Embedding resilience in portfolio construction: Where the value is in credit

Investor resilience has come under severe strain in 2020; perhaps to levels not experienced since the darkest days of the global financial crisis. But as we approach the end of the year, market signals and economic reality have become seemingly oblivious to one another, including in many areas of the credit market. This disconnect raises questions that emphasize the importance of integrating resilience into their portfolio construction process, as this Q&A with Institutional Investor explores.

Where the value is in credit

Even before the COVID-19 pandemic, low and negative interest rates and climbing valuations were making it difficult to construct a credit portfolio for all seasons. With the additional issues presented by the pandemic and its resultant economic fallout, the challenge became that much more difficult. You’d never know it speaking to Colin Purdie (CP), Aviva Investors’ Chief Investment Officer, Credit and Josh Lohmeier (JL), Head of North American Investment Grade Credit. They don’t downplay investor concerns – but they are confident that their approach and strategy can handle whatever global markets throw at them and discuss where they see value and alpha in the credit market right now.

When the pandemic emerged, did you find your credit strategy required some tweaks to deal with what was happening?

CP: The short answer to that is no. In down markets as well as up markets, we don’t just hold yield; we don’t just buy BBB and hope the spreads tighten. We don’t have that bias in our portfolios because of the process that we use.

JL: We’re not trying to pump the gas or the brake, or time the market. Ours is a story of allocating risk more effectively than the market. We’ve built our entire strategy around portfolio construction and risk allocation so that we don’t have to guess the possible direction of the market. If we can achieve a better understanding of why and where credit benchmarks are inefficient at a point in time, and still get great idiosyncratic ideas bubbling up from our research team, our job as portfolio managers and risk allocators is to put those pieces of the puzzle together in a more thoughtful way. The end goal is to deliver consistently positive outcomes for the same beta as the universes we’re being asked to manage against.

CP: This crisis escalated quickly, but there was no need for us to panic at that point. Our beta was in line with the benchmark, so it wasn’t as if we were sitting long, felt wrong, and needed to jump out of it. The process stayed the same, but obviously we looked at things slightly differently. We’d been running with a positive technical in markets for a number of years in Europe based on everything the ECB [European Central Bank] had been doing with buying bonds. Alongside the positive technical environment, the prevailing fundamental story was that economies were starting to improve, with Europe ticking up from what was a relatively mediocre place. Then the pandemic struck, and the conversation suddenly changed to, “Well, actually, this is going to have a very sharp, potentially short but deep impact on economies, and it’s going to impact some sectors more than others.”

In the US, for example, the banking sector got hit quite quickly because people were thinking it was going to be 2008 all over again. We determined immediately that it wasn’t a financial crisis, but a corporate crisis. So, it was a matter of looking at sector fundamentals and valuations and balancing that against the technicals – which were changing all the time – and trying to ascertain whether we were getting paid for the risk that we’re taking. Our process had us in the place we wanted to be – we didn’t need to offload risk as quickly as possible.

Even if you’re not stepping on the gas or pumping the brakes, you obviously can’t be coasting or sitting still.

JL: No, we still have a view on the markets. Allocating risk is like dancing a delicate tango – you  work very hard to figure out where the best value is across sectors, curves and ratings, then you strategically position your risks in a way that allows you to neutralize your beta to the benchmark – all while getting rich alpha from your top idiosyncratic picks and being more efficiently allocated structurally. Overall, I don’t think our industry does a very good job of allocating risk. It does a great job of finding idiosyncratic things it likes and can articulate, but not a great job of holistically putting it together in a more thoughtful way that gives a client a better risk-adjusted return. That’s the area of the market where I think we’ve excelled, and we’ve really seen a lot of external growth over the last couple of years on the back of that process and that message.

We create a portfolio based on the world we think is going to happen, and then we stress test that portfolio against different environments, including severe systemic shocks. We do that to make sure the core portfolio we’ve built for the world we think is going to happen is also downside protected in a systemic shock environment. By forcing your portfolio to always serve those two masters, you’re prepared for an environment like we experienced in Q1. Instead of scrambling to change your strategy or position, you’re immediately going on offense and thinking, “Based on what I know now, and based on the valuations I see today post-volatility, where can I shift risk to take advantage of it?” You’re not adding or reducing risk at that point, you’re trying to recycle risk.

Where are you seeing value and potential in the credit markets at the moment?

