Martin Foden, RLAM’s Head of Credit Research, on a credit philosophy for white-knuckle times
What's it been like to lead a credit research team through Covid-19?
It's felt like a rapid series of accelerated mini-cycles. First, huge dislocation when we went into lockdown. Swathes of the economy went from 100% to zero output, obliging credit analysts to dust off cash burn analysis and consider truly accessible liquidity versus unavoidable fixed costs.
That phase changed quite quickly because of the speed and scale of government intervention. But the analysis enabled us to pinpoint high impact sectors, e.g. aviation and leisure sectors exposed to discretionary consumer spending, high fixed costs and often high leverage, to understand potential portfolio risks and, just as critically, the opportunities for investment as markets reacted fairly indiscriminately.
It may be fine to have some high impact exposure if you have credit mitigation at the point you bought the bond - security, ideally senior secured, and strong covenants. The first crisis phase was a visceral reminder of why our focus on the sustainability of the lending position is so critical.
How does your approach differ from other credit investors?
Credit markets tend to fixate on the more superficial and transitory characteristics of bonds: point-in-time ratings, i.e., default probability but not loss rates; position in an index; or perceived liquidity.
All that stuff commoditises the investment decision. And loses sight of what we love about this job: the idiosyncratic nature of the asset class, which repays bottom-up, fundamental analysis. The net result of the market fixating on superficial characteristics is that we can typically source and buy credit-enhanced bonds without compromising portfolio yield in the way economic theories might lead you to expect. That means we look for security over tangible assets, strong covenants that give us control and visibility, and a robust lending structure in terms of seniority.
What practical effects does that thinking have?
That philosophy manifests itself in our portfolio structure and our team structure. Depending on the fund, over half of our credit portfolios might be invested in secured positions, compared to a typical benchmark index of about 10% to 15% in secured bonds.
We also have a very experienced team that's seen many cycles, but not so large that insight is dispersed or siloed. We don't think the value of that insight necessarily lies in forecasting what's going to happen - the precise risk trigger. It lies in understanding the specific nature of credit risk, potential impacts on lending positions and building in effective mitigants.
Where are we now?
In the eye of the storm. It's calm but feels uneasy because the government will have to slowly pull away the struts, the support. High impact companies are tentatively re-emerging to test out where they can operate in terms of breakeven cash flow, but it's early days. Bond markets, from a pure pricing point of view, are relatively peaceful - for now.
But it would be naïve to think this is the end game. Whilst government intervention may have dampened and delayed the immediate impact of Covid-19, as analysts, we have to consider that the wider impacts - economic and societal - will be playing out for a long time.
That said we don't necessarily expect defaults to get up to the global financial crisis level again because of the very rapid and deep intervention of government. The fall out will likely be sector-specific: there are high impact sectors and others that are more immune. One thing we do know - fundamental credit analysis remains vital!
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All information is correct at September 2020 unless otherwise stated. Issued September 2020 by Royal London Asset Management Limited, Firm Reference Number: 141665, registered in England and Wales number 2244297; Royal London Unit Trust Managers Limited, Firm Registration Number: 144037, registered in England and Wales number 2372439; RLUM Limited, Firm Registration Number: 144032, registered in England and Wales number 2369965. All of these companies are authorised and regulated by the Financial Conduct Authority. Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number 364259. Registered office: 70 Sir John Rogerson's Quay, Dublin 2, Ireland. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number 99064. Registered Office: 55 Gracechurch Street, London EC3V 0RL. The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Royal London Mutual Insurance Society Limited is on the Financial Services Register, registration number 117672. Registered in England and Wales number 99064. Telephone calls may be recorded.
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