Webinar: Active credit: more risk or more return?
20 October 2017 | Webinars
As yields have been squeezed to historic lows investors have too often been tempted to pursue greater risks. Is this the only option?
Paul Malloy, head of fixed income for Vanguard Europe, speaks to Leo Schulz, senior investment writer, about active credit and the market outlook.
This is an edited transcript of their conversation.
Leo Schulz: Active credit. Is it right for you? Is it right for your clients? Where does it go in a portfolio? What are the current markets and what's the outlook? So many questions and fortunately we have the exact right person here to answer them. My name is Leo Schulz and I have with me Paul Malloy, head of fixed income at Vanguard Europe. To all our live listeners, you should now see a box appearing on your screen in which you can submit questions for Paul. We'll work them into the discussion as we go along and anything we don't have time for we'll follow up individually.
Today's agenda - what is the credit market? It sounds like an easy one, but we'll see if it turns out that way. Active or passive, a few insights from Paul on choosing the right strategy, then we'll look at current markets and then we'll look at the outlook for credit in a low interest rate world, and then finally we'll look at the benefits for a long-term investor.
Okay, what is the credit market? Paul, could you talk us through the difference in these two charts, the one side corporate and on the other side credit?
Paul Malloy: Sure, so whenever you take a look at the corporate and credit markets, and a lot of people think that they're the same thing, but ultimately there's some slight nuance between the two. Corporates are focused really on corporate entities. Credit, however, introduces a different segment of the market and these are areas like supranationals, a lot of the AAA space, that isn't normally part of your corporate universe.
Leo Schulz: So an example of a supranational entity, Paul, would be?
Paul Malloy: An example would be like the European Investment Bank, where there's a number of different countries pooling money together - a conglomeration of different countries.
Leo Schulz: So that would have a higher credit rating, but it's not an actual state entity as such?
Paul Malloy: No, they typically have higher ratings, but it is possible for a region that is less credit worthy to pull together and have a supranational of a little bit lower quality. But also in this credit space you do get emerging markets, you know, so if we're talking about a Global Ag based product, you'd be talking about high-quality emerging markets like Poland, or [Mexico]
Leo Schulz: When you talk about Global Ag, that's the Global Aggregate Index?
Paul Malloy: That's right, that's correct.
Leo Schulz: Or a universe such as the Bloomberg, Barclays, Global Aggregate Index?
Paul Malloy: That's correct.
Leo Schulz: And that would form as you would say, your investment universe, the bonds in which you could trade in a typical fund?
Paul Malloy: Yes, it forms your baseline going forward, so how do you know whether you're doing a good job or a poor job? You need some benchmark. Even with an active fund you need something with which to measure yourself. And within an active fund it's possible to go off benchmark to generate some additional returns, but this gives you a good anchor and a good starting point from which to build your investment block in an investment universe.
Leo Schulz: So a credit fund - if we just look at the charts here again on the left hand side - we have financial institutions, industrials, and utilities is the first entity there, so the credit market is giving you a wider universe, isn't it?
Paul Malloy: It is.
Leo Schulz: In which to move around, in which to look further, and to look for an opportunity? And would that tend to be on average a longer or a shorter duration, Paul, on the credit side?
Paul Malloy: So it ends up being roughly about the same. You'll typically get a little bit longer-dated on the credit side. The higher quality an issuer is, the more cheaply they can secure longer-term funding, which they'll likely do. So there's a direct correlation between some of the credit worthiness of the issuer and where they can issue on the curve, so you'll find less lower quality issuers issuing stuff a little more near term, high-quality issuers issuing stuff a little longer.
Leo Schulz: And when you talk about the curve, you mean the maturity of the bonds, don't you?
Paul Malloy: Exactly, so five years versus say thirty years.
Leo Schulz: And the core currencies in this world, Paul?
Paul Malloy: The bigger part is still US dollars, you're talking in the credit space, followed by euros and then sterling. And then there are some other currencies in there but they don't really amount to nearly as much as those three big markets.
