The summer holidays are upon us and so is the berry picking season with the forests and fields yielding strawberries, raspberries, and blueberries all waiting to be picked and served. Here, in Switzerland, July tends to be the perfect month for berry picking, depending on Mother Nature’s whims of course. Berries and bonds have a couple of things in common, as they both tend to have an optimal time to be picked and both offer yield: berries in the form of a harvest and bonds in the form of income. The berry picking analogy is an apt one for us active corporate bond investors, as we seek to pick the right bonds at the right time. It is this ability to forage for the best bonds at the most opportune moments that can give active investors an advantage over passive investment strategies.
Unlike passive strategies, there are many effective strategies an active investor can use to boost returns. To give a clearer picture of the benefits from active bond selection we will now highlight three strategies (with real-life examples):
Active managers are able to invest in new corporate issues from day one. Passive strategies do not have this luxury as the index rebalancing takes place once a month. Therefore, a passive solution cannot benefit from the performance potential in the initial period of a bond launch. A recent example of a new issue in the US that we participated in was T-Mobile, one of the major US wireless communications companies that came to market with its inaugural investment-grade deal. In the current environment, telecom is one of the few robust sectors with a limited direct impact from Covid-19-related risks.
In April, to finance its long-anticipated merger with Sprint, T-Mobile issued 19 billion US dollars’ worth of secured bonds over five different maturities ranging from 5-to-30 years. Demand for T-Mobile’s inaugural senior secured deal was strong with 71 billion dollars of demand, amounting to an oversubscription of 3.7x. We targeted the five-year part of the deal as it looked most compelling to us on a valuation basis considering the bond curve was flat at new issue.
The bond performed well in the month following the issue, increasing in price by six percentage points and the spread tightening by around 115 basis points (see chart 1).
We are long-term investors and do not invest in bonds to flip them for a quick profit. Therefore, this short-term performance example shows how taking part in new issues opens up opportunities to pick up high-quality bonds at prudent prices that can then deliver long-term outperformance. As for passive products, they cannot take part in new issues, as they will only include a bond after it is added to an underlying index after issue.
As global bond investors, we have to determine if the issuing company is capable of paying the interest and principal on its bonds, we do this through diligent credit analysis and stress testing.
One current example is an airline-leasing company, Avolon. The Covid-19 outbreak brought the airline industry to a standstill and as is common in investing, current news trumps long-term views. However, despite the corona crisis, air cargo and travel will continue.
So, let’s look at this contrarian prospect, and put it through our credit-analysis grinder.
With the onset of the coronavirus lockdowns and at its worst point in March, we stress-tested the firm. We calculated that even after a 40% drop in its operating cash flow, it would maintain around 1.5 billion US dollars in liquidity (see chart 2). We do not foresee a 40% drop in operating cash flow for this year. In fact, after the release of Q1 figures, we found that Avolon’s liquidity situation would be even stronger in a stressed situation as, amongst other steps, Avolon had reduced its capital expenditure (CapEx) by postponing some projects to the next year (see chart 3). Therefore, as bond investors, we are confident that the firm can service its debts now and for the foreseeable future, so we are comfortable in holding their bonds.
In-depth credit analysis is part of our daily work, and we regularly stress test the bonds we hold in the portfolio in order to make sure they can withstand market shocks. Passive strategies do not offer this more tactical approach, leaving the investor at the mercy of the market’s whims.
It is our firm belief that fixed income markets are inefficient. This does not mean all fixed income markets are inefficient all the time, but it does mean that occasionally inefficiencies present themselves, in particular when you invest globally. This is evident in times of market stress, but in our experience, there are more subtle inefficiencies that show up on a regular basis, ones that active managers can spot if they know where to look for them.
Active managers can make relative-value trades to extract extra yield without compromising the portfolio’s risk. A good example is a company that has issued bonds in different currencies and with a similar maturity. Even after taking into account hedging costs, there may be times when the yield differential between the two bonds is such that it is more profitable to hold one bond rather than the other. The risk for the investor remains the same, as bonds issued by the same company carry the same credit risk (provided that they are of equal subordination). Many active managers do not use these types of relative-value opportunities, despite the fact that they can help optimize returns without compromising the risk of the portfolio.
An example of a relative-value trade opportunity that has provided yield optimization over a period of years is British American Tobacco (BAT). Chart 3 shows two BAT bonds with a similar maturity but denominated in different currencies (US dollar and euro). Throughout the previous five years, the two bonds have had periods of when the US-dollar denominated bond provided a superior yield to the euro-denominated one and vice versa (even after hedging costs are taken into account). When used by active managers, it is precisely these types of opportunities that can provide long-term outperformance. It is essential that an active manager does not pick and follow just one bond from a company. They have to know the firm’s full offering and be able to optimize their investments based on which specific bond is offering the investor the best return for a similar risk. Passive strategies cannot partake in relative-value trades, they will only include specific bonds that are included in an index. For the investor, this means losing out on potential returns over the long term.
New issues, in-depth credit analysis, and exploiting market inefficiencies are just some of the effective strategies available to active corporate bond investors. By looking globally and investing actively, corporate bond investors can pick bonds for their basket that can yield a harvest of long-term returns.