With chronic under-funding of pension plans, this interview (conducted by Savvy Investor) explores the role of intermediate credit in better managing duration exposure.
Bonds that have a maturity between one and ten years
Intermediate credit refers to bonds that have a maturity between one and ten years, and a duration of around 4.5. Much like long credit, it is largely used by corporate defined benefit plans as credit is the most natural hedge for pension liabilities. Intermediate credit is also used by investors who want more credit risk with less exposure to interest rate volatility due to its shorter duration.
Sebastian Culpan-Scott, Editorial Director at Savvy Investor asked James Vokins (JV), Global Head of Investment Grade Credit and Joshua Lohmeier (JL), Head of North American Investment Grade, for their views on the market and Aviva Investors’ investment process.
How can managers phase in intermediate credit over time?
JL: Many pension plans invest in intermediate credit as part of their LDI (Liability Driven Investment) strategy. For those that have lower funding status, the most important thing is to have the right duration for your assets. This generally takes the form of long credit mandates as a blunt instrument for maximum duration, with equities being the primary risk factor to generate higher returns and hopefully, improve funding status. Long credit assets have a maturity of 10+ years. As funding improves and equity risk is lower, plans tend to pay more attention to the curve of their liabilities and more closely match the duration. This necessitates the need to incorporate intermediate credit.
The duration of the liabilities naturally falls as plans and pensioners age
In addition, the duration of the liabilities naturally falls as plans and pensioners age. Pension plans need to mirror this falling duration as their cashflow needs naturally increase to pay retirees. Increasing an allocation to intermediate credit can bring the overall duration of the assets more in line the decreasing duration of their liabilities over time and more closely match their cashflow needs.
How do you manage the correlations between various credit (sectors) in different environments?
JV: We account for the correlations in two ways. The first is when we construct our custom sectors. Rather than relying on standard industry classifications, we build our custom sectors around credits that have high correlations of spread movements and similar volatilities.
The other is through our portfolio construction process. In optimising portfolios, we need to consider the correlations between the custom sectors. These correlation statistics are part art and part science. We have historical data for each custom sector. However, the past is rarely equal to the present. We therefore make adjustments to the historical correlations to make them reflective of the current market conditions based on the forward-looking views of our fundamental research team.
What is the average credit quality of the intermediate credit universe and where do you position yourself?
JL: Generally speaking, the average credit quality we expect to see in broad-based intermediate market indices is in the A2/A3 range. Our strategies tend to hold bonds that have similar credit quality profile to their respective benchmarks because we aim to be beta neutral. We do not want to be reliant on the direction of spreads to generate returns.
Are there credit-related concerns about specific sectors?
JV: Right now, we have concerns about all the sectors. Spreads are at historically tight levels and any wobbles in the economy could cause them to widen significantly. We are very focused on downside protection in our portfolio construction process. We don’t know what is going to be the next driver of volatility or when it will occur. We only know that volatility will occur at some time in the future.
Acknowledging where you are getting paid to take risk is a huge part of our portfolio construction process
That is why we embed downside protection into our portfolio construction process to prepare for volatility. As spreads continue to tighten, sectors with a higher probability of tail risks and sensitivity to macroeconomic factors start to trade a lot closer in spread compared with less cyclical sectors with more stable cashflows. Acknowledging where you are getting paid to take risk – and where you are not – is a huge part of our portfolio construction process.
Can you speak a little bit about corporate credit analysis itself and the types of ratios or characteristics that you’re looking at most frequently?
JL: Our credit analysts use a Fundamental, Valuation, and Technical framework to analyse credits. These factors are combined to generate an overall rating. In addition, each recommended credit receives an investment thesis and risks to the recommendation. This includes many ratios focused on cashflow generation, corporate leverage and forward-looking views for growth and management behaviours.
Which sectors are you overweight/underweight currently?
JL: From a risk perspective, a couple of our larger overweight positions are financials, capital goods and electric utilities. Financials, most explicitly banks, have issued a lot of bonds this year and are trading a bit cheaper relative to history for still very consistent earnings and highly capitalised business models.
Many of these overweight positions have exposure to the aerospace industry which we feel is poised to recover; they should see a benefit as the economy continues to normalise post-COVID and companies invest. Electric utilities is one of our core low-beta positions that we feel is relatively cheap compared to the high-quality universe. Our biggest underweight is technology. Big tech has come under heavy scrutiny from the Democratic US administration, and the sector is also heavily exposed to China.
Are there sectors that are excluded from your portfolios due to ESG concerns, or other ESG factors that are considered in intermediate credit portfolio management?
JV: We take a holistic approach to ESG integrate it into our credit research, but this is not binding on our investment decisions. Our analysts consider ESG factors along with other fundamental considerations when evaluating a credit. We combine fundamental, valuations, and technical factors when making a recommendation on a specific credit. As a result of this analysis, we can and do exclude securities for ESG purposes. We also engage with companies to improve their ESG metrics so we can be a part of guiding solutions rather than just taking an exclusionary approach.
Do you try to generate alpha from sector bets, individual security selection, trading decisions, or duration?
We tend to focus on sector allocation and security selection as our primary alpha sources
JL: We don’t try to generate alpha via duration. Our overall duration is kept in line with the benchmark and we maintain fairly tight bands on key rate durations. Instead, we tend to focus on sector allocation and security selection as our primary alpha sources. Our portfolio construction process drives our sector allocation. It also provides the potential for some security selection alpha because it helps determine where on the curve we should take risk within a sector. We rely on our analysts for additional security selection when they recommend their top idiosyncratic ideas.
What trends are you seeing in corporate credit issuance? Are more companies issuing debt now because of future inflationary concerns?
JV: Last year was a record-setting year for issuance as companies first needed capital to survive the COVID crisis, then had to clean up balance sheets, and later borrowed because of low all-in yields.
This year has maintained a pace that is a bit higher than we would have expected considering the significant issuance of 2020. However, we think low all-in yields and concerns around rising interest rates have pulled forward some issuance into the first half of 2021. We also continue to see liability management exercises. Where companies are scrutinising their maturity horizon and buying back debt with some excess liquidity to smooth out their future maturities over time. Some of the excess cash and issuance from 2020, as well as the issuance in 2021 is being utilised for these purposes. We expect a more typical run rate in the second half of 2021 with marginally less issuance due to the very ‘heavy’ start to the year.
What are the similarities between Aviva’s long strategy and intermediate credit?
JV: We are agnostic to benchmarks when we manage our strategies. Both strategies use the same portfolio construction process. The only difference between the two processes is that one uses the one to ten year curve and the other the 10+ curve as the benchmark.
What differentiates Aviva’s intermediate credit managers?
JL: Our portfolio construction process is the main factor that sets us apart from other managers. By using custom sectors, volatility targeting, and embedded downside protection we aim to generate returns that are uncorrelated to market movements and other managers.
Our portfolio construction process is the main factor that sets us apart from other managers
The process is also designed to perform well when the market sells off. Our process also allows us to take advantage of curve opportunities within sectors, which is a key component of our portfolio construction tools and is a bigger part of the intermediate credit market as a potential driver of alpha.
This interview was originally published in Savvy Investor.