Faced with declining interest rates and elusive yield, fixed income investors are on a quest for solutions to these challenges. In this special report, we discuss such solutions, including a strategy that unearths value across the capital structure in corporates, and creating a portfolio with the right balance between long duration public and private credit.
Independent research identifies opportunity along the quality spectrum.
The current state of the credit market requires an eagle’s eye to identify selective opportunities. They aren’t easy to find, which is why Bryan Krug, founding Portfolio Manager of Artisan Partners Credit Team, underpins his high-conviction investment process with deep fundamental – and independent – credit research. II recently spoke with Krug about the work behind the process that invests across the capital structure, and why it’s a difference maker.
How would you sum up your investment philosophy?
We are value-based investors. We invest across the capital structure and the risk spectrum, and we look for opportunities of dislocation and mispricing. Where we get our edge is through our fundamental credit research process. We do independent work. We talk to not only the management of a company, but also suppliers, competitors, former employees, and so on, and through those conversations we’re able to triangulate independently what’s happening with a company. Based on our views that emerge from that research, we identify the part of the debt portion of the capital structure that we believe offers the best risk-adjusted return. And, we have a concentrated portfolio where our best ideas meaningfully impact performance through the cycle.
Can you give us an example of that in action?
We have a full-time data scientist to try to get a greater depth of understanding through public and private sources of data, which in turn allows us to confirm or reject investment theses. In one example, there was a restaurant company that was in the process of being bought out, the same store sales look to be relatively stable, and their margins looked to be improving. On the surface that sounds reasonable and stable. However, when we dug deeper into the underlying data through alternative data methods, we found that traffic was down double digits, and that was being offset by double-digit price increases. In that case, the core health of businesses is clearly deteriorating. That strategy is just not sustainable for the long term. That’s the kind of incremental insight we gain from using independent data.
What do you focus on to determine where you should be positioned across a company’s capital structure?
We form a fundamental view on the trajectory of the business, based on our independent research. With that view, we anticipate how financial leverage will work through different parts of the capital structure. With each capital structure, we assess the maturity profile and the opportunities for the company to enhance its capital structure by performing a capital market transaction – and then we identify a piece of debt with the best risk-adjusted return. In general, if we’re more constructive on material credit improvement, we’re likely going to be more junior in the capital structure or in the part of the capital structure that’s most likely to experience spread the most compression.
Does a more complex capital structure mean there is more opportunity?
Capital structures evolve, and as covenants have become looser, debtors have opportunities and flexibility that they wouldn’t have had 10 or 15 years ago. That flexibility sometimes will allow junior capital to potentially become more senior than the bond indicates. So, there are times when a junior piece of paper can actually be refinanced into a more senior piece of debt because documents generally are more issuer-friendly. While we’re doing our deep dive on companies, we also do a deep dive on the documents to understand what flexibility the issuers have. This is important and worthwhile, because the market often does not anticipate those potential transactions, which creates opportunity for us.
What are some of the other key differentiators in your investment process?
We invest across the full quality spectrum, and we are very selective when we’re going into the lower grades. There are a number of businesses that have strong business models with higher-leveraged balance sheets that are justified. We view that as an opportunity that many of our peers would avoid. You could have a CCC rating and this can be CCC bonds that have equity subordination of 50% of the capital structure. So, we think the risk of impairment is low. We think that a lot of our peers gravitate toward higher quality, which is the most efficient part of the market where there’s very little ability to differentiate.
Another is that investing across the capital structure has clear benefits to mitigate risk. We tend to think on a risk-adjusted basis, by investing across the capital structure you can have different outcomes among securities of the same company. For example, if a company were to test a financial covenant, that would be a negative event for a bond, but it could actually be a positive event for the term loan. So, our ability to flex between bonds and loans gives us the advantage of a broader opportunity set to express our views.
Another differentiator is that we’re cash-flow lenders as opposed to asset-based lenders. The reason is because cash flow is what will ultimately pay back our invested capital – it’s much more real. Asset value is great theoretically, but it is also tied to cash flow. In the event of a deterioration, the asset value collapses. A good example is in energy, when higher oil prices became lower, asset value fell apart pretty quickly, and investors who thought they were protected by asset value were actually impaired.
