Confronting the Covid-19 crisis within the credit markets – Perceptions, insights & learnings

NordicInvestor contributing editor, Hamlin Lovell, hosted a roundtable discussion amongst asset managers, banks and insurance companies from the US and Sweden, covering topics including the Covid-19 crisis, policy responses and recovery; macro outlook; divergences between different credit sub-asset classes; expected return drivers; the uneven recovery in liquidity; potential liquidity mismatches in daily dealing vehicles; ESG for risk management and alpha generation, and current positioning.

Read on for a summary of the discussion or click the image below to watch the discussion on Vimeo.

Panelists; Karsten Marzoll (top left), Martin Axell (top right), Jonas Thulin (bottom left), Anand Dharan (bottom right)

Jonas Thulin, Head of Asset Management at Erik Penser Bank, in Stockholm. started teaching economics at various universities, before moving to the corporate side running a Pension Trust (Ericsson). He then moved on to London and New York working with trading strategies, and returned to Sweden to build up research and strategy at Nordea, where he ran Asset Allocation at Nordea. He “jumped ship” to Erik Penser Bank in 2017 and the firm has since grown AuM by 280%.

Karsten Marzoll is a Senior Fund Analyst within Swedish bank SEB’s Manager Research team of 6 analysts, located in Stockholm, covering 3^rd party funds/managers in liquid fixed income (Investment Grade, High Yield, Unconstrained) and Equities (US, Europe, partly Sector). He has 33 years of industry experience and previously worked for SEB in Luxembourg managing discretionary mandates and fund of funds, focused on fixed income, and is originally from Germany.

Martin Axell is the Co-Head of Multi Asset at insurance company, Länsförsäkringar, in Stockholm, and is the senior portfolio manager of blended Multi-asset funds and hedge funds. Credit investing includes internal funds and external management. He has 18 years of industry experience and has previously worked in London as the head of fixed income at the UK’s second largest pension fund, the BT Pension Scheme, as an Investment Manager at Morgan Stanley and earlier as a Portfolio Manager at SEB.

Anand Dharan is Investment Director at Wellington Management, Boston, which he joined in 2015. He belongs to Wellington’s Broad Markets fixed income team, which manages multi-sector fixed income portfolios.

Whereas the global financial crisis was caused by a global economic slowdown, the Covid-19 crisis was caused by a public health crisis. “Central bank rate rises or credit crunches did not cause this crisis. The financial system remained intact and there was not a financial crisis”, says Marzol. But central banks clearly solved the crisis at least for most investors: “the magnitude and speed of policy response was unprecedented in peacetime”, says Dharan. “The policy response was fast and well timed because the tools had been tested in 2008 and 2011”, concurs Marzol. Axell agrees: “central banks took years after 2008, but they had all of the tools ready this time, which led to a record speed of recovery”.

The policy response was also qualitatively different: “the genuine coordination of fiscal and monetary policy between Congress and the Federal Reserve – with monetary policy financing government spending – worked well and is likely to outlast the crisis”, says Dharan. Thulin was one of the first strategists who placed his faith in the policy actions: 

The base case macro outlook now is broadly bullish, though there are regional variations and risks to the central thesis.

Thulin’s contrarian call in the spring has, as of November 2020, moved towards a more consensus view on the near-term economic prospects for a continuing recovery: “we expect economic growth in 2021”, says Marzol. “We are bullish because we expect a vaccine rollout, and see improving consumer confidence and spending, which will be helped by fiscal stimulus and record central bank liquidity. Economies should reopen by the second quarter of 2021 at the latest”, says Axell.

But the medium term picture may be less clear: “risks include fiscal stimulus fading by year end 2021, a European sovereign debt crisis, the ongoing trade war, and the fact that very few defaults are now priced into credit markets”, adds Axell.  Dharan’s concerns are somewhat more distant: “we are confident about 2021, but are alert to the risk of a divided US government reducing fiscal stimulus. We are also closely watching geopolitical risks and supply chain risks that could threaten the staying power of the recovery beyond 2021”.

The economic and market rebound has not been globally synchronized or evenly balanced in 2020 and is not expected to be in future.

Thulin underscores this point: “the different policy responses have opened up huge growth and market differentials between the US and Asia, and Europe. This has dented the outlook for some asset classes and countries, especially in Sweden where headwinds are accelerating”.

Inefficiencies and mis-pricings have also varied between sub-asset classes and sectors, which strengthens the case for a dynamic and opportunistic approach to asset allocation.

Dispersion has been seen not only between continents but also within countries’ credit markets: “we expect persistent inefficiencies in credit markets partly due to the uneven policy responses and liquidity conditions: for instance, central bank asset purchases have focused on corporate credit but not as much on securitized credit. Different markets have also over or under-reacted to news-flow around Covid and policy responses, which results in mis-pricings varying between asset classes. We have used global high yield as a lever for adjusting overall credit risk, halving it between June 2020 and November 2020, and we opportunistically move between sub asset classes regularly”, says Dharan. Axell has also taken some profits on high yield this year:

Carry is expected to be the main drivers of returns, while there is more debate over potential gains from roll down and spread tightening – and duration risk.

