Our investment philosophy in the UK corporate bond strategy is built around the principles of being active, pragmatic and risk aware.
We are active in that we are always looking for the best ideas to implement and to do that on a regular basis through a repeatable process. This has been a critical driver of alpha generation over the last three years for the strategy.
We also think it is important to actively manage the strategy in a pragmatic way. That is not always the case in this asset class. Some fund managers become permanently defensive or permanently aggressive or hold a structurally long or short duration position. We try very hard to avoid dogmatism – we simply look to position the portfolio based on our assessment of macro-economic environment with clear consideration given to any potential tail risks that may arise.
We aim to consistently buy low and sell high as we navigate through the credit cycle. As spreads get narrower and credit gets expensive, we get more defensive. When we see more volatility, when spreads widen and we see value emerge, we start to add risk. That has been key to delivering alpha through different phases of the market.
Understanding the macro
Another part of pragmatism is understanding the macroeconomic environment today and how conditions may change in the future. The strategy has been able to generate about half its outperformance because of top-down positioning and the other half from bottom-up credit selection.
The final pillar of the philosophy is being risk aware. We operate within investment grade credit, where avoiding idiosyncratic losses is key to alpha generation, so we are focused on not only picking winners but, importantly, avoiding losers. Detailed credit analysis on the businesses we lend money to is always central to our investment framework. It is also vital to maintain a highly liquid strategy which allows us to implement the active pilar of our investment philosophy and rotate the fund as and when conditions change.
The great attraction of investment grade credit is that it represents a senior claim on high-quality businesses, and you can earn steady, reliable income in a world where income and yield is constrained. But you have to avoid situations that go wrong to generate strong returns over the long term and to do that effectively we undertake extremely thorough credit analysis. You do not want to be in a position where you are left holding bonds with a deteriorating credit profile, that are downgraded to high yield or that default.
Adding risk and playing defence
Coming into 2020 the strategy was very defensively positioned. This was because we saw spreads that were mispriced for the macro environment, and we questioned whether there was too much complacency in markets. In that environment we were willing to be underweight risk.
This protected the strategy from the downturn that came as the markets reacted to the Covid pandemic. By the end of March 2020, we had become more constructive as we saw valuations that offered compelling buying opportunities on a longer-term perspective. Knowing the credit markets well and having a strong team of analysts behind us enabled us to move quickly to rotate the portfolio into higher yielding opportunities. We had a good understanding of macro conditions; the vast level of support from central banks and governments gave us more confidence to add risk. By the time we got to April and May the strategy had shifted to overweight credit risk versus the market.
Over the last six months, we have begun to question the prevailing market narrative that markets can get more expensive indefinitely because of central bank support and an improving economic outlook. We believe that valuations already fully reflect this rosier outlook, and we have started to see signs of complacency again in some parts of the corporate bond market. Against that backdrop we have been moving up in quality, with AAA-rated bonds and gilts to add to the defensive ballast in the strategy.
At the moment, investment grade credit is expensive relative to history. We have become more selective about the risk: selling long-dated bonds that we think are overpriced as they can damage returns in a risk-off environment but retaining bonds that we think still look cheap and can rally further. We are also closely monitoring the outlook for inflation and interest rates to manage out duration risk.
We think it makes sense to be more defensive than the market and to anticipate some turbulence. In volatile markets you can outperform by buying the right risk when others are selling, and there are times in more bullish markets where you take your foot off the gas and think carefully about what you want to own.
We think being underweight risk is likely to be a core driver of alpha generation over the next 12 months. We anticipate a potential future event that is sufficient to shake market complacency and create volatility. This could be a result of tapering from central banks, for example, a slowdown in China that weighs on growth or a Covid development. This dynamic positioning will allow the strategy to redeploy into credit and to add risk when it is more attractively priced.
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