Issuer quality: First, last and always

The discriminating bond manager who aims to consistently preserve capital through fundamental security selection can be identified by the determined and inquisitive posture of a lender. Her campaign strategy would mirror her analytical criteria: “Is this a worthy borrower who will meet its debt obligations?” and “Is this a good company that needs to exist?”

In short, it’s a strategy of avoiding losers.

With the double mandate of mitigating both default risk and volatility, managers who sincerely seek strong risk-adjusted returns cannot avoid stringently vetting borrowers and performing a deep analysis of fundamentals. Stable cash flows, a well-managed balance sheet, barriers to entry in an industry and a defensive posture as determined by a company’s market position are among the essential characteristics of a credit’s ability to repay its debts.

The resulting fundamentally-built portfolio is often materially different in its behavior than the broader market. It’s one where the yield profile is complemented with risk goals such as a high Sharpe ratio, low volatility, high alpha, low beta and high risk-adjusted returns.

But this manager isn’t in favor in today’s investing environment. Seemingly, the market is crowded with investors looking to replicate entire asset classes, sticking to indices intended to be comprehensive snapshots of the markets they emulate. Such products are available aplenty across the entirety of fixed income, but they are not without potential pitfalls.

Of particular concern is when credit becomes indexed, as in the case with high yield corporate and bank loan funds, constructed of securities without regard for underlying creditworthiness by their very design. This means investors can be exposed to the best and worst of the asset class…on purpose.

Even the investor who thinks he is managing risk, by dwelling narrowly on credit ratings and duration and buying fundamentally-indifferent indices in a bird’s-eye-view attempt to avoid categories of risk, may be falling prey to a misguided narrative.

The errant conventional wisdom is simple: high yield goes up when credit spreads go down, and intermediate duration goes down when interest rates go up. This, the thinking continues, is why shorter-term credit-oriented strategies, like floating rate funds, did so well through September and broad market fixed income indices did so poorly this year (Figure 1).

Figure 1: Performance of Morningstar’s Bank Loan and Intermediate Bond categories for 2018 through Friday, December 14. (Source: Morningstar Direct)

This logic ultimately reaches a flawed conclusion: Because credit strategies invest in bonds with credit spread exposure, they will have principal losses when credit spreads rise.

Why do we believe this is incorrect?

This thought process fails to distinguish between a carefully selected portfolio of short-duration bonds and a broad market passive index of high yield debt, whether short-term or not. The fears articulated by the conventional wisdom assume category-level portfolio exposures without attention to the issuer quality of the debt within those portfolios. With credit spreads still near secular lows despite recent volatility (Figure 2), a selection strategy informed by fundamental analysis may instead be the key differentiator of a manager.

Figure 2: Average credit spread of the Bloomberg Barclays US Corporate High Yield Index from September 30, 2010 through December 14, 2018. (Source: Bloomberg Finance, L.P.)

Here’s the distinction with a vital difference. Imagine two portfolios: One, indiscriminate with respect to credit quality; the other, focused only on capital preservation, aiming to identify creditworthiness while screening out volatility catalysts. One can quickly see this as a comparison of apples and oranges.

Perhaps it’s time for fixed income investors to come home. Buying bonds is a discipline of lending, not trading. In our view, a portfolio of debt is best when one lends to borrowers with good credit, not one that alternates between lending to everyone (buying an index) and lending to no one (selling an index) based on a bet on the direction of interest rates and credit markets in aggregate.

Fixed income is really not that complicated. Issuer quality and security selection matter. Period.

The “covenant-lite” era in loans

Another factor differentiating portfolio performance concerns the treatment of loans. Owing to the high demand for variable interest rate products over the past few years, loans have appeared to have been overbought for some time, despite their longer-term credit spread exposure to spreads near their tightest levels in years.

This may finally be changing. Recent loan market declines appear to be signaling a shift in demand. At the same time, it is our opinion that this weaker price action isn’t the only way in which the market has deteriorated. Even now, borrower-friendly “covenant-lite” loan agreements — offering, it would seem, reduced security and protections for lenders — are proliferating just as they did before the last financial crisis in 2008.