If spread compression has led to huge price rises since March 2020, the attribution profile may now be reverting to coupon clipping. “The key drivers of return will be carry and roll down. We do not see much further scope for spread tightening in general”, says Axell. Dharan agrees that carry will be key but does see somewhat more scope for spreads to come in: “currently, we see carry as the main source of returns. Additionally, central bank support, consumer and market sentiment could further tighten spreads on RMBS, EM corporates, senior secured leveraged loans, and longer dated corporates. We do not expect much from roll down because the curve is fairly flat until the long end”.

The risk and timing of interest rate rises is also contentious: “we see some risk of long end interest rate rises outweighing any spread compression for long duration US investment grade. Therefore, we own the shorter end of the curve and are underweight the long end, partly through using derivatives”, says Axell.

Managers are taking active views on credit sub-sectors.

Credit sub-sectors can be compared by weighing up factors such as breakeven defaults versus forward looking defaults, price momentum, supply and demand technicals, and monetary policy. “In November 2020, our key overweight positions include leveraged loans, emerging market corporates and RMBS. We also like some emerging market sovereigns, other securitized credit, and convertible bonds”, says Dharan. “We also like leveraged loans, and emerging market hard and local currency debt. We additionally like shorter duration investment grade credit. We expect cyclicals, travel such as airlines and leisure such as restaurants could outperform from spread tightening at the sector level”, says Axell. “We have less in high yield because it is only pricing in defaults of 2-3%, and there is some risk of another European sovereign debt crisis”, he adds.

Sector rotation could be a bigger source alpha than security selection in 2021, though the potential for active trading may be lower for some sub-asset classes.

Alpha could be added from top down asset allocation calls or bottom up instrument selection, as well as timing calls. “We expect to add 65% of alpha from asset allocation and 25-30% from sector and security selection. We are bullish on potential for sector rotation right now because we see decent dispersion. Average turnover across the approach is around 50 percent per year, but less liquid sectors with higher transaction costs, such as leveraged loans, tend to turn over more slowly”, says Dharan.

“It can be more difficult to add value from active trading where bid/ask spreads are higher, but those managers we cooperate with expect continued dispersion between Covid winners and losers”, says Marzoll. Yet the name picking opportunity set might be narrower in future: “we expect it will be more difficult to generate alpha from security selection in 2021 because volatility could go down further”, says Axell. Thulin is more focused on trading in and out of sub-sectors rather than selecting either managers or individual credit securities:

The liquidity picture is mixed with some sectors having recovered to match or even surpass pre-Covid liquidity while others remain less liquid and more expensive to trade.

Active trading requires reasonable liquidity and one broad generalization is that central banks are the key players behind the liquidity recovery. “This was the first crisis of this magnitude since Dodd-Frank and Basel 3 implementation, and we learned a lot about the reluctance of the sell side to make markets at precisely the time when markets needed the sell side to act as a liquidity “shock absorber”. There may need to be a larger role for central banks in the future in these kinds of market environments”, says Dharan. Marzol agrees:

Indeed, the sectors being bought by central banks have returned to their former liquidity: “we have seen a general improvement in liquidity with US Treasuries and Agency MBS back to pre-Covid levels”, says Dharan. Axell agrees that asset purchases have been important: “central bank support for investment grade credit in most developed markets has been good for liquidity and in the Swedish market rated bonds are now on average as liquid as before. In three sub-sectors of the Swedish real estate credit market – public property, housing and logistics – liquidity is now better than pre-Corona”.

Central banks are generally not buying structured credit (beyond some triple A tranches) nor loans, and these sub-sectors are laggards in terms of liquidity: “some securitized and non-investment grade corporates that do not benefit from Fed buying are less liquid”, points out Dharan.

“In Sweden, credit ratings seem to be important in determining liquidity: “unrated bonds have not yet recovered”, says Axell.

Indeed, there may be special liquidity issues in some of the smaller markets, which argues against the “home bias” of some allocators. Sweden’s Riksbank asked BlackRock to write a report on the country’s corporate bond markets, which concluded that they were illiquid and dysfunctional, though the report was not fully published for fear of compromising the Riksbank’s asset purchases!

There is a growing debate over how to manage and avoid liquidity mismatches in daily dealing vehicles, from a top down and a bottom up perspective.

“A crisis always teaches us more about liquidity. Some Swedish high yield funds had to suspend dealing for a period in March 2020. Fortunately, funds we are covering did not have any issues”, says Marzoll. “Whether daily dealing is appropriate depends on market regulation and whether the regulation is being adhered to”, says Thulin. The Luxembourg regulator has recently deemed leveraged loans ineligible for UCITS, which can have liquidity of between daily and twice monthly (but the regulator has not ruled loans out of various other investment vehicles that might also have daily dealing). “This is prudent to protect retail investors after the moves seen in March and April, given that UCITS is supposed to be the safest vehicle” agrees Axell and adds:

The question of liquidity is also more nuanced than a binary prohibition on an entire sub-asset class. “It is crucial for regulators to understand liquidity from different angles, be active and understand if liquidity for a fund fits an asset class”, says Marzoll. “Fund size can be important as well”, he adds.

