Credit roundtable discussion

Is it possible to exploit credit market inefficiencies and, if so, how given the current environment?

Martin Foden: We operate in a market with established, structural characteristics which drive a misallocation of credit and, ultimately, mispricing. Rating agencies are clearly still the biggest driver of asset allocation, yet credit indices also contribute to these market inefficiencies. If we accept that there are inefficiencies, the last thing you want to do is internalise these within your own process. Also, given the potential severity of credit losses due to the asymmetry of risk and return, people hunker down to name recognition and the highest profile companies. You definitely can exploit those inefficiencies.Joe Abrams: How you go about exploiting them varies. The ability to trade investment grade credit has got more difficult. So perhaps you should look at a buy and maintain approach, moving away from a fixed income benchmark – trying to exploit the credit risk premium that is there but in a lower transaction cost, lower fees-type manner.Christine Farquhar: If people are value driven, they can find the inefficiencies but then they have got to be patient to exploit them and you need patient clients.Patrick Zeenni: What is key in exploiting the inefficiencies is a real global/helicopter view approach between different geographical regions and different products. Looking not only at fixed rate bonds but also vanilla credit derivatives, hybrid corporate debt, floating rate notes… We see inefficiencies in the global high yield market, some of it due to the significant outflows in the oil sector. For example, you can catch cheap European issuers who issued in USD that were hammered by the outflows in the US. Looking at cross currency issuers is a great source of opportunities.Foden: There is a real opportunity to exploit credit market inefficiencies as the market as a whole becomes more thematic and takes macro views, looking across different markets and asset types. The more that microscope gets pulled back and the more people are looking top down and macro, the more opportunities there are on the ground. The sterling credit market is a wonderful expression of that. It is so nuanced and specific. If you look at the index, it is two-thirds to three quarters large global companies that can issue long dated capital. But that leads a wonderful tail of opportunity of mid cap/small cap, private companies and SPVs where real targeted, bespoke, bottom-up analysis discovers some fantastic returns for the fundamental credit risk that you are taking.Zeenni: Take the example of the fallen angels and the rising stars. When an issuer goes from a fallen angel or from investment grade to high yield, there are a lot of inefficiencies thanks to index rebalancings. On the one hand, you need to be very diligent in your screening in order to catch those at a depressed price. On the other, you need to be able to sell your position if you have a rising star who has been much prized by the market.Foden: In a real world sense and an intuitive sense there isn’t a fundamental shift in the characteristics, if a company hasn’t changed in any way apart from one notch of rating, one notch of opinion from the rating agencies. The client will understand what you are trying to do and you will have that mandate to take those opportunities.Abrams: A number of fixed income managers over the years in this bull market have perhaps been consistently overweight beta in fixed income markets. They have used credit sometimes to do that. Active management will now or at some point come to the fore, because you will not be able to just be overweight in the market in order to derive your alpha. So the identification of effective active managers, who are not just grabbing the bull run, will come to the fore and become a lot more important.Farquhar: But opportunities come at the most difficult time when liquidity is not there; investment banks are not playing and they are not coming back. So active allocation is probably the starting point and how you allocate at the start of a mandate rather than relying on being able to sell bonds in order to take active positions or change those positions. Foden: That big downshift in liquidity and banks just not being there in the way they were in 2007 in terms of warehousing and providing liquidity, has to frame your approach to delivering outperformance.Farquhar: But with high yield bonds you have always been able to rely on a shorter maturity. You get your money back quicker on average than in investment grade.Zeenni: There are a lot of opportunities in the short duration space for high yield managers. It is a win-win strategy since on the right issuers, you can earn performance with a limited risk as issuers redeem their bonds early by exercising their calls or making tender offers. We are seeing a continuing trend around refinancing. Basically issuers buy back old high coupon debts and issue longer debt with lower coupons. In the European Market, for example, about half of the redemptions over the last year were not original maturities but early calls or tenders. What is key maybe more than ever is looking at governance. Many of the last troubled issuers clearly had a lack of strong governance.