Flexibility means having the freedom to invest strategically across fixed-income markets. In this paper, we look at how flexible strategies generate returns by allocating capital and risk across the credit spectrum.
Lying at the heart of flexible strategies is the ability to invest throughout the credit spectrum. An unconstrained approach lets investors form a panoramic view of fixed-income markets and only take on risk when particular areas offer attractive risk-adjusted returns.
Credit markets have developed rapidly over the past two decades as post-financial crisis regulation and the growth of emerging markets have encouraged investors to look at different regions, sectors and instruments.
The fixed-income universe has globalised at a particularly impressive pace over the past 20 years (see figure 1) and as countries exist at different stages of the macroeconomic cycle, a global approach helps investors take uncorrelated positions and capture alpha.
Figure 1: A more diverse credit ecosystem
Source: Bank of America Merrill Lynch, as at September 2019.
Bond issuance in non-US-dollar currencies has also risen. Boosted in part by the birth of the euro in 1999, the non-dollar part of the market has expanded from less than 5% in the early 2000s to almost 25% in 2018. Flexibility means investing in the most attractive currencies and taking advantage of mispricing through different instruments.
Flexible strategies also invest across different credit classes, to help fund managers deliver returns across different markets and interest-rate environments. Moreover, adding extra credit classes with different underlying drivers and behaviours can improve the risk-reward profile of portfolios - or the ‘efficient frontier'.
But flexible strategies go further than diversifying between credit classes. A truly unconstrained approach invests across the credit curve, sectors, ratings and liquidity profiles. This means that the returns of flexible-credit strategies are driven by a broad range of factors, helping investors diversify their sources of alpha and reduce volatility.
Allocating throughout the credit spectrum also increases investors' exposure to expanding industries. The share of banking and financial-services issuers in the high-yield universe has more than doubled over the past two decades, as the footprint of media firms - previously the largest sector - has fallen by almost two-thirds.
Regulations brought in after the financial crisis also encouraged companies to issue new types of instruments. For example, ‘Coco bonds', or AT1 instruments, were first issued in 2014 as a way to make the banking system more robust and able to withstand external shocks. Five years later, the European market is worth more than $200bn.
Flexibility can also help navigate volatility. Investors that scan the credit spectrum for attractive opportunities are better placed to capitalise on dislocation in markets during times of uncertainty and capture the upside when others are unable to.
Hermes' approach to allocation
We champion flexible credit investing and determine top-down allocations by considering a range of factors that drive global markets. We then turn our attention to strategic asset allocation across credit markets, considering different regions, ratings, parts of the curve, sectors and currencies. Finally, we set our medium-term asset allocation across credit classes. Once we have defined our allocation strategy, credit selection is driven by high-conviction, bottom-up security analysis.
We consider valuations very carefully, and our focus on fundamentals rather than prevailing sentiment helps us take advantage of undervalued credits.
Liquidity is also a core consideration. We believe that investing globally throughout the large capital structures helps us achieve better portfolio liquidity than constrained strategies are able to secure.
Our flexibility also allows us to have an up-in-quality, large-cap bias when our risk appetite is low and our strategy defensive. Favouring quality, more-liquid instruments provides us with a good degree of flexibility when we are looking to reallocate capital. Sufficient liquidity also lets us act quickly during periods of volatility.
Be prepared for all seasons
The dislocation that we saw at the end of last year emphasised how important it is to invest with flexibility throughout the entire credit spectrum. In a global and rapidly changing market, a flexible approach to credit allocation can help identify undervalued areas and take advantage of opportunities generated as regions, sectors and instruments evolve.
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 Bank of America Merril Lynch, as at September 2019