Leo Schulz: And typically a credit fund would be hedged back into its base currency, would that be true?
Paul Malloy: Yes, that would be typically true because if we think about what does fixed income provide versus what does currency provide, currencies have a much higher volatility than fixed income. So if you were to not hedge your currency, or if you would not hedge your currency exposure, you would be effectively having your currency volatility overwhelm your fixed income volatility, and you're not really getting the purest of your fixed income exposure.
With that said there is some room within an active fund to tilt your currency exposures a bit, but ninety-eight percent of portfolios should really be currency hedged.
Leo Schulz: You want it to be a credit fund, don't you, not a currency fund?
Paul Malloy: That's correct.
Leo Schulz: Active or passive - now the two lines that we're looking at here, the light green line you've just been talking to, you've just mentioned the Bloomberg Barclays family of indices, the particular one is the USD 1-5 Year Credit Index, and then the dark line would be a representative Vanguard credit fund. So what are we looking at here, Paul, what should we see here?
Paul Malloy: Yes, well I think if we take a back even in step of active or passive, what is the framework for making that choice? So active is all around the idea of taking some additional risk to get some additional assets.
Leo Schulz: And so with the green line, the dark green line, which is the credit fund, you can see that it's a little bit above when the markets are up and a little bit below when the markets are down, so that's under that additional risk that you talked about.
Paul Malloy: Exactly, yes, and if you can time it properly, you can hope you can add value through this extra risk-taking and ideally outperform your benchmark.
Leo Schulz: But an equity fund, Paul, and the index, are going to be quite different to an active fund, so does that carry over in a fixed income world?
Paul Malloy: So I think that with fixed income because it's more of an over-the-counter market, there are many different bonds to choose from. With equities there's one equity and there's a lot of focus, a lot of liquidity on it, so it's a much more efficient market. So opportunities exist in equities to actively invest but the less liquid a market gets and the more esoteric it gets, the more there exist opportunities for arbitrage. And fixed income, because of its over-the-counter nature and the expanded universe of securities, I think lends itself to active management, and passive as well.
Leo Schulz: And so with fixed income the approach might be the same, but what you're aiming for, your target, would be different?
Paul Malloy: It would be lower, so what you could produce from a return is directly related to volatility. So fixed income securities are typically less volatile, therefore if they're not moving around as much, you have less opportunity to have more significant amounts of alpha.
Leo Schulz: So using the same approach, you might target to mirror the index and that would be a passive strategy, or you might try to outperform the index, and that would be an active strategy.
Paul Malloy: That's correct.
Leo Schulz: If we move to start looking then at current market conditions, so we've got a sense of what the market is, we've got a sense of how you approach that market in an active fund. And what we're looking at here then are default rates coming into this year. I just wonder, Paul, if you could tell us, in the context of a bond market, of a credit market, what constitutes a default?
Paul Malloy: So technically speaking, what constitutes a default is not meeting any of your required obligations - so missing a coupon payment, missing a maturity payment. But ultimately when you look at this chart, it really describes what you could pay for it – you're paid for the possibility of default.
And underlying every bit of pricing of a fixed income security – of a credit security - is how much compensation do I need for the risk of default? So this doesn't necessarily mean that these are the exact amount of securities defaulting at every single point in time, but these are implied rates of default and what's currently being priced into the market.
So it's more of a probability of default and that will directly relate to the overall yield that you would purchase these securities at. So the yellow line is high yields, higher implied default rates, therefore would have a higher yield - that's the risk you're getting compensated for.
Leo Schulz: And the credit market that we're talking about, that would be represented broadly by the lower, dark green line?
Paul Malloy: That's right, the active credit that we're undertaking at this point is much more focused on the investment grade market, which is of higher quality.
Leo Schulz: But a default is not necessarily an absolute event, so it's not necessarily bankruptcy or non-payment for every after, it can be a postponement or a delay?
Paul Malloy: Or some sort of restructuring event, there's many different types of debt out there at this point in time, whether they constitute default, or not defaults, but they do feed into the broader pricing of risk in the market. I think that's the key takeaway for thinking about default rates and implied default rates in the marketplace - how much should you be getting compensated for that risk?
