to 50/50 High Yield/Leveraged Loans, and now have non-traditional satellites.” The CAMRADATA panel agreed that no one team could be expert in every type of credit; the knack was not to be tempted into unfamiliar areas by exigent conditions.

The simplistic notion that the illiquidity premium is always positive– that’s the excess reward for the illiquidity – is naïve. They are time-variant and not consistent across asset classes

Jackson stated that some vehicles do not deserve to be called MACS, when specialist funds are simply bolted into a superstructure and then allocated from a central desk across the specialist funds. Hansmann agreed that MACS worked when the central team made decisions with a fuller understanding of each area of deployment. This is the argument MACS use against fiduciary managers such as SEI, which use individual specialists in each sub-sector of credit. Jackson suggested a MACS manager is best positioned to allocate dynamically between asset classes. Khanghura repeated his claim that many MACS are not as dynamic or knowledgeable as they might be. “I don’t see many comfortably switching between say, US High Yield and Emerging Markets.” One of Khanghura’s chief concerns was that many US-based MACS were still anchored in US High Yield.

The three MACS managers present then had a chance to prove their dynamism and breadth. Hansmann began by recalling how Investec had profited from banks’ regulatory capital provision in recent times. “At the beginning of 2017, post the Deutsche Bank saga, it was easy to pick attractive names in bank capital with spreads being attractive across the board. We held Nordic, UK, Swiss and some French names until summer 2018 making about 10% in the process. After spreads compressed and the credit curve became flat and only short-dated CoCos seemed attractive. Hansmann described it as “a first-call trade”, which was defensive in the downturn, making money even as the broader credit market sold off. Only after that repricing did it make sense to go longer again, looking to an intermediate call date in select names making 8% in the first few months of 2019.

Hussain said: “In liquid credit you are not going to add much performance by individual stocks but you can protect the downside. My starting point in sub-investment grade is never have investments forced on you.”

The Royal London MACS does not hold any financials. “Bank financial statements don’t tell you the risk position. I know because I used to work in a bank.” He added that not just banks but lots of blue-chip names know what they have to do to satisfy the credit ratings agencies. But these influential firms “don’t do a good job. I like that because it gives me a job,” said Hussain. He then gave Vodafone as an example. “Just look at the Enterprise Value; it’s in the low single digits, with debt being a large proportion. That tells you all you need to know about the prospects for this company. Then compare Vodafone to Virgin Media, which has a double-digit multiple, due to its stable growing cashflows. That is a business we much prefer.”

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CLOs are a type of instrument Hussain likes right now because you can look through to the underlying names when evaluating their use as protection. “If things go wrong, we get higher recovery rates but hopefully we can get out before then,” he said. “At this point in the cycle we want as much liquidity as possible so we have a preference to the higher rated bigger tranches.”

Hussain’s cautiousness was echoed by Tomlinson, who might be looking at structures to access distressed debt for LPP but was wary of actually buying any non-performing loans right now.

Like Hansmann, Jackson emphasised MACS’ dynamism. In the third quarter of last year, Hermes held 100 units of risk in its long portfolio, including a big exposure to Hard Currency Emerging Market Debt “where the baby was being thrown out with the bathwater.”

By the end of the year, markets may have suffered their worst quarter for years. Hermes’ response was to increase the number of long units of risk to 120. Not that Jackson’s team directly compare themselves with the market index. “We are fully bottom-up. Trying to figure out which part of the market is going to be winning is very hard so we look at individual securities in the environment. A good contrarian example for last year was some headline grabbing large BBB corporates. Companies were facing potential credit rating demotions to High Yield: Hermes saw value where other investors saw companies struggling.

Fast forward to May 2019 and Jackson sees huge uncertainty in the markets. Hermes is down to 80 units of risk, including going short iTraxx cross-over payers. “There is more gamma in the portfolio and we are waiting to see some value before buying,” he said. In contrast to Hussain, Hermes does buy financials.

He ended on a confident note: “Irrespective of a pension scheme’s strategic asset allocation, I believe there should be a place for credit.”The question for the years ahead is how much of that credit will be channelled through MACS.

Trying to figure out which part of the market is going to be winning is very hard so we look at individual securities in the environment

Our approach to holistic returns means we are committed to delivering excellent long-term investment performance and stewardship, while improving the lives of many.

