By Thomas Samson and Hugo Squire, Muzinich & Co
As volatility rises and the beta rally draws to a close, how can investors strike a balance between return maximisation and drawdown protection?
In our view, the fundamental backdrop in European high yield remains strong and investors should continue to benefit from the attractive carry available. The high yield market is less levered, better rated and has greater interest coverage ratios on average than at any time in the past several years.
Having said that, 2018 is turning into a year of transition as the market begins to contemplate life after European Central Bank (ECB) quantitative easing (QE). Rising rates, plateauing or rising credit spreads and increased volatility are returning to credit markets.
We believe that, in this context, active management and stock picking will once again come to the fore and managers will need the full suite of investment tools at their disposal to transition smoothly into a new regime.
Extraordinary central bank measures have had a profound effect on risk assets over the last two years. From our observations in the credit market, spread dispersion was all but erased and bottom-up credit selection was not necessarily rewarded.
As we begin the slow process of withdrawal from these extraordinary measures, we believe it is inevitable that dispersion rises from historically low levels and credit selection becomes a meaningful differentiating factor. Identifying the good credits from the bad will once again drive returns.
Fig. 1 – Spread Dispersion Rising from Lows
Data source: BofA Merrill Lynch HE00 European HY Index, as of 12 June 2018.
Likewise, we consider the market reaction to episodes of political or macroeconomic risk will no longer be dampened by ECB support, and as a result there are likely to be more prolonged bouts of volatility. Indeed, we believe we already seeing signs of this (Fig. 2)
Fig. 2 – Volatility Levels Set to Rise
As volatility returns, investment strategies with the ability to put in place strategic and tactical hedges could provide better risk-adjusted returns than their more constrained counterparts. We think having structural portfolio protection in place makes sense here and one interesting way to do that is via credit options (Fig. 3).
Fig. 3 – Out of the Money Credit Option Dynamic Hedging
Comforting though it is, this portfolio protection does not come without a cost, and finding a way to finance it and to prevent too great a drag on portfolio returns is key. Investors with a flexible mandate and access to investment tools other than bonds may generate alpha to offset the cost of these hedges. One example of this flexibility would be the ability to invest either via credit default swaps (CDS) or bonds.
Derivatives such as CDS can be used in a number of ways in seeking to enhance returns. As Fig. 4 highlights, CDS are at historically cheap levels relative to the cash bond market and choosing the instrument with the greatest total return potential may lead to meaningful alpha generation over a pure bond strategy.
Fig. 4 High Yield Cash Spreads versus CDS
The ability to invest via CDS is particularly interesting in the high yield market due to the callability of high yield bonds. Embedded call options are a common feature of many high yield bonds (around 60% of the market). This means that they are unable to participate fully in any spread rally as the call option can be exercised by the bond issuer, thus limiting bond price appreciation. CDS, on the other hand, behaves in a similar way to bullet bonds and can therefore continue to appreciate, providing additional convexity (Fig. 5).
Fig. 5 – Bullet Bonds and CDS May Offer More Opportunities for Price Appreciation
Note: The above example is based on two bonds with the same coupon and maturity – 3% coupon, 5-year maturity, callable at 103 anytime, 3% coupon, 5-year maturity, bullet.
A further way of generating alpha is to seek returns from sources which do not rely on market direction. We believe that distortions created by QE, for example the historic low levels of spread dispersion, have resulted in an opportunity-rich environment for arbitragers. Unnaturally close relationships between credits of varying quality, or clearly distorted credit curve shapes, should begin to normalise and bring profits to those positioned to exploit these abnormalities.
Using the tools outlined above, as the regime shifts and the market finds a new equilibrium for risk assets without the prop of QE, we believe active managers can navigate this transitional period effectively and that there remains a place for European high yield exposure as a core holding of investors’ portfolios.
About the Authors:
Thomas joined Muzinich in 2004. Prior to that, Thomas worked as an Investment Analyst at Trafalgar Asset Managers, a distressed-debt hedge fund. Previously, he worked as a financial Analyst at GE Capital. Thomas has a Masters in Finance from London Business School and earned an M.Sc. in Corporate Finance from the Institut d’Études Politiques de Paris, France. He holds the Chartered Financial Analyst designation
Assistant Portfolio Manager & Trader
Hugo joined Muzinich in 2013. Prior to joining Muzinich, Hugo worked in the markets division at Société Générale on the credit trading desk. Hugo studied English and American literature at the University of Warwick and holds the Chartered Financial Analyst designation.