Leo Schulz: And would it be fair to say that although this is just something over ten years, so the financial crisis kind of overshadows the line, looking at the last two or three years, at the line here on the right hand side, is that a high or a low default rate in terms of historical terms, Paul?
Paul Malloy: Still pretty low. You know with the amount of central bank support we have had in the marketplace since the financial crisis, default rates have been on a historically low level, just because of the amount of support that's out there to keep credit markets functioning and the economy moving and growing.
Leo Schulz: So if we just move to the next chart, but we will come back to central bank activity, when we'll be looking at the road ahead, but just to continue for a moment with current markets, if we go a little deeper.
I should just say we have had a question about the US yield curve flattening, which I think means the shorter-dated bonds, the yield on shorter-dated bonds rising while the yield on longer-dated bonds, I'm guessing, is staying fairly steady. But again, I think if we just come back to that, when we start looking at the outlook for the market and again around and I think that's possibly to do with central bank activity at the US, isn't it?
So if we just go back to the current slide and here we're looking at returns for some of the more significant centres in this universe, we're looking at industrials, utilities, and financials. The market, just looking at that line, looks reasonably healthy, there's a sort of a bit of an upturn at the end there on the right hand side, which is always an optimistic thing. Where are you looking for opportunities at the present time, Paul?
Paul Malloy: Yes, at the present time, some of the greater opportunities are around the idiosyncratic risks in the marketplace, so individual bond selection, individual issuer selection.
Leo Schulz: And this is because each, as I think you were alluding to before, common equity is common equity and every share is the same as every other share, but with bonds there’s this idiosyncrasy, each bond is different to every other bond.
Paul Malloy: That's correct, and when we're looking at that in the context of the current market environment, you know, global spread levels are steady, sitting around the twentieth percentile, you can see that a lot of the different sectors are returning roughly the same thing.
So the ability to add value through some of these broad sector allocations at the current levels of spread has gone down in our opinion, so we're switching to a focus on what are the names that we would like the most because there's a certain level of overall support for the market in general there.
We have been riding the wave of central bank liquidity, central bank support, a better than expected, faster recovery out of Europe and inflation that stayed in check on a global basis, not forcing central banks to move too far too fast, which is a little bit of what's happening with the US yield curve.
It's a reflection of the lower but longer steps, you know, we're making some moves, the Fed is moving more in the short-term part of the market, but the market's expecting a lower terminal rate of Fed funds over the long term, so I think that's why we're seeing some of the flattening in the US yield curve.
Leo Schulz: So when we look at those three lines, I think as you're saying, they're moving pretty closely together aren't they? So the opportunity's not to be weighting one sector over another, but really looking individual issue by individual issue, and looking for that idiosyncrasy, stock by stock by stock.
Well, I think what's interesting to many of us, Paul, is the extent to which financials seem to have come back into the fold. What's the story with financials?
Paul Malloy: Well, financials have been an improving story for quite some time, pre-2007 banks in particular were higher rated with a lot more leverage. And so there were some banks out there levered up to thirty, thirty to one, and AA-rated. Post-financial crisis, there were a lot of downgrades, and then a lot more regulatory capital requirements, so that banks are structurally safer and holding a lot more capital on their balance sheets than they have at any point in the past ten years.
So with that, what I think you're really seeing reflected in financials in particular, is that they've got pretty strong balance sheets and have been forced to de-lever a lot and be less systemically risky to the global financial markets, which was ultimately the intention of many of the regulators.
Leo Schulz: So would you say then that financials have come back to a, you always try to avoid the word normal, but they've kind of normalised their position within the market?
Paul Malloy: Well they've become safer and therefore the market is reflecting that in its price. And it goes back to the conversation we were having earlier on default rates and implied default rates, and default probabilities, that the default probability for bank debt now is much lower, especially with the introduction of things like alternative tier one capital and various loss-absorbing capital securities. There are mechanisms in the capital structure that can be written down before a default would take place at the broadest, most senior bank debt level.