The value of investments and the income from them can fall as well as rise and you may not get back the original amount invested.

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CREDIT

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A reveille has been sounded in markets that are now experiencing feverish activity as half a decade of inertia gives way to volatility. Explanations for the panicked stampede of the Q4 2018 sell-off, subsequent rebound and recent weakness mask the importance of properly calibrated defensive and flexible portfolio strategies in this kind of market environment.

The past two quarters at the turn of the year saw an extremely volatile period for markets, and aside from this I would like to highlight three notable things that stood out to me about the fourth quarter of 2018, the first quarter of 2019 and the last few weeks.

The first is the sheer ferocity of both the downward plunge and the subsequent recovery. The second is the fact that so many people were shocked by this turbulence after such an extended period of dead calm. The last is the remarkable symmetry between the two quarters’ rise and fall in spreads and the potential for this latest move to reach the same magnitude.

There is a real sense that market participants (including those in the credit-market) have fully participated – or perhaps even taken a levered exposure – in the market fall that was experienced and have then under-participated in the subsequent rally.

We have certainly observed this in the relative performance of some other investors, which have not had the benefit of either defensive portfolios or a defensive strategy going into the fourth quarter of 2018.

Worryingly, we believe that market participants’ memories are getting shorter and shorter: that they fear the cost of hedges and defensive strategies more than they do sell-offs, that the Fear of Missing Out is greater than being too long and wrong. Our concern is that this is becoming increasingly inconsistent with the desire of end-investors for a more defensive mindset. We are convinced that flexibility and pragmatism will be the watchwords for fixed-income markets in the medium term.

Importantly, against this backdrop, investors in Asia and around the world must consider the relative value of assets in fixed income markets and look ahead, creating a portfolio that can manage the growing risks in the system.

But where does this value lie? While we saw greater value in the most liquid parts of the fixed income universe at the end of fourth quarter than at the end of the third quarter, this trend is now reversing. We now see that, once again, our ideal client portfolios show greater allocations to strategies such as direct lending.

Direct lending is one asset class that has shown increased attraction for our investor base around the world. It offers good relative value coupled with low default rates. We also find that hybrids, subordinated financials and emerging market credit spreads continue to offer some of the best value in public credit markets. However, it’s important to note that with spreads generally tightening, they are less attractive than they were at the beginning of the year. Subordinated financials have moved up in our book, reflecting the very attractive relative value that we see in certain pockets of the market, such as UK insurers, Brexit risk notwithstanding.

European CLO mezzanine tranches is another asset class that given their greater attractiveness on a risk-adjusted basis, shouldn’t be overlooked by investors and could provide an interesting means of diversification. Tranches rated BB and B offer appealing spreads versus the similarly rated European corporates. Their low expected default rates and current good liquidity ensures that they can be readily traded.

While these observations paint a rosy picture of value, there are some areas to be wary of. Government bonds have moved down in our rankings. Yields moved lower following a rally in the asset class attributed to weakening global economic data, the halting of the Fed’s tightening cycle and the pricing-in of rate cuts this year. This repricing of US Treasuries caused an inverted yield curve, which many believe signals a recession within two years.

Direct lending is one asset class that has shown increased attraction for our investor base around the world. It offers good relative value coupled with low default rates

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While many view the inverted yield curve as a warning signal, others are convinced that ‘this time, it is different’. Given the uncertainty as to when this credit cycle will end, we aim to maximise returns while reducing downside risk: we continue to select areas of credit risk we like while adding convexity to our multi-asset credit portfolios.

What can investors take away from all this? Our view is there are lessons to be learnt from looking back on the past nine months. Importantly, avoid silos and consider the wider risk outlook. There’s a lot of tail-risk from protectionism and this shouldn’t be ruled out but investors taking a long-view. In fact, apart from climate change, we see this as the major medium-term risk for markets.

Ultimately things won’t be different this time around, which is why experience triumphs over hope.

To read more, CLICK HERE for the latest issue of 360° where Andrew Jackson, Head of Fixed Income at Hermes, and his team of specialist investors provide a quarterly outlook of risks and opportunities across the credit spectrum – from public to private debt, leveraged loans, structured securities and asset-based lending.

The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.

