Building a multi-asset credit portfolio that delivers alpha

But diversification is just one element of risk management, which covers a wide spectrum of different measures and factors. Risk management itself is not usually the ultimate objective in an investment strategy.

It goes alongside a robust and consistent ability to generate positive returns. So how do we combine these two objectives together in multi-sector credit portfolio? 

Multi-sector credit strategies involve investing in investment-grade and high-yield corporate credit, emerging market debt, securitised credit and loans.

Two key risks to which investors are exposed in fixed income are interest rates and credit spreads. Investors can vary their exposure to interest rates, by varying the amount of interest rate duration (the sensitivity of the price of a fixed income investment to a change in interest rates).

Investors can also vary the amount of credit beta, which is a measure of a portfolio’s exposure to credit markets, by favouring more credit-sensitive areas of the fixed income market.

A multi-sector credit portfolio is likely to have a significant amount of credit beta embedded within it and a less significant amount of interest rate beta. It is critical to separate the allocations to beta from that of other factors that drive returns, such as security selection.

Indeed, this gets at the heart of how we believe multi-sector credit should be approached. We look separately at decisions on the overall level of credit beta and high-level positioning across different credit markets within the portfolio, and the more bottom-up industry and security selection ideas.

In other words, we look to separate the macro from the micro and all within a flexible, risk-controlled framework.

Investment factors

The ability to create a diversified portfolio is dependent on the number of different trade ideas that one can incorporate within a portfolio. Credit beta is the most important top-down factor.

Beneath this, there is the allocation to broad credit sectors such as investment-grade corporate debt, high-yield corporate debt, EMD, securitised debt of various forms and loans.

Allocations to these sectors will provide some diversification but, again, the number of levers are limited. It is only at the security selection level that the ability to diversify becomes truly prevalent.

Diversified credit allows an investor greater scope for generating alpha, or the ability of an investment manager to generate returns above and beyond those produced by the market.

The capacity to produce alpha effectively is dependent on having well-resourced and experienced credit research teams, which are able to find opportunities within their respective markets. Within credit mandates we try to focus on these opportunities.

Flexibility is also a key characteristic. For example, the ability to change the emphasis and focus on more bottom-up, micro positioning from top-down credit beta positioning is important. There are certain periods where credit markets face significant headwinds: deteriorating economic fundamentals, falling creditworthiness and financing concerns.

The ability to adjust exposure to a portfolio’s overall credit beta is important and can be the dominant driver of returns in certain market environments, for example, through the global financial crisis.

There are also environments where credit markets, overall, are relatively stable but where there are significant changes in value among the underlying corporate credits.

We are currently in such an environment where overall volatility is low, but there are changing credit characteristics and opportunities within the underlying markets, issuers and individual bonds.

The best way to approach multi-sector credit strategies is to invest around a risk-controlled framework that enables a flexible approach to positioning from the overall credit beta of the portfolio down to the choice of individual bond within each sector of the fixed income market.

An emphasis on security selection will ensure that returns are sustainable. It also allows different teams, analysts and strategists to focus on their own distinct areas of expertise.

Jim Cielinski is head of fixed income at Threadneedle Investments