JL: One key area is the six-, seven-, and eight-year part of the IG [investment grade] credit curve for riskier credit, relative to the one- to five-year part of the curve. Structurally, we think it makes sense to own more of your riskier beta in the belly of the curve – between six and 10 years, and still have plenty of core defensive positions out on the longer duration part of the market, knowing that fundamentals in valuations have gotten a little stretched. The very front end one- to five-year part of the IG market has been incredibly bid up. Valuations are stretched based on where we’re at in the economic recovery. The technical/stimulus tail has wagged the dog with regards to valuations across all risk assets.

Now it’s about hunting and pecking to balance opportunities that you believe in fundamentally versus the technical argument, and a very real risk that governments are going to do their best to inflate anything they can, including risk assets – so the technicals can keep grinding tighter, as well. Everyone knows that’s where the Fed is focusing its corporate bond buying and its liquidity measures: the market has grasped hold of that and almost priced it in as if companies can’t default. We would caution investors and say, “They’re providing liquidity; they’re not providing revenues or cashflows, so don’t mistake liquidity for bailouts.”

CP: From a global perspective, the technicals and the fundamentals pull you in different directions. For long-term investments, we’re looking to sectors where we have confidence in the cashflows and the business models. We’re not taking a bet on any particular timing for a vaccine or recovery of a particular industry. We hope a vaccine will come through at some point, but consumer trends have changed or accelerated. How people do what they do – and where they do it – will be different, even if there’s a vaccine. We have confidence in IG because of that buy-in that’s forcing people to look for yield, but at the same time, know what you’re buying, know your credits, and understand that the world has changed. A lot of companies that don’t adapt to change will ultimately suffer, and some within the high yield space are clearly going to default. So, one trading theme right now is to stay where we have visibility on cashflows and business models.

Josh, earlier you mentioned “rich sources of alpha.” Where are you finding alpha now?

JL: I would build a portfolio like this: A tiny amount of high-quality BBs inside of five years. I would own some BBB energy risk idiosyncratically, in the lowest quality parts of the IG market and highest quality parts of the high-yield market. I’ll caveat that by saying energy is a hot topic because we’re in the middle of a recession, and everybody’s worried about oil prices. I would argue that we are now in a scenario that will keep oil stable in the $40 per barrel range, and we don’t need a steep economic recovery to keep oil prices at a level that maintains solvency within the industry. As the economy slowly grows, oil demand will pick up faster than supply on a medium- and short-term outlook.

We still think quality banks are a good place to put some money to work. They’ve been forced by regulators to be capitalized and prepared for an environment like this, and they’ve been very proactive in reserving accordingly for a potential recession. And, as mentioned earlier, if you focus on where the cashflows are, you need to pay attention to certain areas of technology, telecoms, and cable because of where the world’s headed – working from home, needing access to data and technology, needing access to phones and internet. Those are all areas that have longer-term stability to their fundamentals. We’re also still bullish on healthcare – not in the short term because of election rhetoric, but in the long term due to aging populations, the need for drugs and the need for healthcare services. Those are all extremely high cashflow businesses. Overall, if you don’t have enough high-quality duration in your portfolio, you’re probably not protecting the potential downside enough.

CP: There are quite a lot of tenders in the market right now – a lot of entities taking out higher coupon debt at a premium, and then reissuing at slightly tighter levels and better spreads. It’s difficult to try and identify where that comes through, but it’s a theme that’s coming into the market. You can screen the universe for who you like here, who has the higher coupon there, and we see deals coming through pretty much every day where companies are issuing and taking out debt at a premium.

Another area of interest in this market is potential M&A. There are quite a few rumors in the European banking sector, primarily in-country M&A, but also potential cross-border M&A as well. There are strong institutions and weaker institutions, some coming together where the sum of their parts is pretty strong. Some of the success we’ve had in the past has occurred when we’ve seen the right combination of companies coming together and have to fund debt for the deal to happen. It’s sector dependent and name dependent, but with the right analysis you can identify who potentially could be a beneficiary. If you have access to the management team and understand their long-term plan around deleveraging, M&A can be an investment theme.

Globally, we are seeing a second wave or extended first wave of the pandemic, we’ve seen a very contentious general election in the US, Brexit is still unfinished business, and in most countries the economy is not really hitting on all cylinders. What are you hearing from investors regarding their concerns?