While many view the inverted yield curve as a warning signal, others are convinced that ‘this time, it is different’

Written by

Andrew Jackson,

Head of Fixed Income atHermes Investment Management

Overexposed fixed income investors The Future of Credit can expect a rude awakening

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Credit investors have enjoyed a strong start to the year. Does this mean the good times are already over? We think the case for credit remains strong but a shift in the backdrop means selectivity and flexibility will be vital for making the most of the asset class.

Boosted by recent tailwinds After last year’s volatility, credit markets have delivered solid returns so far this year. Powerful tailwinds sweeping in include a more dovish US Federal Reserve and expectations-beating corporate earnings. Supply and demand dynamics have further boosted the backdrop, with net issuance levels subdued but investor inflows strong – attracted by the higher yields credit offers relative to other parts of the fixed income universe. Perhaps some caution is warranted as volatility returned to credit in May, with the prospects of a US China trade resolution looking less certain and global growth starting to soften.

Does the strong start to the year mean all the juice has been squeezed out of credit markets, weakening the returns outlook for the rest of the year? We think the answer is no, but with a few caveats. With the current level of default risk likely to remain low, we believe the credit risk premium continues to offer attractive compensation to investors. But selectivity and flexibility will be key to harnessing the full potential of the asset class.

Shifting sandsThe extraordinary monetary policy that followed the global financial crisis was a positive for credit markets. In a broad sense, bad news was good news for credit overall, with exceptionally low rates encouraging many investors to explore beyond sovereign debt into the higher yielding part of fixed income markets, pushing yields down and prices up.

However, we think the recent market rally is different and that it does not necessarily reflect a wholesale reach for yield. What was once indiscriminate buying has now become more selective, but we believe this selectivity has been largely driven by fear, creating market inefficiencies that nimble and selective investors can seek to exploit in pursuit of compelling risk-adjusted returns.

Where swimming against the tide makes sense While investors have shown a strong appetite for buying into the recent credit market rally, there is a palpable wariness around certain segments of the market. Negative headlines around BBB rated credit risk is a notable theme, which has seen many investors steer clear of this higher risk, lower credit quality part of the market. This is reflected in the meaningful underperformance of the BBB segment.

The BBB rated credit universe has tripled in size since 2009, as US corporates have taken advantage of cheap financing for M&A and buybacks. This has helped lift the share of BBB rated bonds in US and European mutual fund portfolios from 20% in 2010 to around 45% last year. It is understandable why many investors are cautious: if a BBB rated bond gets downgraded it moves from the investment grade category to high yield or ‘junk’ status and with many portfolios restricted to holding only investment grade, the market impact of downgrades can be significant. With a muted global growth outlook putting increased pressure on issuing companies, investors are right to be cautious.

However, we believe a selective approach to investing in the BBB universe can reap rewards for investors. We see a significant amount of flexibility in a range of well-run BBB rated companies in terms of the steps they can take to maintain a BBB rating in the event of harder economic times. Examples include companies like AT&T and Anheuser Busch, which have launched debt-friendly initiatives like reducing share buybacks and — in extreme cases — reduced dividends or disposed of non-core assets.

Many investors have also overlooked corporate hybrid securities – bonds which combine features of debt and equity securities. The expected payoff profile – available upside return vs. potential downside risk – of this part of the market is attractive yet it has lagged year to date relative to other areas of the credit market which are perhaps overextended, such as US High Yield.

While investors have shown a strong appetite for buying into the recent credit market rally, there is a palpable wariness around certain segments of the market

21Have investors missed the boat in credit?

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In this vein, dynamism and selectivity are as vital for avoiding the more susceptible areas of the credit market as they are for capturing overlooked potential.

Swimming against the tide of mainstream investors through a carefully plotted route can bring significant enhancements to both the risk and return side of the equation, in our view.

The benefits of a freestyle approachAn unconstrained investment approach gives credit investors access to a broader opportunity set and affords them greater flexibility to adapt to changes in credit risk premia and market technicals across different areas.

We believe this approach is best placed to deliver the full risk-adjusted return potential of credit markets in the year ahead. By increasing the flexibility to seek the best investment opportunities across the global credit universe while avoiding susceptible segments, an unconstrained strategy can provide a diversified portfolio which aims to be high-yielding yet comparatively defensive.

