It is imperative that credit managers recognise the profound structural changes to the credit markets since the financial crisis and find ways to manage the new and rising risks.
Although there is less systemic default risk and lower volatility within credit markets, the structural changes have opened up new risks to performance: liquidity, evolving bond structure, duration and idiosyncratic risks.
To better manage these risks, managers need to be flexible.
One of the risks in today’s low volatility market is the crowded trade at the front of the credit curve, where one finds short duration and shortening maturity. Predicated on fears of imminent rate rises, investors have heavily allocated to short-duration credit, allowing the pendulum to swing in the issuers’ favour.
In the high-yield market, this ‘demand pull’ to feed these mandates has led to a surge in issuance of shorter-maturity, short-call bonds. Many of these have come from smaller companies that were once the staple of the loan market, but because of bank deleveraging and demand, they have refinanced loans in the bond market.
But with more securities subject to shorter non-call periods, achieving long-term, equity-like returns with less volatility is more difficult. In addition, whatever idiosyncratic risks may exist in these names could be magnified given the paucity of trading liquidity compared to pre-crisis levels.
As for the risk of rising rates, making use of a broader set of debt instruments can mitigate these risks. For example, by hedging or using credit default swaps, one can effectively manage for rising rates without having to enter potentially risky positions.
Finally, because the dearth of liquidity will magnify any sell-off, compression in the spreads between low- and high-quality names can be managed by shifting to better credit quality, as one is not adequately compensated for the additional credit and liquidity risks.
An effective way to compensate for not trading down in credit risk for yield is to manage on a global basis and look to emerging markets for opportunities.
One can find spread-equivalent securities in higher-quality global emerging market names. These tend to be globally diversified, high-quality BB large-cap names, with revenue in US dollars. There is, of course, some inherent emerging market risk but this is offset by the high quality of the firms investors are gaining exposure to.
Contingent convertibles (Cocos) have been receiving much interest of late. And, while one can appreciate their merits, their inherent structure raises some concerns regarding whether many of these securities are priced appropriately.
For US banks, preference shares perform a similar role to Cocos and are favoured by the Federal Reserve as a means of building capital buffers. The securities are typically callable after 10 years, have non-cumulative coupons, and are issued out of the holding companies overseeing banking groups.
Mitch Reznick and Fraser Lundie are co-heads of Hermes Credit