Most credit managers and analysts tend to be yield hoarders. Once you understand what this means for portfolio construction, you can exploit opportunities, argues Aviva Investors’ Colin Purdie.
Anthropologists have long divided the various people they’ve studied into different tribes to help them categorise human social groups more easily.
But in the time-honoured tradition of the discipline, no two anthropologists agree and so the definition of what actually constitutes a tribe is contested.
This is partly because each school of anthropology has its own theoretical understandings of social and kinship structures, but it also reflects the complexity of human societies.
The word itself was first mentioned in English in the 12th century, where it was used in reference to the Twelve Tribes of Israel. The origin of the word ‘tribe’ ultimately derives from the Latin, where ‘tribus’ indicated a tripartite division of the original Roman state along ethnic lines.
Although many people today feel uncomfortable to use the word in an ethnic context, the antiquity of the term illustrates that for centuries people have found it useful to categorise people with similar belief systems and behaviours into distinct groups.
More recently, the word tribe has made a bit of a comeback in the field of marketing, where it is used to split consumers into separate groups, based on common collective behaviours rather than demographics. These customers share a way of thinking, experiences and lifestyles.
Aviva Investors has done research across the US long duration credit universe and has found that credit managers can also be divided into distinct groups, each one with its own style and behaviour.
Although the manager prefers the financial parlance of ‘buckets’ over ‘tribes’, it has identified six distinct groups, each with its own colourful name.
There are yield hoarders, gloom boomers, value timers, macro gorillas, closet indexers, and structural advantage managers.
Macro gorillas, for example, tend to take outsized bets on broad macroeconomic thematics, while value timers act under the impression that they can time the market.
But most credit managers fall into the tribe of yield hoarders.
“Not many people think of behavioural biases in credit. But we noticed by looking at spread returns and performance against different spread environments that the majority of the credit market typically are yield hoarders,” Colin Purdie, Chief Investment Officer for Credit at Aviva Investors says.
Yield hoarders are typically looking for bonds with wide spreads, under the belief that spreads will tighten over time. But this also means they tend to gravitate towards the riskier end of the investment grade spectrum, Purdie says in an interview with [i3] Insights.
“What you typically find is that people migrate to the BBB and BBB- part of the investment grade market, because that’s where they see the most value,” he says.
“When you think about it, it is a bit of human psychology and a bit of human bias, but most investors are inherently pretty bullish about both the market and their ability to outperform. And because of this ingrained belief that we can pick the winners and we can avoid the losers, people tend to think: ‘Well, I’ll go where I can make the most money and have the most impact on performance.’
Research analysts typically gravitate towards areas of the market where spreads are wider. In the investment grade part of the market, that is BBB-rated credit. Not only is this area of the market more ‘covered’ from a research perspective, but this is where most of the ‘outperform’ recommendations are found.
“So research analysts typically gravitate towards areas of the market where spreads are wider. In the investment grade part of the market, that is BBB-rated credit. Not only is this area of the market more ‘covered’ from a research perspective, but this is where most of the ‘outperform’ recommendations are found.
“The fact that portfolio managers are then served with more positive recommendations from the BBB space, results in these securities normally finding a way into portfolios. So typically portfolios sit long risk and they sit higher yield than the benchmark,” he says.
The implicit assumption of many credit managers that spreads will tighten might have worked well in the past, but Purdie says this is unlikely to be the case going forward.
“As we have seen in the last few years, it was not necessarily a bad assumption to make, but over the longer term you could question how often that is the case,” he says.
“People don’t tend to count on the fact that spreads will invariably widen at times, and they typically want to be overweight the long end of the curve as well. Because again, if you think about where you can make the most money from a fixed income perspective, it is by buying that spread duration.
“So not only do a lot of people typically buy BBB credit and go overweight BBB or BBB- credit, they also go overweight at the long end. If you are right, then the pay-off can be significant and people generally don’t tend to think: ‘But what if we are wrong? Does it make sense to be there from a valuation perspective?’. These are the questions that we ask ourselves and these behavioural aspects across the market creates opportunities,” Purdie says.