Investors wishing to navigate the credit world would do well to choose a sturdy yet nimble vehicle rather than hop on the same boat as the rest of the crowd.

Investments carry the risk of capital loss.

This communication is for institutional investors and financial advisors only. It is not to be distributed to the public or within a country where such distribution would be contrary to applicable law or regulations. The information may discuss general market activity or industry trends and is not intended to be relied upon as a forecast, research or investment advice. The economic and market views presented herein reflect Investec Asset Management’s (‘Investec’) judgment as at the date shown and are subject to change without notice. There is no guarantee that views and opinions expressed will be correct, and Investec’s intentions to buy or sell particular securities in the future may change. The investment views, analysis and market opinions expressed may not reflect those of Investec as a whole, and different views may be expressed based on different investment objectives. Investec has prepared this communication based on internally developed data, public and third party sources. Although we believe the information obtained from public and third party sources to be reliable, we have not independently verified it, and we cannot guarantee its accuracy or completeness. Investec’s internal data may not be audited. Except as otherwise authorised, this information may not be shown, copied, transmitted, or otherwise given to any third party without Investec’s prior written consent. © 2019 Investec Asset Management. All rights reserved. Issued June 2019.

Investors wishing to navigate the credit world would do well to choose a sturdy yet nimble vehicle rather than hop on the same boat as the rest of the crowd

Written by

Garland Hansmann,

Manager of the Investec Multi Asset Credit Strategy

and

Jeff Boswell,

Manager of the Investec Multi Asset Credit Strategy

2524

The past 12 months have provided an ideal testing ground for multi-asset credit (MAC) strategies. The period has featured interest rate volatility, liquidity shocks and multiple blow ups in the high yield sector, against a backdrop of deteriorating global economic data, trade concerns, monetary policy tightening, Chinese weakness and Brexit.

Royal London Asset Management’s (RLAM’s) MAC fund achieved a positive absolute return with low volatility in this multifariously challenging environment, thereby demonstrating how sticking to a sensible combination of core principles can yield exceptional returns even in difficult circumstances.

Our approach to investing is based on five core principles

Principle 1: Risk Over Uncertainty

Risk and uncertainty both describe situations in which outcomes are unknown. We differentiate the terms by classifying situations in which the distribution of probabilities is known as risk, and situations in which the probability distribution is unknown as uncertainty.

Credit risk can be actively managed with instrument selection, stock selection and duration management. Uncertainty, on the other hand, cannot be managed and so requires active avoidance. Accordingly, we try to avoid areas with political risk, regulatory risk and foreign exchange risk.

We disfavour such sectors as subordinated financials, which can be influenced by numerous factors not calculable from financial statements, and hybrids, which face binary risks depending on the decisions of rating agencies. We have reduced our UK exposures over the past year in reaction to the elevated level of uncertainty surrounding Brexit.

Principle 2: Volatility Aware

Our MAC fund exists to generate a return that is at least as strong as the high yield market, but with less volatility. This requires thinking about the volatility of prospective investments from both fundamental and technical perspectives.

Our MAC fund exists to generate a return that is at least as strong as the high yield market, but with less volatility. This requires thinking about the volatility of prospective investments from both fundamental and technical perspectives

24 Credit Investing Made Simple 2525

On a fundamental basis, the volatility of an investment’s underlying cashflows is a vital consideration. We seek companies with steady, repeatable cashflows because forecasting becomes increasingly difficult as the cashflow volatility increases.

On a technical basis, it is imperative that we consider the volatility of the instruments that we invest in. We must think about the types of investor that currently hold the instruments in order to determine both their current and their future levels of volatility.

Principle 3: Security Focus

We invest in line with RLAM’s core investment philosophy favouring ‘covenants, structure and security’. This allows us to look beyond credit ratings and focus on the important question of whether the rewards sufficiently compensate for the risks.

Embedded security means that if our investment decision does not transpire as planned, and we are not able to sell our investment, we will still have recovery value. It aligns with our volatility awareness principle, because it reduces the downside risk of any given investment.

Principle 4: Selective and Liquid

We do not believe that there is sufficient premium in the market for holding highly illiquid securities, given the considerable risks to smaller companies at this late stage of the business cycle. Companies with greater liquidity in their capital structures should prove much safer investments.