CP: From an international perspective, the primary concern that we hear from investors is about negative interest rates. Throughout continental Europe – not so much in the UK right now, but potentially in the future – government bond investors are losing money by investing. That’s going to remain the case for some time, and it forces government bond investors to hunt for yield. They’re asking: “Where do we hunt? Where is the sweet spot?” It’s a case of how far you want to push yourself along the risk curve. And that’s what investors also talk to us about. They’re landing in a fairly similar spot to where we are – investment grade is the sweet spot because you still have higher quality companies, visibility around earnings, and a bit of comfort around a fundamental story, albeit in a challenged macro environment. You also have the extra yield coming from the credit spread, so you’re not structurally locking in a loss on the portfolio. In Europe specifically, that’s the key question that keeps getting asked: “Where do we put money so we don’t structurally lose it, but at the same time not open ourselves up to a deteriorating macro environment?”

JL: The US may not have negative rates, but they are far from extremely positive. As Colin noted, our clients are worried about where they’re going to get the returns they need. It’s the same problem whether you’re the CIO at a pension fund or a retiree managing your 401K. Unfortunately, what governments need to do to stimulate the economy unfortunately punishes savers. One of the ways they can inflate the economy is to inflate risk assets, and by inflating risk assets, you’re inflating valuations.

We can’t mistake bailouts for solving all the world’s problems and solving all the corporate problems that are out there from a growth, cashflow, and earnings perspective. Also, don’t mistake the liquidity being provided to the market for bailouts for the entire credit universe.

We’re stuck in a cycle of investors feeling forced to take risk, and then relying on a bailout from the entity that forced them to take the risk. That’s not a fundamentally strong place to be as a global economy, but that’s the tug and the pull our clients are facing. Do they get rid of Treasuries and go into investment grade now, because Treasuries aren’t providing anything other than duration risk and liquidity? And for IG risk, because they still have a return target they need to meet, do they put some into high yield?

CP: You can’t be passive; you have to be active and pick your spots. The authorities won’t buy defaulted bonds, so don’t think they will. If you own them and the business model fails, you take a loss on it; investors shouldn’t forget that.

What makes Aviva’s credit approach and strategy stand out?

JL: In a market where every manager is trying to out-research each other, our biggest points of differentiation are how much thought and effort we put into portfolio construction and allocating risk more effectively. You can give two portfolio managers the same 20 best ideas and they can deliver portfolios with totally different outcomes, based on how they deploy that risk. The biggest value adds we provide clients are a consistent outcome regardless of the direction markets are headed, a strong focus on downside protection at all times, and a risk profile that is neutral to the market. Most managers have a style bias – they’re either a beta manager that aims to out-carry the benchmark and they’re going to show volatility in both sides of the market cycle, or a defensive manager that is going to hide out and lose money in flat or rallying markets but win in a sell-off. Often multi-manager platforms are trying to package up the right balance of risky managers and defensive managers to get to the right conclusion. No matter who you place us with, we believe our style, our strategy and our risk allocation process result can in a complementary outcome for an investor at all stages of the economic cycle.

CP: I’d also emphasize our approach on ESG. The importance people ascribe to ESG is slightly patchy in the US, but the trend is only going to become more and more important to all clients. It’s not enough to say, “We integrate ESG into the investment process.” You have to show what you do with the money, how it makes an impact, how it actually changes companies or investment portfolios, and that’s what we do. We’re currently aiming to engage with 1,000 companies on climate change, predominantly with CEOs; no one else is doing that. We are engaging with other companies on an individual basis to make them more sustainable – for example, BP and its changing climate strategy; Barclays, which we’ve helped push from a one of the laggards to one of the leading banks in Europe on that front. Volkswagen had to make a lot of changes following its emissions scandal and is now at the forefront of electric vehicles, and we’ve engaged with them through that whole process. Yes, we integrate ESG it into our investment processes, but we also try to make companies better so that active ownership is a meaningful thing.

Speaking of complementary, one gets the sense speaking with you both that Aviva’s scope as a global organization can help investors, too.

CP: The US and global markets are connected. You can’t understand one without understanding everything else that’s going on. We’re a global organization with a structure that encourages collaboration. Josh and I are on the same team. Our analysts globally are on the same team and organized by sector, and that gives us the ability to understand what’s happening in each individual market and how it impacts the whole. We call it connected thinking, and it’s not only an efficient way of working – it gets us to the truth quicker.