Counterparty relationships are also relevant in predominantly over the counter (OTC) markets: “we have found enough liquidity for our style of management, and our centralized trading desk is helpful in working with the sell side to locate liquidity”, points out Dharan.

ESG analysis of credit can use extensive quantitative data and it also needs to make qualitative assessments.

ESG is essential in the Nordics, but allocators are not always rigidly prescriptive about how managers apply it: “Client demand and regulation show increasing our interest in ESG. We focus on it and analyze how managers integrate ESG into their investment process for different sub-asset classes”, says Marzoll and adds;

Many managers are designing their own questionnaires and data analysis, scoring and ranking techniques: “for our internal credit fund management, we have developed an in house scoring and rating framework that is shared with our equities teams. For external managers, we have a DDQ on ESG”, says Axell. Deep data dives are vital for Thulin: “this is very much a numerical data game for us. We insist that managers push ESG as far as possible and do not break SRI rules. We have collected 20 million ESG datapoints, which include companies’ supply and distribution chains. Getting a top ESG score is a numbers game and we can prove this mathematically. Only a handful of funds in Europe fit the bill, but that is enough for a small local actor like us”.

Wellington’s process includes a range of qualitative and quantitative data: “our ESG analysis is integrated into risk and investment management, and our centralized ESG team carries out bottom up research and company engagement across asset classes.

We also research ESG risks such as climate change, stranded oil and gas assets. We have a strategic alliance with Woods Hole on climate research, which also impacts our investment decisions, for example with CMBS deals with exposures in locations outside of official flood zones but that are increasingly flood prone due to climate change. Data is rapidly improving in this area”, says Dharan. Marzoll is also seeking more data around climate risk: “we are going further to ask for more transparency on fossil fuels and greenhouse gases”.

ESG approaches can be adapted to sub-asset classes.

Beyond corporate credit, climate related considerations can be applied to ABS or sovereign credit: “we look at climate and flood risks in mortgage bonds, and sponsors’ lending practices. We monitor the size of fossil fuel energy exports for sovereigns”, says Dharan. “

European Union Sustainable Finance initiatives for labelling funds and activities are a welcome change, although the proposed rules may not capture all approaches – and could differ from some existing national labels.

“We are following the new rules closely. It took a long time and is a good step forward. They will help to watch out for greenwashing”, says Marzoll. Axell also embraces the moves:

Dharan also sees value in the policies: “the EU taxonomy and sustainable disclosure requirements are a step in the right direction, which help managers to determine if they are “light green” or “dark green”. We are managing a number of funds towards the light green label”.

Yet a single framework is not necessarily a comprehensive blueprint for every ESG approach: “it is not just about labelling and language. Managers need to demonstrate their own philosophy and conviction in certain sectors, as we do with certain Impact Investing themes, such as clean water and equitable housing. We would seek to orient towards those themes irrespective of the EU taxonomy”, says Dharan.

Indeed, the somewhat narrowly defined EU categories, which are heavily focused on climate, may exclude some funds that are classified as sustainable in some countries. Says Thulin: “we have been early movers. I have been heavily involved in a reference group discussing the new EU rules, which has identified a regulatory arbitrage issue. Some funds labelled as sustainable in Sweden will not meet the EU definition”.

This might be disappointing for some managers, but it could throw up opportunities for some allocators:

ESG-driven government policies can also lead to positive and negative alpha as they create new winners and losers and mis-pricings.

“ESG is not only about risk monitoring, but also about creating alpha from ESG in general”, says Marzoll. One thematic source of alpha could be the EU Green Recovery Plan and Biden’s Green Agenda. “These policies will create new winners and losers different from those under previous regimes. There are opportunities to reorient infrastructure around the reality of climate change and the measures are broadly reflationary and positive for employment”, says Dharan. “We have high conviction in the EU green agenda, for example, but there are still questions about political will,  especially in the US. Though there is a growing consensus on climate risk, the US election may not lead to the most transformational green deal. Even if the Democrats end up with a majority in the Senate after the special Georgia elections, it will be a slim one, and with a lot of more centrist Democrats”, says Dharan.

“We have been heavily into solar and battery, which has produced great returns based on changes in pricing, and a deep value chain. We do our own due diligence on the nuts and bolts and layers of supply chains. We are also looking at green bonds, and believe some corporates are greenwashing”, says Thulin.

If the fashion swings too far towards green investing, a “bubble” could develop and some assets may already be overpriced:

Overall, credit managers need to retain a flexible and tactical approach to capitalize on potential volatility and uncertainties ahead.

We want to than all participants for a very intersting discussion which probably could have continued even longer. 

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