Leo Schulz: OK, Paul, I think until, certainly for some years after the financial crisis there was a lot of hoarding of cash particularly by non-financial companies, global non-financial companies, which make up a large part of the credit market and their balance sheets were almost out of balance in the sense that they held a lot of smaller amounts of debt than they might have traditionally had, and larger amounts of cash and liquid instruments, has that changed in recent times?
Paul Malloy: There's still quite a bit of corporate cash spinning out there, but they're trying to figure out what to do with it. So probably about eighteen months ago there was a pretty big rash of M&A activity out there and that was fuelled a bit by the low interest rate environment. You could issue some debt as well as spend some cash and undertake stock buy backs.
Paul Malloy: Some have been waiting to spend on some capex spending, so they've just been trying to figure out what to do with the cash and it ultimately comes down to an investment choice, just like we make - what gives you the highest return - buying back stock, investing in plant, property and equiPaul Malloyent, or it's M&A.
Leo Schulz: There have been some big M&A deals announced recently, haven't there, has that been affecting the market?
Paul Malloy: Some but not much, it's actually slowed down considerably from where we were eighteen months to two years ago.
Leo Schulz: But corporate earnings are quite good, aren't they, so would you say that companies can afford to borrow more?
Paul Malloy: They certainly can, at this point, as long as earnings and cash flow generation stays at their current levels. That definitely supports holding a little more debt on the balance sheet.
Leo Schulz: Paul, I just wonder if there was a serious slow down, if there was a recession, how would the market respond to that?
Paul Malloy: Well I guess there are two parts to that answer: first of all if there was some sort of recession that's where fixed income starts to hold really, and harness a lot of its power. It sits as a ballast to offset equity, so far as a properly allocated portfolio, it would offset some of your risk, your equity position because even when you build up to a credit market you've got a certain level of risk-free interest rates.
Paul Malloy: And then some spread on top of that to compensate you for the default rate that will likely happen specifically in the fixed income spaces but the spreads would widen, but at the same time that risk-free interest rate so US Treasury bills and probably gilts would tighten because you would assume there would be some central bank support, additional liquidity thrown into the marketplace, interest rate cuts, and you know those things would start to offset each other to a certain extent.
Leo Schulz: So that would protect the value, particularly of investment grade bonds, and even credit, we talk about a credit and it does have, it's a higher risk obviously than a core government bond that the US or UK government bond, but nevertheless these are still highly, relatively highly rated.
Paul Malloy: Yeah they're still very high quality securities and assets, you know, we've talked about something different in the high yield market as you remember from that default rate chart, it's one of the things to be cautious of in this current market environment, actually, is this reach for yield, that a lot of investors have gone down in quality to high yield, into emerging markets to try to get that extra incremental yield. But if you saw in that chart that the default rates spread apart, so you've got to be careful that you're getting the right return for the level of risk that you're taking.
Paul Malloy: So if you're moving down into the high yield space, you've got to be ready to, you're not getting that risk-free offset but that's some stuff that's on its way to equity like volatility and therefore you could lose more than say an investment grade portfolio.
Leo Schulz: So investment grade continues to behave as a bond in a difficult situation. Is Brexit causing any issues, Paul, or likely to?
Paul Malloy: Right now, most of Brexit has been priced into the currency markets. The pound has been moving around quite a bit with the headlines whereas the equity markets and the fixed income and the credit markets actually haven't a whole lot. Post referendum the Bank of England came out pretty rapidly with some measures to kind of help stabilise the risky assets, and then we haven't really seen a whole lot happen since then, it's been pretty quiet. There's still a lot of uncertainty, and we're not really going to know a whole lot more until we start to break through some of these things on the negotiation, as we start to in the spring time, where we get a year on from the clock.
Leo Schulz: Yeah, but investment grade credit is going to be fairly resilient to that kind of change, isn't it?