You have significant loan exposure, which means you likely keep a close eye on underwriting. What trends are you noticing in that regard?
We’re seeing a couple of trends in the below investment grade market. The high yield bond market has shifted more to a high-grade, higher quality market. Most of the underwriting has been higher quality issuance over the last few years. For example, the amount of CCC new issuance has been below historical averages. On the loan side, it has been incrementally more aggressive than it was in the past, and documents have gotten looser. Additionally, there’s been a massive trend of junior debt capital moving to the private credit solutions, because it’s become a more robust source of financing and, in certain cases, the private market is cheaper than public market alternatives.
How do you size up the current investment environment overall?
It’s an odd environment for investing, in my opinion. There’s a lot of focus globally on central bank activity. If you look at bond yields globally – the pricing on a valuation basis, they’re pricing-in recessionary environments. And equity markets are not pricing-in recession at all. It’s a very odd dynamic, fueled by liquidity-induced drought, and rallied by central banks broadly. Central bank policies are blunt instruments. As we look at valuations, particularly higher quality bonds in the marketplace, they’re extremely expensive on both a spread and a yield basis. As a result, we are flexing our ability to invest across the ratings spectrum. In our view, BB bonds are expensive and have tightened to relatively unattractive levels. We think we can pick-up spread by buying B loans that on a loan-to-value basis are reasonably close to some of the BB bonds. That’s an opportunity we’re seeing in today’s market.
Because the lower grades of the credit market have lagged dramatically, we think there are selective opportunities that could achieve equity like returns. Rising dispersion across credit quality has led to increased alpha generation potential through credit selection. These tend to be more idiosyncratic names that’s often overlooked by the market.
The views expressed are those of Bryan Krug as of the date of publication. Artisan Partners is not responsible for and cannot guarantee the accuracy or completeness of any statement in the discussion. This material is provided for informational purposes without regard to your particular investment needs. This material shall not be construed as investment or tax advice on which you may rely for your investment decisions. Investors should consult their financial and tax adviser before making investments in order to determine the appropriateness of any investment product discussed herein.
Fixed income securities carry interest rate risk and credit risk for both the issuer and counterparty and investors may lose principal value. In general, when interest rates rise, fixed income values fall. High income securities (junk bonds) are speculative, experience greater price volatility and have a higher degree of credit and liquidity risk than bonds with a higher credit rating. The portfolio typically invests a significant portion of its assets in lower-rated high income securities (e.g., CCC). Loans carry risks including insolvency of the borrower, lending bank or other intermediary. Loans may be secured, unsecured, or not fully collateralized, trade infrequently, experience delayed settlement, and be subject to resale restrictions. Private placement and restricted securities may not be easily sold due to resale restrictions and are more difficult to value. The use of derivatives in a portfolio may create investment leverage and increase the likelihood of volatility and risk of loss in excess of the amount invested. International investments involve special risks, including currency fluctuation, lower liquidity, different accounting methods and economic and political systems, and higher transaction costs. These risks typically are greater in emerging markets.
Artisan Partners Limited Partnership (APLP) is an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Artisan Partners UK LLP (APUK) is authorized and regulated by the Financial Conduct Authority and is a registered investment adviser with the SEC. APEL Financial Distribution Services Limited (AP Europe) is authorized and regulated by the Central Bank of Ireland. APLP, APUK and AP Europe are collectively, with their parent company and affiliates, referred to as Artisan Partners herein.
© 2019 Artisan Partners. All rights reserved
For Institutional Investors Only—Not for Retail Distribution
As you read this, the Fed has recently announced yet another interest rate cut. Rate changes are always significant events for investors – and whether they will occur can generate uncertainty. But as, CME Group’s Owain Johnson, Global Head of Research, and Bobby Timberlake, Director, Financial Research & Product Development Group, pointed out in a recent story on CME Group’s Open Markets, there is a fairly reliable predictor of what the Fed might do at any given time. And it’s likely something you are already paying attention to if you’re a fixed-income investor.
By Owain Johnson and Bobby Timberlake
Perhaps the most-watched U.S. financial benchmark – the Federal Funds target rate – is attracting significant new attention from traders as volatility returns to the U.S. interest rate market, after a prolonged period of stable and very low rates.
