It's been a challenging year for fixed income investors with rife uncertainty. All eyes are on central bankers as they constantly navigate mixed information about their economies' health, while the headlines are full of geopolitical tensions. As we get mid-to-later in economic cycle, investors look to build in some protection in their fixed income portfolio by going out and finding extra yield without going down the credit curve, and focusing on capital preservation.
This environment highlights the importance of an all-weather approach, allocating to fixed income securities that can withstand both uncertainty and shocks while generating meaningful yields. We're championing this in the Principal High Grade Capital Securities strategy which gives us expert access to high quality names but via a subordinated approach to protect against external factors.
Understanding subordinated debt
Given spreads continue to be the tightest they've been across all fixed income instruments, subordinated debt stands out because of the yields on offer. Additionally, these bonds have coupons that are fixed for a certain period and then either called at par or ‘refixed' at predefined spread above the prevailing reference rate.
These characteristics mean that even in today's environment where interest rates are dynamic, and with uncertainty around growth and inflation, subordinated debt can offer attractive and rising income. This should prevail despite the rate path that central banks set.
Past performance is not a guide for future performance, but it's interesting to see how subordinated debt has performed during previous periods of stress. Historic data demonstrates that subordinated debt shows lower volatility than high yield debt, with a subordinated premium that generated superior performance against investment grade. It's an asset class that can provide a smoothing of performance during periods of market distress.
Creating an all-weather portfolio
However, as with any fixed income investment, research around issuer and credit risk is crucial. We have positioned the Principal High Grade Capital Securities strategy to be exposed to a diversified set of very high credit quality names, and this boils down to the rating and market reputation of the issuers. As a long-only manager, we do not employ leverage, nor do we utilise hedging or derivative structures in the portfolio.
Issuers must undergo a strict review process to be approved for our investment universe, and in our euro-denominated strategies, we allocate exclusively to investment-grade debt instruments. Size is an important consideration, and we stay with the most liquid issuers, abiding by minimum standards on minimum new issue size and how much outstanding paper they have in the market. And then, when we do buy into subordinated debt, we don't allow for concentration. For instance, the Principal High Grade Capital Securities strategy currently has around 114 holdings and the largest of these will be between 1.5% and 3%.
We also have a liquidity risk framework, which means we regularly assess our strategies' liquidity risks both in normal circumstances and simulated distress scenarios. We like to keep cash at up to 3% in anticipation of redemptions, and this has demonstrated its worth in the past. For instance, during the peak of COVID in March 2020, we encountered the most stressed scenario in the 20-year history of our global strategy, with redemptions reaching 12% of the NAV. Our proactive strategy allowed us to react and meet all liquidity demands and still outperform peers who faced similar drawdowns.
We prioritise diversification of issuers but, in terms of sectors, our focus on credit quality typically takes us towards large financials – such as the top tier banks and insurers – and regulated utilities and energy companies. The former are extremely well capitalised and issue mostly to refinance existing instruments, while the latter have become significant issuers of subordinated debt to finance the investments due to the surge in energy demand around data centres/AI, and the transition to sustainable energies.
Our focus on credit quality means this is a very defensive strategy. Case in point, in our almost 40-year track record, we've never had a default in our funds. When the Credit Suisse AT1s were wiped out in the UBS takeover weekend, we had zero holdings of such paper because our analysis had months before removed Credit Suisse from our approved list of issuers.
IMPORTANT INFORMATION
This material covers general information only and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account.
Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal. Fixed-income investment options are subject to interest rate risk, and their value will decline as interest rates rise. International and global investing involves greater risks such as currency fluctuations, political/social and differing accounting standards. Preferred and capital securities rank junior to senior debt. Non-investment grade securities offer a potentially higher yield but carry a greater degree of risk. The potential for income and return is accompanied by the possibility of loss. CoCos may have substantially greater risk than other securities in times of financial stress and an issuer or regulator's decision to write down, write off or convert a CoCo may result in complete loss on an investment. Inflation and other economic cycles and conditions are difficult to predict and there is no guarantee that any inflation mitigation/protection strategy will be successful.