“Covenant-lite,” strictly speaking, means there is no financial maintenance covenant in the loan agreement. This covenant inside the loan document serves as a leverage test measuring the issuer’s debt against earnings and limits how much leverage a company can have both when it issues new debt and as an ongoing operation. When the covenant trips, the loan goes into default. Where there is a weak underlying credit, the existence of a maintenance covenant doesn’t necessarily provide safety; it can just mean a sooner default.

The absence of once-common maintenance covenants does not mean that value and protection cannot be found in loans. Most loans contain a variety of subsidiary covenants: a limit on increased borrowing or a restriction on paying dividends to equity holders, to name two examples. Covenant restraints on cash exiting the business to favor equity holders can still be a strong validation of creditworthiness in a loan that is missing a conventional maintenance covenant.

On the other hand, the absence of managerial due diligence in reviewing covenants in a credit agreement — the hurried consequence of buyers seeking generic category exposure to loans — can be perilous in these “covenant-lite” times. Compare, for instruction, the lawsuit over J. Crew Group’s use of credit facility baskets to move value away from debtholders, to cite just one instance[1]. It’s a case not so much of buyer beware, but frankly of “manager RTFP” (read the fine print).

The until-recently robust syndicated loan market is partly the result of indiscriminate buying — of lenders taking risks they don’t understand, outlined in documents they don’t read — in the blinkered quest for exposure to an asset class irrespective of underlying creditworthiness. With J. Crew as a cautionary tale, overcoming these costly shortcuts is an exercise in security selection, not asset allocation. In other words, only the fundamental debt buyer is doing what it takes to spot the difference.

Controlling the controllable

Like election results, markets cannot be foreknown. Accordingly, managers who base their decisions on interest-rate movements may be achieving their targeted returns as much by luck as by skill. By contrast, in a short-duration portfolio of credits bearing strong fundamentals, the net position reached over time is likely to be more consistent — overperforming in declining and underperforming in rising markets, with lower volatility throughout. Here clients may derive not only financial value, but also another important dividend of consistency: peace of mind.

A manager focused on fundamental selection of short duration credits can more confidently aim to assiduously manage and mitigate risk. Other exogenous factors, like market movements and changes in rates and spreads, resist tidy domestication much less prediction. One aspect of bond risk, however, is indisputable: an issuer’s risk of default is different (and often lower) over a one-year timeframe versus a seven-year timeframe (though credit ratings don’t generally distinguish between durations).

Experience dictates that bonds are asymmetric to the downside: losses if an issuer defaults usually dwarf the interest paid, and large price declines take a while to earn back through interest alone. Return-focused managers on the wrong side of a directional move, like a market decline ignited by a hike in interest rates, will have a long row to hoe in recovering from losses realized at the start without a corresponding price recovery.

In the end, it’s a matter of alignment. This is not to say advisors have to be steadfast in their party’s camp, fundamental versus indexed; instead there is room to reach across the aisle and embrace both in a portfolio. Proper portfolio positioning aligned with client goals should be the aim. A more diverse path to reach the same goal might actually render a more optimal outcome.

Indexed products can provide cost effective ways to replicate commoditized parts of an asset class, the pros and the cons. Meanwhile, as we have pointed out, not all attempts to manage risk are desirable. Coupling passive indices with active managers, who embody risk-consciousness, does not have to be an either/or.

When complementing broad market strategies, the fundamental credit selectors, with their straightforward, risk-averse profiles of low-volatility, high-alpha, creditworthy holdings, may offer clients comfort and confidence. These managers buck the herd mentality and aim to consistently generate income for their investors by lending to borrowers they select because analysis leads them to conclude these companies will repay their obligations.

Before investors subscribe to the passive index ideology and buy into the one-sided campaign rhetoric that managers who aim to control risk are categorically overpaid and under-skilled, it may be worth considering whether risk-minded and indexed fixed income are better off co-existing. This bipartisan portfolio, each approach focused on contributing what it does best, may be the one which helps advisors achieve their client goals most consistently. Maybe a two-party system isn’t so bad after all.

Distinctions do make a difference... and just maybe a stronger portfolio.

© Zeo Capital Advisors

[1] J. Crew has been entangled in legal battles since 2017 when they did a debt exchange where the value of the J. Crew brand name was transferred as collateral away from the lending group.

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