The Q&A: Why credit needs a reset
Author: The editor's desk
December 7, 2018
With Andy Kochar, Portfolio Manager and Head of Credit on AGF’s Fixed Income team.
How would you describe your investment style?
Credit investing is often mischaracterized as a simple yield harvesting exercise, wherein investors simply want a solution in the quest for greater yield. To me, however, it has always been an exercise in harvesting total returns — as opposed to just yield-seeking — wherein returns can come from either coupon-clipping or price appreciation. Secondly, the goal of seeking optimal returns cannot be achieved without factoring in inherent risks underlying a sector, an investable theme, or a company. From my point of view, given the asymmetric, risk-reward nature of the asset class, credit investing starts as an exercise in avoiding the wrong investments before picking the right ones.
How does credit fit into a broader investment strategy?
In a secular bull market for interest rates, portfolios that have deployed healthy allocations to credit risk have benefitted handsomely as a result of their potential to mitigate interest rate risk while posting healthy total returns. Secularly, on a risk adjusted basis, credit remains an attractive asset class. From a Canadian perspective, over the past decade, investment grade corporate bonds and the deployment of high yield bonds have done exceptionally well. We believe investment strategies must continue to deploy credit but in a much more active manner than they have in the past. This would include not just rigorous bottom-up credit selection, but prudent category allocation between investment grade, high yield, preferred shares, emerging market debt, and convertible debentures.
What’s your current take on credit markets?
After the last major drawdown in credit markets in 2014-2015, credit markets posted healthy returns for two years, until early 2018. Since then, we have maintained a somewhat cautious view, largely due to rich valuations. Having said that, 2018 has been a wonderful year of bottom-up credit selection, much like 2017, in which macro-economic conditions have been largely favourable. Going forward, we anticipate continued cyclical repricing of risk in the near term and will use these conditions to pick companies that we believe provide adequate risk-adjusted opportunities.. We don’t have an issue with the fundamental backdrop for credit. Valuations give us a pause.
Is fixed income an attractive asset class at this stage in the cycle?
Very broadly, one must always remember the core purpose of traditional fixed income is capital preservation. During times of sustained uncertainty in the markets, traditional fixed income assets are an excellent hedge. As far as traditional fixed income returns are concerned, long-term return opportunities are challenged. To earn superior risk-adjusted long term returns, categories such as investment grade, high yield, preferred shares, convertible debentures, and emerging market debt should be deployed over traditional rates. Finally, as rates, especially in the shorter end of the yield curve back up, investors have an excellent opportunity to reinvest their coupons at higher rates and enhance their return. One must not underestimate the power of compounding in a rising rate environment.
Where do you see the biggest opportunities?
In the near term, we see opportunities in the preferred share market as well as select opportunities in convertibles and emerging market debt. We continue to remain cautious on investment grade. Within high yield, we like certain parts of the market and continue to selectively add as this market corrects. There are certain companies that are getting unfairly punished as they throw the baby out with the bath water. Long term, we continue to stay patient and vigilant and watch all these categories for significant repricing before jumping in with both feet.
What about EM?
I mentioned previously how macro-economic events have driven returns, and that is especially true here in light of trade risks and geopolitical uncertainty. That said, we’re now seeing a greater divergence in the performance of individual EM countries, favouring those who have lowered their interest costs, termed out their debt, and implemented reforms. This could lead to opportunities in companies that were previously unfairly punished, though I remain cautious.
Are certain sectors/geographies more favourable than others?
The majority of opportunities we’re finding are close to home— both in the U.S. and Canada. There are some opportunities in Europe (especially peripheral Europe), Asia (particularly China), and Latin America (particularly Brazil).
Andy Kochar is Portfolio Manager and Head of Credit on AGF’s Fixed Income team. He is a regular contributor to the AGF Perspectives blog.
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