Paul Malloy: I think it would be on a name-by-name basis, so a lot of your US dollar demands and we're talking about global credit here, you know, sterling is not the biggest part of that marketplace, so there might be a few individual names that you would want to look out for, but ultimately they wouldn’t be the biggest driver of global credit at this point.
Leo Schulz: There's a lot of alternatives, a lot of space to move around there. Let's just move to looking a little bit ahead. These are slightly complicated charts, but actually the message there I think is reasonably simple. On the left hand side are official interest rates for the US, UK, the European Central Bank and Japan, and then we have the central bank balance sheet and that essentially is quantitative easing, the amount that those institutions have spent on quantitative easing.
Leo Schulz: And I wonder if we just go back to the question that we had earlier on, Paul, talking about the flattening of the US yield curve, which I'm guessing is an outcome of US interest rates rising, so how's the market reacting to that?
Paul Malloy: The market hasn't really done a whole lot. I mean, hopefully that lower for longer assumes more accommodative policies, you know, lower longer-term interest rates basically means lower mortgage rates and lower financing rates, so these are all things that can keep the markets going. And the only thing that would be worrisome is if the curve got too flat or inverted, you know, where we had people stopping from investing long-term and move to shorter dated - typically things that have precluded a recession is a conversion in the yield terms - but we think that the probability for recession is pretty low at this point.
Leo Schulz: But one thing I think that a point, you're talking about company earnings, company balance sheets and the health of companies' finances, corporate finances is going to be a result of good economic conditions and the fact that we've got growth from employment and so on, relatively low inflation, what's your feeling for the growth cycle as it were?
Paul Malloy: Yeah we're well on our way in the growth cycle and we've had a lot of support by central banks over the past ten years and they've been very cautious so far in the removal of the stimulus that, particularly the ECB for example, you know, there's a lot of talk around the taper, but at the same time they're still buying - they're just buying a little bit less - so I view it more as easing up on the accelerator from a euro standpoint as opposed to starting to put on the brakes.
Paul Malloy: And then I would say the US is maybe a little bit more about foot off the gas and let's coast a little bit and both are interesting. But with the US, the fiscal side of things - so tax cuts and any of the potential infrastructure spending - I think that gave the Fed a little bit of cover. Maybe there are some tax cuts on the way, we can move rates a little more progressively under that cover, but we can see from these charts that the extent to which the balance sheet unwinds on these projections is not terribly steep, compared to how quickly they went up. They're not coming down at that same rate.
Paul Malloy: So if I had one big take away, from that chart on the right, is that balance sheets went up quickly but they're not moving down at the same pace.
Leo Schulz: Paul, thank you for that. Of course that represents buying corporate bonds as well and we could sort of see that as continuing. We've just got a couple of minutes, literally a couple of minutes left, Paul, so I just wonder if you could give us in a few words really, what are the benefits within a well-balanced portfolio, what are the benefits of an active credit allocation?
Paul Malloy: Yeah, really it’s two-fold: it gives you some diversification that in the worst of times it will provide a ballast against the big risk sell off, and if risk assets are going gangbusters, you get some credit spread tightening, and any bit of lower interest rates that are part of that, you're not really going to notice a whole lot because your equity allocation's doing so well, it's still going to be positive-positive.
Paul Malloy: And fixed income has a carry component to it, so if nothing else changes you still realise your yield's maturity and still get some income.
Leo Schulz: By carry component you mean essentially the income component
Paul Malloy: Exactly.
Leo Schulz: The interest rate on it. So, Paul, just very quickly, we've got ten seconds left, anything for the Budget tomorrow?
Paul Malloy: No, we don't really expect anything on the Budget front – it’s not really going to be a big reform like I think 2014 was, we may see some minor things here and there that are more political moves than real fiscal moves.
Leo Schulz: Paul, thank you very much and to those who we haven't managed to answer your questions we do have some contact details for you and we will definitely get back to you. Some interesting opportunities in active credit strategies, and a great option for clients looking to diversify their portfolios, and who are also looking for an element of income generation.
Leo Schulz: Just as a reminder, we hold a webinar for UK financial advisers at 2pm on the first Thursday of each month.
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