We were delighted to host the first session of Columbia Threadneedle’s Trustee Training Programme 2022 on 3 February. We brought pension trustees together to introduce the main styles of corporate bond portfolio management, and to explain the differences between them. The aim was to help trustees learn how to identify which style is right for their scheme.
- In active portfolio management, a fund manager exploits pricing and market inefficiencies, as well as other trends, to take positions against a benchmark with the aim of generating a return in excess of that benchmark. Portfolio turnover tends to be high.
- With passive management, rather than outperformance the manager effectively aims to replicate the benchmark. Turnover can be mixed and is driven by turnover in the benchmark.
- With buy and maintain management, the portfolio objectives are set based on client priorities. Bonds are bought and, ideally, held to maturity. Turnover is low.
Types of credit strategies
- The portfolio management process consists of four steps that are designed to filter down the investment universe into a portfolio of 100-150 individual bond securities.
- The process begins with an available universe that could consist of around 6,000 companies, which is then filtered down into approximately 800 companies that are subject to in-depth credit analysis and an assessment of creditworthiness. Individual securities are selected based on portfolio management style, client guidelines and an assessment of outlook and relative value.
- Credit research is a vital part of the process, looking at both the willingness and the ability of an issuer to service and repay its debts.
What makes an issuer worthy of buy and maintain credit?
- Ongoing maintenance of the portfolio will depend on the management style adopted, and deal with day-to-day activity such as the reinvestment of coupon income. Companies within the portfolio are also subject to ongoing monitoring of credit quality and outlook.
- Downside risk management is an important element of portfolio management. Should the outlook for a company turn negative, the consequent action taken needs to be considered on a case-by-case basis. Any decision to sell a security needs to consider the extent of the change in company outlook, the impact to the overall portfolio and client requirements.
- The consideration of environmental, social and governance (ESG) factors needs to be embedded throughout the portfolio management process; financial, operational and reputational risks linked to ESG can materially affect a company’s cashflows and their ability to repay debt.
- A credit-default swap (CDS) is a cheap, liquid and capital-efficient way to gain exposure to corporate bonds, without having to own the underlying physical security.
- It is a derivative that enables investors to take a long or short position against the “spread” component of a corporate bond yield (spread being the premium that exists compared with a government bond).
- A CDS is akin to an insurance policy, that provides protection in the event of a corporate debt default, in return for the payment of an annual premium.
A credit default swap (CDS) is akin to an insurance policy
- Using CDS alongside government bonds or interest-rate swaps generates a similar outcome to holding physical bonds.
- Adding CDS exposure does not affect existing hedging activities; and CDS are generally more liquid and cheaper to trade than physical corporate bonds.
- The most commonly traded CDS contracts reference two investment grade indices: the iTraxx Main, which covers Europe, and the CDX NA IG, which covers North America. Both contain 125 names, equally weighted. There is no UK equivalent.
- CDS and physical bonds markets generally track each other well in normal market conditions. There have been notable dislocations in times of market stress, when liquidity deteriorates disproportionately in the physical bond market, giving rise to greater volatility than seen in the CDS market.
- There are some notable differences between physical bond and CDS indices in terms of composition. The former is market capitalisation weighted, the latter equal weighted, and the former reference individual bonds whereas the latter reference issuing companies.
- Blending the two CDS indices on a 50/50 basis is a sensible way to create well diversified, passive, and capital efficient exposure to corporate bond markets.
Which approach is right for your scheme?
Choosing the right management style for a scheme depends in large part on its funding position and long-term objectives. Generally, when a scheme is underfunded and it is aiming to close its funding gap, an active management style that looks to generate excess returns, or the use of CDS, is likely to be more suitable.
If a scheme is fully funded, then a passive or buy-and-maintain approach might be better aligned with its longer-term objectives.
Passive strategies are good at generating broad overall exposure to credit markets, but they can be restrictive because they are tied into matching what happens in the wider market. Buy-and-maintain strategies on the other hand can be more flexible and more closely targeted at the scheme’s objectives.
A pension scheme’s long-term objectives can also influence whether the scheme invests in shorter- or longer-dated securities. If a pension scheme is considering a buy-out in the near future, it would typically want to be invested in more liquid assets that can be sold, or realised, quickly. That would suggest shorter-dated securities where there is greatest depth in the credit market. Where the pension scheme is seeking to run the portfolio down through time, longer-dated securities can be effectively used to match the cashflows of a pension scheme’s liability profile and lock into a certain yield. Finally, CDS instruments are a good option when pension scheme wants to get exposure to credit markets quickly or in a capital efficient way.
What’s important when assessing creditworthiness
The main job of the credit analyst is to assess whether a company will be able to repay its debts over the life of the bond and to combine that with a valuation of the bond, to decide whether investors are being adequately compensated for the risk the company may fail to repay. This is a forward-looking process considering how the credit quality of the company will change over time.
Overall, analysts focus on two key pillars: the business fundamentals and the financial profile of the company. And combine this with an assessment of internal risks such as a large acquisition and external risk such as regulatory change or a technological shift.
Specifically within business fundamentals, analysts look at the stability and profitability of the company, both on a standalone basis and within its sector, considering the competitive environment and leadership within the sector. The competency and strategy of management is considered, as well as how the company treats bondholders relative to shareholders.
Within the financial profile, the scale and consistency of cashflow generation is central, as well as cash distribution, considering whether internally generated funds can cover the company’s spending needs. The overall borrowing profile of a company is important, as well as its liquidity, including cash on hand and access to capital markets.
Hints and tips: what to look out for in portfolio implementation
While it is the role of the credit analyst to assess the underlying creditworthiness of a company, the portfolio manager’s primary responsibility is to deliver the client’s objectives through the construction of the portfolio.
Once the credit analyst has published their research, the two will then collaborate to choose the most appropriate companies and the best ideas so that the portfolio manager can build the most suitable portfolio according to management style and objectives.
For example, within an active management style the portfolio manager may aim to identify those companies whose price makes them look cheap within their sector or relative to the analyst’s valuation. With a buy-and-maintain strategy, the portfolio manager may focus on the highest-quality, most stable companies, with strong forward-looking outlooks.
The portfolio manager will also want to achieve the cheapest and fastest execution for the client. The manager might consider using CDS if it is the most efficient way to gain credit exposure, before moving later into the underlying physical security.
ESG
ESG is a crucial part of credit portfolio management and there are a variety of ways that it can be integrated into the process. At one end of the spectrum is a fully integrated approach, where ESG is naturally embedded into every stage of the investment process, from credit research to portfolio construction.
In the middle of the spectrum, exclusions might be applied to eliminate companies that don’t, for example, meet certain international conventions, or that sit in undesirable sectors, such as tobacco, fossil fuels or arms.
At the other end of the spectrum, there is the impact approach, which actively seeks positive ESG outcomes.
ESG is an important driver of company value and long-term success, and the consideration of ESG factors within credit research contributes to a company’s creditworthiness assessment. If a company has a poor ESG profile, then investors will expect that to be reflected in the price and be compensated for the additional perceived ESG risk.
