How to build your multi-asset credit portfolio

Bonds can be broken down into three yield components. First, the risk-free rate, which is the theoretical rate of return of an investment with zero risk. 

Accepting that there is no such thing as a risk-free investment, we describe it as the minimum return an investor can expect on a specific investment. This rate is usually associated with government bonds. 

The second component is the swap or the fixed rate an investor receives for holding a security for a specified amount of time versus receiving a floating rate on the same risk investment. 

The third component is the risk premium, which consists of credit, liquidity and for certain emerging market bonds, a country risk premium. 

A MAC strategy aims to capture and take advantage of these three risk premiums while simultaneously minimising credit cost from bonds declining in credit quality or defaulting. 

Expected loss 

Expected loss is an estimation of the default and recovery risks that may occur over a specific time frame. 

A hypothetical portfolio made up of high-quality defence, chocolate and communication companies would likely have a low expected loss based on an overall low projected default rate for the entire portfolio. 

In comparison, that of a low-quality technology, cyclical and emerging market bond portfolio with an overall high projected default rate will be substantially higher. 

The key to a successful MAC strategy is optimising your risk-adjusted total return as opposed to achieving the highest yield. At all times you need to optimise your risk-adjusted return on risk-adjusted capital.  

The credit/business cycle 

Economies typically follow a credit cycle, with a progression from downturn, to credit repair, to recovery, to expansion and late cycle, then back to downturn.

Defaults start to rise in the expansion and late cycle phase and peak in the downturn phase.

The credit risk premium follows the same pattern and global MAC strategies are designed to monitor all country default cycles on a global basis.

MAC strategies dial down the risk profile towards conservation in the later parts of the expansion and late cycle phase as it heads towards a downturn.

The key to a successful MAC strategy is optimising your risk-adjusted total return as opposed to achieving the highest yield

They dial up risk investments – high-yield, bank loans – during the credit repair, recovery and early expansion phases to optimise risk-adjusted capital.

This is the primary advantage of global MAC strategies – they are uniquely able to weight exposure towards regions, sectors or countries that are in the later stages of the credit cycle, while simultaneously increasing exposure to markets emerging from a downturn, giving the investor a better opportunity set for potential outperformance.

Another advantage of this approach versus a single-asset strategy is its ability to lower correlations by investing in multiple credit asset classes such as bank loans, emerging market debt, high-yield, mortgage-backed securities and more. 

Many of these asset classes have low correlation to the overall aggregate bond index. A global multi-asset credit strategy has the advantage of being diversified across some or all of these asset classes, thus lowering its overall correlation to the benchmark. 

Generating alpha 

In addition to the ability to capture credit risk premium by allocating to attractive asset classes and geography, MAC strategies allow the investor to take advantage of idiosyncratic credit opportunities, such as short-duration bonds, even though the credit cycle might not be in an advantageous stage for that particular country.  

Another common example is cross-currency bonds where the same issuer might be significantly cheaper in a different currency. Other alpha strategies include taking advantage of different parts of issuers’ credit curves. 

Kevin Kearns is senior derivatives strategist and portfolio manager at Loomis, Sayles & Company