Federal Funds (FF) futures settle each month to a simple average of the daily Effective Federal Funds Rate subtracted from 100. The futures contract allows firms the ability to hedge short-term interest rates or to express a view on the Fed’s likely direction of travel.
FF contracts with longer terms to expiry also allow market participants to act on views as far ahead as a year where there is greater uncertainty, given that the Federal Reserve incorporates new economic data into each meeting’s outcome.
Managing Rate Risk
After a long period of interest rate stability in the wake of the global financial crisis, with a target range of 0-0.25%, the Fed announced a series of nine increases between 2015 and 2019 followed by a cut in autumn 2019. This period of greater central bank activity led to a significant renewal of interest in trading and hedging Federal Funds futures.
Volume and open interest trended sharply upward, with visible spikes preceding rate changes. Even when compared to the most active periods of the low-interest era, both volume and open interest increased by around a factor of five. For 2019, average daily volume has reached nearly 400,000 contracts, with open interest around 2.2 million. Using the contract multiplier of $4,167, these numbers represent around $1.6 billion and $9 billion in notional exposure, respectively.
This growing volume was not simply concentrated among a few extremely large players, but rather came from new participants and smaller players increasing their holdings over time.
The Large Open Interest Holders count tracked by the CFTC shows that the number of counterparties holding reportable futures positions has more than doubled since the recession. Compared to the depths of the zero-interest rate environment around 2013, they have more than tripled.
Some market participants also use the price signals from Federal Funds futures as a predictive signal of the FOMC’s likely rate decisions. Comparing front-month Fed Funds futures prices, as observed four weeks ahead of a Fed meeting, with the Fed target rate after the meeting shows that the futures market is a relatively accurate guide.
Over the last 15 meetings to September 2019, Fed Funds futures have priced an average around two basis points away from the target rate, with a maximum divergence of 11 bps when moves of 50-75 bps occurred regularly. The two outliers arose in January and October 2008, when the Federal Reserve made emergency cuts totaling 125 and 100 basis points for those months.
Futures prices a month out did not anticipate off-cycle or larger than standard cuts, but after each unscheduled cut the futures quickly re-priced to include the new expectations, landing within 10 bps of the realized target rate.
The growth in trading volume and participation in Fed Funds futures looks to have increased the spectrum of viewpoints being incorporated into its price discovery, increasing its predictive abilities. But whatever the cause, the Fed Funds futures serve as an efficient tool for near-term interest rate hedging.
In a time of shifting expectations about where the Fed will or won’t move its target rate, that makes it a key barometer for anyone following financial markets.
As investors look to diversify their fixed income strategies, an integrated and holistic approach can make a big difference.
Traditional investment grade public fixed income investments are a mainstay of institutional portfolios, and the same can be said of investment grade private credit to some degree, depending on the investor’s goals. In an ideal scenario, an investor might see a benefit to these two elements of their fixed income strategy being integrated in both spirit and execution – the left hand knowing what the right hand is doing, you might say. At SLC Management, the public and private fixed income teams work together to deliver investment grade long-duration strategies to a range of client types. To understand the upside potential of this for investors, II spoke with SLC Management’s Rich Familetti, Chief Investment Officer, U.S. Total Return Fixed Income, and Sam Tillinghast, President, U.S. Private Fixed Income.
You both run long-duration portfolios. Where are you seeing interest in your strategies from investors at the moment?
Rich Familetti: On the public fixed income side, we are seeing a strong demand for designing and managing liability-driven investment (LDI) strategies. We have a long history of delivering both traditional and customized solutions for clients, and it continues to be a growth area for us across the board, particularly among corporate defined benefit (DB) plans. We manage portfolios across the duration spectrum and have seen strong excess returns across almost all of our strategies. In the long duration space, we’ve had good performance while consistently providing the proper risk profile required to hedge long duration liabilities. In public fixed income markets, we’ve been able to consistently find mispriced or undervalued securities, and that’s a result of a team-oriented and hands-on approach between our portfolio managers and credit analysts.
