Sponsor’s position paper by Stephen Holt, Principal Global Investors
How greater focus can aid bond investors and generate returns
– Multi-sector credit strategies are an attractive solution for return-seeking bond investors in a complex investing environment.
– Typically these diversify not just by sector but across industries.
– We believe that the finance industry offers particularly attractive opportunities as capital structures are de-risked and re-structured driven by ongoing regulatory change.
– Global Capital Structure Opportunities is a multi-sector style of credit strategy that focuses on the full capital structure across a single global industry to deliver mid-to high single digit returns with relatively low volatility.
These are difficult times for bond investors. The challenge of maximising returns without taking exceptional levels of risk is complex in an uncertain environment. Selecting from the range of mainstream single-sector solutions — Gilts, investment grade credit, high yield, etc — presents a classic Hobson’s choice.
So what’s the alternative?
As returns have trended downwards, return-maximising bond investors have tended to increase allocations to credit, reasoning that higher yields will compensate for the additional credit risks they are assuming.
– Some have increased allocations to illiquid credit.
– Some choose to actively manage their strategic exposures in liquid sectors.
– And some have gravitated towards multi-sector fixed income, or multi-credit strategies.
Successful managers of multi-credit strategies need a wide skill set: top down sector allocation, duration and curve expertise, and bottom-up security selection across the widest possible global investment universe, particularly in U.S. fixed income sectors and U.S. dollar-denominated issuers which dominate global bond markets. At Principal Global Fixed Income, we are strong supporters of multi-credit fixed income investing. We believe, however, there are alternatives that return-seeking investors should also consider.
Taking a different approach
Multi-credit fixed income strategies rely on sector diversification for risk control, and sector rotation for return generation. They tend to offer exposure to a wide range of instruments, issuers, and industries. Here we advocate a different approach: applying a multi-sector approach to a single industry. In a financials context, this translates to: multi-structure, single industry.
In 2013, we launched a strategy that focuses on a very specific opportunity set – the debt issued by investment grade-rated financial companies. Financials are a much maligned subset of the fixed income universe, for good historical reasons given their role in the Global Financial Crisis (GFC). However, it is the very actions taken to strengthen these institutions that have created exceptional opportunities within this single industry.
Our strategy is called Global Capital Structure Opportunities (GCSO). In essence:
– GCSO is a single industry, multi-structure credit strategy that invests primarily in bonds issued by investment-grade rated financial companies to benefit from the secular de-risking and improving credit fundamentals.
– I t demonstrates high-conviction global security selection and manages risk by dynamically allocating up and down the capital structure based on our macroeconomic outlook.
– GCSO is a sustainable, high-quality strategy that seeks to deliver mid-to-high single digit returns over a full market cycle.
Why financials?
As the world emerged from the GFC, there was an unprecedented focus on addressing the risks posed by global banks. In 2010, a framework emerged from regulators to achieve the necessary secular de-risking. Reform has been comprehensive, focusing on:
– Higher capital levels and quality of capital (e.g. through loss sharing and bail-in provisions)
– Higher liquidity requirements
– Resolution plans
– Stress testing
– Forced de-risking of certain business lines (e.g. proprietary trading, and pre-clearance of dividend and capital plans)
– Reduction in event risk (e.g. caps on leverage)
The reform process paved the way for more complex capital structures. Instead of a simple senior, subordinate, and hybrid debt capital structure, the industry began to move towards an expansion of the types of securities available and an increase in the number of levels within the capital structure. This process is ongoing and will continue to evolve for a number of years,
altering the opportunity set along the way.
This increased diversity of opportunity creates an environment suited to the translation of a multi-sector style of approach to a single industry. The range of ‘sectors’ within financials (essentially levels of the capital structure) differs from those in a traditional multi-sector approach, but the skills required are very similar. With interest rates set to rise, financials debt offers exposure to an industry with improving fundamentals that is set to benefit from higher rates.
Global capital structure opportunities
GCSO launched in April 2013. The strategy allocates up and down the capital structure within a single industry like traditional multi-sector strategies allocate across fixed income sectors. Just as risk is more concentrated in a single sector strategy, focusing on only one level of the capital structure can be riskier, as volatility increases dramatically as we move down the credit spectrum towards contingent convertible capital (“CoCos”). We expect the strategy to deliver a yield in the 3-5% p.a. range, with additional returns driven by spread compression: between different parts of the capital structure, and between financials and the rest of the corporate credit universe.
Despite launching shortly before the Taper Tantrum, in an increasingly difficult credit environment, GCSO has delivered exactly as we would have expected, and has significantly outperformed the Barclays Aggregate, Investment Grade, and High Yield indices. Just as importantly, it has delivered these returns with relatively low volatility.
GCSO has been managed since inception by London-based portfolio manager Randy Woodbury, supported by a team of analysts focused solely on financials. It utilises a process with two key components: a top-down macro view of credit markets, and an intensive issue-specific analysis of each layer of the capital structure to identify mispricing and relative value.
Where does it fit?
GCSO should appeal to return-seeking bond investors searching for an alternative to single sector strategies in challenging markets. Such investors should find multi-sector strategies appealing. GCSO is a distinctive alternative, applying a multisector style of approach across the capital structure of a single industry.
GCSO is designed to deliver mid-to-high single digit returns over an economic cycle. As the de-risking process within financials continues, delivering consistently improving credit fundamentals, investors would do well to question whether such returns are available elsewhere.