The vast expanse of our investment universe means that it is possible to select relatively big companies and at the same time maintain adequate diversification to protect us against one-off events. The size of our investment universe offers us the luxury of being highly selective in our stock picking, instead of simply buying asset classes.

Principle 5: Nimble and Responsive

The markets in which we operate contain large amounts of passive money. Around two thirds of the leveraged loan market, for example, is driven by structured buyers through collateralised loan obligations. They are forced to sell when bonds are downgraded.

This gives us, as active managers, a significant advantage. We are able to think on an absolute basis rather than a relative one, meaning that we are not forced to rely on rating agencies, which can be slow to act and can look at the wrong things from an investor’s perspective.

Being nimble and responsive means that we are able to leave our investments swiftly, as market conditions change, rather than waiting on rating agencies. We are also happy to hold a downgraded credit, provided its investment case remains, because our only concern is that the rewards justify the risks. The likely triggers for us to sell would be impairment or potential volatility.

Keeping our eyes on the prize

We strive to make credit investing as simple as possible. By reducing uncertainty as much as possible, and focusing instead on what we can measure (default risk, liquidity risk, volatility risk), we are best able to assess the balance of risks and rewards in our investment decisions. As the past year has shown, the right set of principles, meticulously applied, can deliver robust performance in all kinds of environments.

Being nimble and responsive means that we are able to leave our investments swiftly, as market conditions change, rather than waiting on rating agencies

Written by

Azhar Hussain,

Head of Global High Yield

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Oct 17 Nov 17 Dec 17 Jan 18 Feb 18 Mar 18 Apr 18 May 18 Jun 18 Jul 18 Aug 18 Sep 18 Oct 18 Nov 18 Dec 18 Jan 19 Feb 19 Mar 19 Apr 19

Royal London Multi-Asset Credit Y Inc Investment Grade Credit Index * Global High Yield Index **

% Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec YTD

2017 - - - - - - - - - 0.16 -0.18 0.15 0.13

2018 0.33 -0.20 -0.11 0.53 -0.15 -0.36 0.90 0.61 0.54 -0.06 -0.65 -0.84 0.52

2019 1 .92 0.79 0.41 0.87 4.04

Past performance is not a reliable indicator of future results. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The impact of fees or other charges including tax, where applicable, can be material on the performance of your investment. Source: RLAM as at 30 April 2019, gross of fees and gross of tax, for the Y Inc share class. Inception date of the share class is 9 October 2017. *BofAML BB-B Global Non-Financial High Yield Constrained Index ** BofAML Global Broad Market Corporate Excluding Sub-Financial Index.

Cumulative total returns (since inception)

The views expressed are the author’s own and do not constitute investment advice. All information is correct at May 2019 unless otherwise stated. Issued May 2019 by Royal London Asset Management Limited, Firm Registration Number: 141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; These companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064. Our Ref: AL RLAM PD 0017

26

FOR PROFESSIONAL CLIENTS ONLY, NOT SUITABLE FOR RETAIL INVESTORS.

58337 05 2019

Past performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested.

Issued May 2019 by Royal London Asset Management Limited, Firm Registration Number: 141665, registered in England and Wales number 2244297; and Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439. These companies are authorised and regulated by the Financial Conduct Authority and are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office:

55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064.

Ref: ADV RLAM PD 0003

COMBINING DIVERSIFICATION WITH

INCOME PROVISIONSIn the continuing volatile environment, investors are seeking a diversified solution with the potential to withstand a range of economic and market scenarios. In response to this, RLAM developed the Royal London Multi Asset Credit Fund.We believe that by combining assets across the credit universe, investors can enhance returns in a risk-controlled way.

• Diversification – focuses on ‘alternative’ credit sectors, such as global high yield, asset backed securities and loans.

• High income – exposure to higher yielding areas of the credit market which may be beneficial in a low rate environment.

• Duration – favours a shorter duration approach to mitigate against volatility or interest rate rises.

• Expertise – follows the same established philosophy as all of our actively managed credit funds.

To find out more, please contact us at institutional@rlam.co.uk or call 020 7506 6500 or visit www.rlam.co.uk

58337 MAC Advert A4 May 19 ART.indd 1 28/05/2019 11:36

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