Sam Tillinghast: On the private fixed income side, we focus on opportunities in investment grade private credit, which is a newer asset class to many investors. This segment of fixed income has higher yields than comparable public bonds, and financial covenants and collateral securing the loan. These are issuer and transaction types that you don’t normally see in the public markets, so they provide additional diversification. Traditionally, the asset class has been dominated by insurance investors to back their long-term liabilities. At the moment, we are seeing a lot of interest from smaller insurance companies looking to outsource part of their balance sheet and to pick up additional yield for comparable credit quality. And we’re seeing corporate pension plan sponsors who are looking for additional yield and diversification versus their traditional public credit allocations. Overall, on the investment-grade private side, we’re more of a spread shop than a volume shop. That leads us to move into more niche areas than other insurers, and away from more of the traditional types of privates.
You both mentioned DB plans. What roles to you see DB plan sponsors expecting of traditional public fixed income and private credit?
Familetti: Corporate defined benefit pension liabilities are typically discounted using high-quality corporate bond yield curves. So, investment-grade corporate bonds, and treasuries to a certain extent, have been the natural home for most liability hedging assets. That has been a source of demand as more plan sponsors have looked to de-risk their plans. Sponsors certainly need to be active in managing those assets, in part because the discount rate is drawn from such a narrow universe. Liabilities aren’t subject to downgrades or defaults, so it’s important to diversify and have an active strategy around long-duration assets to keep pace with the liabilities.
Tillinghast: We think that high-grade public bonds will continue to form the majority of most DB plans’ portfolios. Investment-grade private credit should be thought of as a high-quality complement to provide diversification in sources of alpha. We’re focused on more complex and often structured transactions within investment grade private credit. We’re typically getting 50 to 100 basis points over equivalent public bonds, with historically lower losses than the publics. That’s due to the covenants and collateral that I mentioned previously. That additional spread reflects the complexity of the deals and the lower liquidity of private markets. While it is true there’s not as much liquidity as there is in publics, we think investors are typically over compensated as the lower liquidity really reflects a lack of sellers, not a lack of buyers. I’ll add that DB plans are long term in nature and generally have the capacity to give up some liquidity on a portion of their portfolio.
It sounds as if there’s a role for both public and private credit in liability-hedging portfolios?
Familetti: Absolutely, and as a good example, we manage the Sun Life U.S. corporate DB plan using a combination of public and private credit in a customized LDI framework. Our allocation to private fixed income is currently in the 15-20% range, and that goes back to what Sam mentioned about private fixed income being a good diversifier with the right sort of duration characteristics to seamlessly integrate into that LDI framework. Private credit also has a volatility profile very similar to A and AA corporate bonds that make up the methodology for determining discount rates. So, it’s a good asset class that adds some extra income without going down in quality and works well in a liability-hedging strategy.
Since you mentioned insurers: risk transfer is a hot topic of the moment. How do insurers view private credit in a pension buyout?
Tillinghast: Insurers tend to be very comfortable with private credit – in fact, you could say they are the most comfortable with it of all investors. A typical large life insurance company holds about 20% to 30% of their assets in investment grade private credit. The transactions that we source are generally priced at attractive yields, and we’d expect them to be very desirable to insurers.
Can you describe some of the similarities and differences in how you approach the public and private spaces?
Familetti: I think both teams look to source good relative value through really digging into the securities we purchase and through looking for areas that are undervalued. We also both utilize some of the broader SLC Management resources, such as the Global Research Team. The biggest difference is that public fixed income markets require a significantly more active strategy when you consider the technicals of the market. The public markets are generally more volatile than the private side, given the number of participants that can push bonds around and have an impact on value over a comparably shorter horizon. We’re really looking to exploit relative value across individual securities or across sectors of the market. The breadth of the public markets means that we’re able to find undervalued – and avoid overvalued – issues that can provide good risk adjusted returns for our clients.
Tillinghast: In the private markets, we’re always comparing the transactions that we do to equivalent public bonds in the context of relative value – the additional spread that we pick up at issuance when we initially buy the transaction. We look for niches where we have deep expertise. For example, areas such as aviation or financials are often avoided by other investors. One of the most important parts of private credit, however, is the origination or sourcing of transactions. A small amount of privates trade in the secondary market, so you must identify the opportunities when they first come to market. To do that requires a wide range of strong sourcing relationships that allow you to see a good variety of transactions. If you’re not called by that placement agent or intermediary when that deal first comes to market, you’re unlikely to have the opportunity to invest. In other words, relationships are extremely important for private markets.
