Sponsor’s position paper by By Martin Foden, Royal London Asset Management
Markets have been affected by intermittent bouts of volatility during 2016, beginning with Asian stock market turbulence in January, and more recently the sharp reactions to the UK’s decision to leave the European Union.
In fact, it is becoming increasingly plain that exogenous shocks, liquidity challenges and volatility are the new normal for investment markets and against such a backdrop the cornerstones of our long established credit approach have never felt more relevant: (1) effective portfolio diversification to dampen idiosyncratic risk (2) acute targeting of market inefficiencies to embed undervalued bonds (3) high quality credit analysis undertaken by an experienced credit team within an environment that encourages interaction and efficient decision making.
Whilst the general merits of forecasting may quite reasonably be called into question at times like these, it does feel prudent to assume low yields continue to be a feature of the investment landscape. Having persisted since the financial crisis, yields have been further anchored by policy makers’ responses to impending Brexit. In our funds, we focus on stable, long-term income generation, which we think should be a valuable component of achieving attractive returns in an environment where a growing number of core government bonds are currently yielding negative returns.
Investment universe
We place a high level of importance upon searching for investment opportunities in under-researched areas of the market. We believe that although credit ratings can be a useful part of risk assessment, they do not provide the full picture; bonds with very attractive fundamental credit characteristics and structures can often be under-rated because of rigid rating agency methodologies and the limitations in the scope of their research. The fundamental question for us is whether the price of a bond is an accurate reflection of its overall risk and return potential, and we operate a stock-specific approach across sectors to constructing our portfolios. As a consequence, our portfolios tend to differ in composition from those of more benchmark-driven competitors and from market indices, as they reflect our conviction in specific issues, entities and areas of the market.
In terms of credit sectors, we tend to limit investment in supranational and government agency debt, as we find that credit bonds offer a better balance between risk and return for long-term investors. We continue to operate a bias towards under-valued secured debt within our credit portfolios and remain keen to look beyond more superficial credit characteristics which continue to be over-valued by the market. This has been further perpetuated by the recent mushrooming of high-level, rules-based bond selection in the market, whether due to the transplanting of Smart Beta processes from the equity market or the influence of regulation and central bank purchase programmes. This demands that investors become more focused on the specific risks of bonds, using these distortions to identify and embed under-priced and over-looked bonds of the highest quality without compromising return. Examples of areas where mispriced credit enhancements can be extracted include asset-backed securities, residential and commercial mortgage-backed securities, investment trusts, social housing and real estate. The yield advantage from bonds in these sectors, despite their low risk characteristics, renders them attractive, and through our specialist credit analysis we identify opportunities in individual bonds where ‘overall’ credit risk (probability of default and loss of capital) is significantly mispriced.
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