Credit where it’s due – what separated the winners and losers in the multi-asset credit world
Getting to grips with multi-asset credit performance in Q1 2020
Investors will be sitting down to review Q1 2020 fund performance after one of the most extreme quarters on record. In the third in our series of blogs helping asset owners get to grips with active manager performance, Nick Cooney looks into multi-asset credit to ask: what has happened to credit strategies in Q1 2020? What are the right questions to ask managers? What have we learnt about manager skill?
What is multi-asset credit?
Multi-asset credit, or MAC for short, describes funds that are typically tasked with total return targets of cash +4-6% pa, and provide investors with a low governance way to access multiple credit-related asset classes globally.
This is not just about mainstream corporate bonds. Portfolio managers are generally given wide discretion to buy and sell assets in different sectors and select securities that they believe are attractive within each of those sectors. Typical investments include high yield bonds and loans, without direct reference to index benchmarks.
What we have learned
We have seen more dispersion among MAC funds than many other areas in Q1. Sometimes the returns generated have been perplexing – some lower risk funds seeing higher-than-expected losses.
Q1 2020 unfolded so fast that most managers were not able to alter their portfolios significantly, so returns were largely driven by their positioning going into 2020. So, Q1 probably hasn’t taught us a huge amount about manager skill, but it may have highlighted under-appreciated areas of a manager’s process.
It’s important to note that there was a positive rally in markets post quarter-end, so the performance in Q1 needs to be seen in that context because in many cases the losses don’t represent a permeant impairment to value.
Key performance drivers
Duration: Falling government bond yields were positive for returns. In terms of Q1 2020 performance, it was a case of the longer the term of the bond investment the better. The outcome was that funds that hedged out the natural duration in corporate bonds did worse; and those with allocations to longer dated investment grade assets tended to do better. Typically though, we don’t expect MAC managers to take large active interest rate positions to add performance.
Loans: The loan market suffered severe price falls, driven partly by technical factors and role of Collateralised Loan Obligation (or CLO) managers who are substantial buyers in the corporate leveraged loans market. This was surprising as loans are often seen as more stable than comparative high yield bonds. Managers allocating to loans as a defensive play found that this did not work.
Sectors: Energy and names exposed to leisure/hospitality were hit particularly hard, especially in the US, with large parts of the market priced for default. The rating agencies have moved fast, already downgrading many energy names, and some defaulted in April. Our higher rated managers had overall taken steps to mitigate some of these risks.
Securitised credit: some high-quality tranches suffered extreme price falls (as did the lower mezzanine tranches). While this is reminiscent of 2008, CLOs originated post-2010 (coined “CLO 2.0s”) are generally much more robust and it would take underlying default rates several times greater than have been seen historically to impair these higher rated tranches. Prices recovered significantly post quarter end for the highest rated securities (supported by government policy), but the lower rated are still significantly down year to date.
Credit rating: the lower quality CCC and B rated segments did much worse than the BB and BBB segments in Q1 - this is the "rating bifurcation" in the industry jargon. The CCC bonds have also rallied less than other bonds post quarter end, so this was one performance theme that didn’t just reverse post quarter end.
The story however is more complicated considering that within the European Loans market, CCC rated issuers significantly outperformed other segments in April, providing double-digit returns (albeit on the back of poor March data).
The big question in credit, particularly in high yield, is defaults and downgrades. Avoid them and you earn your yield, get too many and your yield is eaten away. Near the end March, half of US high-yield securities were trading at levels considered likely to default (yields were more than 10% above government bonds) and some energy bonds had yields above 20%. We have seen defaults in April at their highest level since 2009, and Fitch forecast a rise in default rates to around 5-6% for 2020 and 7-8% for 2021. Overall spreads still seem to be providing good compensation for this risk, but the picture changes daily and being selective is key.
Questions to ask your manager?
How did your positioning fit with your process? When discussing performance with your manager, it’s not the losses so much that are worth focusing on (everyone lost money in Q1 after all) but the process. Dig deeper on which parts of the portfolio the manager lost the most on, why were these in there and what’s the reasoning for them going forward.
Which bonds were downgraded/ defaulted or are on watch for downgrade/ default? As a credit investor this is key. A MAC manager can’t avoid them all, but you’ll want some good explanations when it does happen.
What has your trading activity been? Again, the key here is consistency with process. Trading costs have been elevated since early March so over trading could be damaging to returns. High portfolio turnover also raises questions about how robust the original stress testing was within the fund.
We always recommend clients avoid knee-jerk reactions at times like these. Credit investors have suffered losses, but with high returns still on offer, we believe MAC managers should be well set up to deliver attractive returns in the recovery. The key is making sure you have good managers with strong processes that are aligned to your objectives. The MAC universe has evolved significantly over the last decade and continues to do so. You may want to take another look.
Get in touch to discuss further. Read also Madeline Chelper’s blog on ARB managers.