Does credit investment all come down to manager selection?

Bob Hymas: Manager selection is always an important part of it. I still come back to how it fits into what you want to achieve. It needs to be manager selection as well, just because each manager has a different approach.

Within that general spread tightening period, there have been many idiosyncratic events that meant if you were not on top of your credits, you would have underperformed

Jonathan Butler, PGIM

Richard Butcher: Yes, you ask yourselves what are you trying to achieve. So, again, liquidity, duration, all of those sorts of things. Once you have defined the answer then you can go and look who will deliver it. There are still a lot of trustees who do it the other way around.

Hymas: And your risk appetite, that is very important.

Butcher: It is all of those factors, so decide what characteristics you are looking for and that will then narrowly define who can provide that particular solution.

Greg Fedorenko: It is something of a gross generalisation, but we prefer managers with a bottom-up research approach to a top-down approach; the reason being that the really nice aspect of credit is if a bond does not default and you hold it to term, you will earn your spread. That is a contractual return that is due to you.

In this context the thing that really kills you as an investor is if the bond does default, or if you get your fundamental case wrong. The nice thing about multi-sector credit portfolios is they allow managers to exercise this kind of fundamental research skill irrespective of the legal structure of the instrument itself.

A lot of talk has been generated recently about relative value in loans versus bonds versus collateralised loan obligations versus other asset classes.

In theory, a multi-sector credit portfolio is a very good way of addressing these kinds of concerns. The difficulty, as always, is in finding a manager with the right kind of credentials to actually put the theory into practice.

Butcher: You have got your investment characteristics, you then define what answer you are looking to address and then you will consider the universe of managers. Some you will be able to exclude very easily because they just do not meet the profile that you want.

You will end up with a range of however many, who will provide the answer that you want, and then you start to get into, ‘So what is the strength and depth of their research capability, what due diligence are they doing?’, and all of those sorts of things.

And you will choose the one that most closely matches your profile, and that is generally a decision between, ‘How much are they going to charge for this and how much do I want to spend, and therefore how thorough do I want their process to be?’

Chris Redmond: I broadly agree. However, I find it fascinating that over the past five years what has mattered is not bottom up – it has been central bank policy, quantitative easing, understanding the major sectors experiencing challenges, the influence of fracking on the self-sufficiency of the US in energy, and understanding Middle East policy and Opec and the like; it has not been bottom up.

Butcher: I think it has been bottom up. We have certainly had the discussions: what is it we are looking for? And in having that discussion we will discuss all of those things that are going on in the world. So there are lots of factors you consider, but they are in the bottom part of that analysis.

Fedorenko: If you look back at 2016, you see the nadir of market turmoil and everyone thinking the world was going to end in February. At this point what mattered was your underwriting skill and the depth and faith you placed in your bottom-up analysis, which allowed you to take a considered view as to whether your investment thesis still stood.

There was quite a sharp differentiation between managers who did trust their underwriting and those who did not, and that is the real value of bottom-up.

Jonathan Butler: Spreads have obviously tightened a lot since 2009, except for major wobbles in 2011 because of the European sovereign crisis and a wobble at the end of 2015 because of the energy crisis. If you played that macro bet, you probably have done well.

But within that general spread-tightening period there have been many idiosyncratic events that meant if you were not on top of your credits you would have underperformed.

The scary bit now is, obviously, after all that spread tightening, what is the next chapter going to be, where not immediately, but at some point defaults will come back and the top-down returns are not there to soften those blows?

Fedorenko: Obviously the macro has been hugely influential, but I feel as if we are through the looking glass, to an extent, in that every single thing people thought could possibly go wrong last year did go wrong. And yet here we are with valuations at post-crisis tides in many asset classes.

Trustees cannot deal with macro events tactically. Perhaps even our consultants and our managers cannot deal with them tactically

Richard Butcher, PTL

So, as a macro investor, you are having to predict not only the outcome of the event itself but also what the reaction to the event will be, which can be a much more difficult thing to try and assess.

Butcher: Trustees cannot deal with these things tactically. Perhaps even our consultants and our managers cannot deal with them tactically. [Economist and FT journalist] Tim Harford says aim for a steady return through diversification, keep your costs low, that is the best you can get. And maybe we do not need portfolio construction or trustee deliberation that is much more sophisticated than that.

Hymas: What you do want to have some comfort about is that the assessment has been made of how the portfolio can survive the shocks. You have to have a look at scenarios – what economic impact do they have and how might the portfolio react to them? And is there a way you can afford to let it?

Butcher: You can model some of that, can you not? But it goes back to the diversification point. If you have all of your eggs in one basket then if there is a shock you are going to get burnt.

Hymas: It is managing that downside, it is understanding that downside.

Butcher: You might not be able to manage it but you might be able to understand it.

Hymas: Manage as best you can.