Microsoft vs Dell
Because of behavioural biases, Aviva Investors also believes that most of the commonly used benchmarks are problematic. Instead, they reconfigure the benchmark into custom sectors based on volatility. They then manage the risk by targeting a level of volatility that is in line with the original benchmark.
“We deconstruct the typical benchmarks. If you take a standard global benchmark in credit, we break it down into different sectors,” Purdie says.
“If you take any one sector and look at the spread of names and issuers within that sector, they can be massively different. Take for example the tech sector: at one end of the quality spectrum you’ve got Microsoft and at the other end you’ve got a company like Dell.
“They are very different companies. They’ve both got positives, but their business models, cash flows, risk profiles, credit ratings and outlooks are very different.
“From a credit perspective, Dell is rated down at the lower end of the investment grade market, while Microsoft is obviously viewed as having a pretty fortress-type of balance sheet.
“Given the behavioural biases that we’ve talked about, if you say to a credit analyst: ‘Okay, Microsoft is trading at, let’s say, 50 basis points over and Dell is trading at 300 over,’ most analysts would gravitate towards covering Dell at the cost of covering Microsoft.
“What can Microsoft tighten to? If it would tighten 10 per cent, then it would tighten 5 basis points, while if Dell tightened 10 per cent from 300 it is 30 basis points. So they think there is more advantage in covering Dell.
We are not going to pick a higher spread name versus a lower spread name, but we are going to make two higher spread names compete for a space in the portfolio
“Naturally, more people are going to be bullish on Dell than they are on Microsoft, because they are going to be looking at the absolute spread levels and they are not going to be thinking about the downside. They are typically going to be thinking about upside and they are going to say: ‘We want to be overweight Dell and we will go underweight Microsoft’,” he says.
But other than having the same industry title, Dell and Microsoft don’t have a lot in common. Purdie and his team look at other sectors that might contain companies with similar risk profiles to the two technology companies.
“If you take, for example, the retail sector, again you are going to see similar examples. In the US, you’ve got Walmart, which is an extremely strong retail name and then at the other end of the spectrum, going into the high-yield space, you’ve got Macy’s, which used to trade in investment grade,” Purdie says.
“They have different business models, risk profiles and styles of retail. Again, looking at them from a volatility perspective, Walmart and Microsoft are actually closer in how they operate from a spread perspective and from a risk perspective.
“And Macy’s and Dell are closer from a volatility and risk perspective. So, we put those names in the same sectors, i.e. Macy’s and Dell in one sector, and Microsoft and Wall-Mart into a different sector.
“What this means from a portfolio management perspective is that we are not going to pick a higher spread name versus a lower spread name, but we are going to make two higher spread names compete for a space in the portfolio,” he says.
Experience during March crisis
This approach helps Aviva Investors to manage the risk in its credit portfolios, as most investors into investment grade credit expect their holdings to have a defensive quality. Yet, when markets go into a tailspin and liquidity dries up, as happened in March this year when the full extent of the coronavirus pandemic became clear, every manager feels the pain.
“What we are trying to do is have volatility in line with the benchmark, so that we are not getting caught out by a downturn,” Purdie says. “But when you look at the market environment as a whole, it has been an extraordinary year already. We came into it with a view that was relatively cautious on credit, but clearly I’m not going to tell you that we saw COVID-19 coming.
“We were just generally quite cautious on spread levels, leverage was a bit high, particularly in the US and especially in US corporates. And then there was a significant event towards the middle of March as the true impact of COVID-19 became known and we saw significant stress in the credit markets.
“I think one benefit of our approach is that we run an equal volatility portfolio to the benchmark, so we don’t suffer significant drawdowns in a normal market environment. But I think it is fair to say that this wasn’t a normal market.
“The reason why I say that is that we did not see people selling what they wanted to sell; people were selling what they could sell. You saw people being unable to get bids on paper that were lower quality and, in some instances, further out the curve.