It’s often thought that information and data are harder to come by in the private credit space. Is that the case?
Tillinghast: Certainly, there’s less publicly available information on transactions in privates. That said, in terms of underwriting transactions, we’re often able to obtain more information on our issuers than is typically available in the public markets. As these transactions are confidential, the issuers will provide any credit or financial information that we request. There’s also a much longer timeline for private transactions and we’re able to spend weeks, sometimes even months on due diligence. You could make the argument that private lenders actually have more information when it comes to underwriting the transaction.
In terms of valuation, you’re comparing the private transactions to other private transactions that have recently come to market – but also to what’s happening in the public markets, and you’re adding a premium for the private transactions depending on the type. A typical corporate transaction in the private market would be valued at 20 to 25 basis points more than a comparable corporate in the public bond market. And if the deal is structurally complex, you might add over 100 basis points, this is the end of the market we’re generally looking at.
By Adam Quinones, Global Head of Mortgages and ABS, Refinitiv
Mortgage-related market data used by investors isn’t always clean, particularly on older loans. A new report produced by Greenwich Associates and sponsored by Refinitiv examines how technology and data analytics is helping to improve risk decision-making on mortgage-backed securities.
U.S. mortgage debt currently stands in excess of US$12 trillion, and the majority of this debt ($9.4 trillion in Q2) is held by institutional investors via mortgage-backed securities, collateralized mortgage obligations and agency (i.e. FHLMC, FNMA, GNMA) bonds.
These institutional investors and mortgage dealers are tasked with developing accurate risk models to help them make decisions relating to, for example, price, yield and risk.
Robust and meaningful analysis relies on quality data, but given that the majority of mortgages involved in these complex computations were initiated before financial markets embraced digitization, there remains a vast quantity of data that is neither standardized nor usable.
Added to this the often-poor due diligence that was carried out when creating many of these mortgage agreements means that much of the data is incomplete or inaccurate, which can result in suboptimal decisions and rising risk.
If we are to avoid any future mortgage crisis, the industry needs to focus on new ways to access better quality data and more insightful data analysis.
Making sense of mortgage data
Several perennial challenges surround the process of ingesting, collating and making sense of data.
Not only has the fixed income market experienced an explosion of available data (which brings its own challenges), but incoming data may be ‘dirty’, non-standardized and presented in different formats, meaning that complex data technology is needed to store and analyze data relating to millions of mortgages and mortgage securities.
Moreover, institutional mortgage investors need to make risk decisions at speed, and relying on overnight batch jobs, although still common in mortgage investing, has become outdated.
The good news is that cloud-based solutions are coming to the rescue, and now mean that the necessary data and analytics can be accessed quickly and efficiently to enable real-time calculations and promote faster, better decision-making.
A complete view of mortgage-backed securities
Over the past decade, much progress has been evident:
- Innovation has meant that individual loans within mortgage-backed securities can now be scrutinized, meaning that investors can form a more complete picture of a potential investment.
- Nearly two-thirds of mortgage-backed securities are now traded electronically, which brings greater transparency and benefits for all stakeholders. Increased data spurs more electronic trading, which generates more data in what is described as a virtuous cycle.
- Industry agreed standards have improved and agency mortgage pools now consist of more specific groupings (‘spec pools’) for greater clarity and more targeted investing.
As technology continues to overhaul traditional solutions to risk management, the industry can look forward to further progress in the years ahead.
For example, machine learning technology that can digest mortgage documents will mean that information is more readily accessible.
In the complex world of mortgages and mortgage-related investments, the role of analytics is set to become ever more crucial as an indispensable tool to help traders form a complete view and make better, faster decisions that will ultimately benefit all market players.
- The mortgage market is characterized by volume and complexity, and market players need quality data if they are to make accurate and profitable decisions.
- The breadth and depth of data available in the mortgage market continues to grow, but incoming data may be “dirty,” disconnected and non-standardized.
- Technology can harness and make sense of this data, delivering insightful analysis and empowering professionals in the complex world of mortgage-backed securities.