Credit where credit is due – making the most of MAC

Written By: Jeff Boswell Strategy Leader Developed Market Credit Investec Asset Management

The search for a sustainable return has led many pension schemes to allocating more investment to a credit solution. Jeff Boswell of Investec Asset management outlines how MAC strategies could help address the challenges

Global growth remains lacklustre and the outlook for inflation highly uncertain. As a result, central banks are continuously looking at the efficacy of their monetary policy and how to sustain the economic recovery. This has resulted in government bonds losing their income-generating qualities, with investors having no choice but to look elsewhere. Multi-asset credit (MAC) strategies typically offer a higher yield, while offering defensive qualities via risk management using several different credit asset classes. The strategy seeks to provide a strong income element on a consistent basis that few other assets can provide. An investor must also consider the security of that income. If, for example, income generation is reliant on equity dividends, there is a risk that these could be deferred in the case of a bad year or poor outlook for the firm. The coupon of debt securities is, on the other hand, predetermined.

Core credit
A substantial allocation to credit is increasingly being recognised as part of the solution in solving the yield conundrum. This asset class substitution is coming from a variety of traditional asset classes. From de-risking core equity holdings to revamping vanilla credit portfolios, through to addressing low-yielding government bond portfolios. Not to mention those DB schemes that are facing the threat of becoming cash-flow negative and struggling to pay pensions without selling down assets. The capture of this credit risk premium is, however, difficult to execute in practice, with the relative attractiveness of individual credit markets changing on a daily basis. MAC strategies seek to find the best risk-adjusted return within the credit markets, while also allowing the fund manager increased flexibility in managing portfolio risks. We regard this unconstrained, flexible approach to credit investment as ultimately replacing a large proportion of traditional segmented credit asset class investing.

Challenging rates and bond markets
With the US Federal Reserve embarking on its rate hiking cycle and the European Central Bank slowing the pace of quantitative easing, this has raised concerns for fixed income investors about the impact of higher rates. In our view, while the likelihood of a normalisation of rates to long-run averages (e.g. 6% for 5-year US Treasury) from today’s levels seems low, any movement in that direction will have a significant impact on bond markets. As we know, not all fixed income instruments, or fixed income strategies, are created equal. Unconstrained MAC strategies, which have the flexibility to derive returns from a broad opportunity set, have typically delivered robust performance through recent interest rate volatility. A key element of this performance is a focus on generating returns principally from credit spreads, rather than any significant duration views.

Volatility is on the rise
Volatility spikes have been much more common in recent years. In our view, such volatility is likely to continue in these uncertain markets. Macroeconomics (low growth), monetary factors (low central bank rates, low dealer liquidity) and politics (antiglobalisation, terrorism, and divisive campaigning) are all contributing to the increasing spikes in volatility. In this environment, we believe a flexible and reactive investment strategy will be far better placed to navigate this array of risks with the potential to perform well in both up and down markets.

MAC well positioned for a challenging interest rate environment
In our view, the likelihood of a true normalisation of rates from today’s level may seem low, but any movement in that direction would have a significant impact on government bonds and other rate sensitive instruments. Even if full normalisation is not a near-term phenomenon, interest rate markets are bound to go through periods of volatility in reaction to rate-raising rhetoric or action.

Not only do MAC strategies have a variety of tools at their disposal in managing their portfolios through challenging interest rate environments, but their focus on generating returns principally from credit spreads provides an effective counter to interest rate volatility. The short duration profile of MAC means there should be no need to predict interest rate moves in the same way as for a typical credit strategy.

The unconstrained MAC approach to investment, across a variety of on and off benchmark instruments, provides the opportunity to create an attractive portfolio which is not only diversified across a variety of sources but also capable of negotiating an uncertain interest rate environment. This versatility, coupled with appealing income generation, will prove helpful in negotiating the yield-challenged environment facing many investors.

The future of MAC
The current yield challenges facing many investors undoubtedly require a new way of thinking in terms of asset allocation. While credit has long been a core income-generating component of many traditional asset allocation models, the evolution of financial markets, coupled with the complexities of investing in the current environment, has cultivated a different way of credit investing. We believe the breadth of opportunity and flexibility afforded to the MAC manager in seeking its target return should not only result in a better investment outcome, but also one that is better than the sum of the underlying constituent parts.

Capturing the right asset mix: The evolution of MAC
Each credit asset class has its own idiosyncrasies, the understanding of which are critical when constructing a broad based credit portfolio. While a siloed credit investing approach may capture the beta of a variety of markets, capturing the right asset mix – and getting the timing right from an asset allocation perspective – is exceptionally difficult. This is one of the key drivers that sparked the evolution of MAC strategies, whereby rather than attempting to thread the needle in terms of this top-down timing, MAC funds principally construct their portfolio through bottom-up credit selection, looking for the best value across the credit markets for a given level of risk.

This approach ensures that rather than relying upon market timing, a MAC manager would typically look for opportunities that are attractively valued within one market over the other. Although a robust top-down process is still critical in terms of establishing a broader portfolio risk bias, as well as any preference for a particular region or sector, MAC portfolios are typically driven by the aggregation of the bottom-up driven best ideas across the credit spectrum.

By its very nature, credit as an asset class also has an asymmetrical payoff profile. A poor investment in credit, which results in a significant capital loss, is unlikely to be compensated by another credit investment, given the inherent cap in its upside. Hence the idiosyncratic risk of one position can have a disproportionate impact on the expected return of the portfolio as a whole. This is why bottom-up credit selection, even in the implementation of a top-down bias or thematic, is essential.

It is worth noting that certain MAC strategies in general do apply a more top-down approach, whereby an allocation is made to internal credit class capabilities or external funds, effectively creating a portfolio of sub-portfolios. We believe this approach meaningfully waters down the key benefits of MAC. Not only does one re-introduce the importance of asset allocation timing, but instead of constructing a best ideas portfolio, designed to outperform the individual credit markets, the main driver of portfolio returns will be beta selection. While any MAC manager should undoubtedly be aware of macroeconomic drivers, socio-political events, and secular trends, we believe the essence of the MAC proposition is to apply a balanced approach, whereby even in implementing any top-down view, it should be executed with the objective of finding the best individual investments to reflect that view.

Another important consideration in the context of bottom-up portfolio construction is that the MAC manager should have the right team structure to assimilate those best ideas, and then make an investment decision on their inclusion or exclusion without undue bias exerted from local teams or asset class specialists. We believe a structure of disparate regional teams, siloed into different asset classes, has the potential to result in the very same structural biases we discussed earlier, which goes against the grain of what MAC is trying to exploit. As such, a robust decision-making structure, with strong alignment of interest from stakeholders, is essential in efficiently executing a best ideas bottom-up driven strategy.

Investments carry the risk of capital loss.

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