“So you saw a lot of pressure on the front end of the curve and you saw quite a lot of pressure on high quality credit, because people were saying: ‘We are seeing redemptions coming through and we are seeing outflows’. I think we saw the record week for outflows earlier this year for US investment grade credit. People were selling anything they could, so it was a very difficult market for a few weeks,” he says.
But the chaos remained limited to a few weeks, as central banks around the world were swift to take action, deploying interest-rate cuts, asset purchases, currency interventions and liquidity injections. As a result, some order was restored to the market.
“It was quite a disorderly market for a couple of weeks and it led to some pretty irrational price moves. Clearly, that gave the Federal Reserve and other central banks a jolt, but we saw a very quick turnaround in terms of their response,” he says.
“We’ve seen the Federal Reserve talking about buying paper at the front end of the curve, up to five years in both primary and secondary [markets]. We’ve seen the ECB talking about the programs that they’ve got in place and might be extended. There should be few questions about the ability or desire of central banks to step in and support the market,” he says.
As a result, credit has benefitted from this quick action and spreads have retraced a lot of the widening that took place earlier in the year. But it does mean credit markets are being pulled in opposite directions, as markets are boosted by confidence in central banks, while the broader economic outlook is poor for many countries.
[In March] we did not see people selling what they wanted to sell; people were selling what they could sell... It was quite a disorderly market for a couple of weeks and it led to some pretty irrational price moves. Clearly, that gave the Federal Reserve and other central banks a jolt, but we saw a very quick turnaround in terms of their response
“We are now in a position of a relatively fragile balancing act because we have very strong technicals in the market driven by central banks and flow data that suggests credit, both high yield and investment grade, has seen significant inflows,” Purdie says.
“But that has to be balanced against a pretty difficult macro and fundamental picture. We know there are a number of fiscal programs in place, but unemployment is high. There are a lot of companies and sectors struggling and we expect defaults to increase.
“The one thing we do know is that central banks will not buy bonds of defaulted companies, so it is about ensuring that we traverse this period in the correct names, supporting companies with business models to cope with the post COVID-19 environment,” he says.
If anything can be learned from the chaos caused by the pandemic, it is that short term technicals matter, no matter how important fundamentals are over the long term.
“Certainly, for the short and medium term, technicals will continue to dominate. There will be opportunities from that, but you’ve got to be careful in terms of how you play it,” Purdie says. “We don’t overreach; we only invest where we have full clarity, transparency and an understanding of the names and sectors that we are investing in.
“There have been some pretty big moves in areas of the market that we think are fundamentally unjustified because of these short term technicals and there is some degree of herd mentality,” he says.
Banks are one example, where valuations dropped to levels that just didn’t make sense, Purdie says. Partly this happened because the experience of the global financial crisis is still fresh in the minds of many investors and so they rushed for the door.
“We are fairly constructive on banks and we’ve been taking some exposure in the senior unsecured banking space, because we think you are getting well paid for that,” he says. “When the market moved out wider, earlier in March, we felt this was actually slightly overdone.
“The market clearly has a bit of a long memory; it thinks back to the financial crisis. It thinks back to these extreme spread moves in 2008 – 09, which were justified at that point of time, but the question is: ‘Are they justified now?’
“Our answer was that they weren’t, and from a risk/reward perspective it made sense to take some exposure there,” he says.
Having a proper environmental, social and corporate governance process helps too, Purdie says as many defaults in credit are the result of poor governance.
“Within credit, if you look at the last 30 years, where the market has had the biggest upsets, it has been in defaults and defaults have been primarily a result of bad governance, for example Enron and Parmalat. You could also argue the global financial crisis was a crisis of governance.
“We know that companies with better ESG metrics are more likely to survive longer term. We think that you are likely to get better longer-term returns, either from the better underlying fundamentals, or because of a lower cost in capital for those companies leading to better profitability in the future.”
“The lesson from all of this is to keep asking yourself the questions: Is it rational? Is it justified? And is it overdone in either direction? If it is, then you should consider, as long as you are comfortable with the fundamentals, taking the other side,” he says.
This article is paid for by Aviva Investors. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.