Stuart Steven

Reacting to changes in credit ratings

Stuart Steven

With bond markets constantly evolving, a key part of fixed income fund management is adapting to change: over the last decade, for example, the UK has seen a significant downward migration in credit ratings, bringing BBB debt towards two-thirds of the index.

As the table below shows, looking at the iBoxx 5-15 Year Corporate Index, more than 60% was in A or higher-rated debt when we launched the Liontrust Monthly Income Bond Fund (MIBF) in 2010; a decade later, this level has fallen to around 40%. Within this, AAA and AA have halved from around 13% of the index to slightly over 6%. BBB assets, in contrast, have close to doubled, increasing from around 36% to just under 60% today, with this shift exacerbated by Brexit and the Covid-19 pandemic.

Credit ratings: iBoxx 5-15 Year Corporate Index (since MIBF inception)

Rating

30.06.10  31.12.14 31.03.17 31.07.20
 AAA  1.70%  0.60%  0.40%  0.30%
 AA  11.50%
 7.40% 7.30% 6.00%
 A  50.90%  39.40% 39.70% 34.60%
 BBB  35.90%  52.60% 52.60% 59.10%


There are several reasons for this changing market make up, from ongoing credit downgrades in the aftermath of the financial crisis of 2008-09 to high levels of issuance from what are traditionally BBB-rated sectors such as telecoms and utilities. Many non-financial companies have also increased leverage levels but while this growing debt on balance sheets
has resulted in credit downgrades, most of this has been a deliberate strategy and is not due to stress.

We are seeing the UK move closer to the US credit model where ‘BBB’ balance sheets have historically been seen as optimal for many sectors. Increased leverage helps to bolster return on equity, particularly in an environment of low economic growth and interest rates, and BBB-rated companies now have greater access to bond markets in the UK and Europe, meaning they are less reliant on banks for finance.

What this means for the investment grade universe is a very different profile over the last decade and, in terms of opportunities for bond funds, BBB is very much the new A.

Impact on Monthly Income Bond Fund

Since launch in 2010, MIBF has maintained a minimum credit rating of A- at overall portfolio level, with an average across bond holdings of BBB+ and derivatives used to enhance this. While this been a mainstay of the portfolio, this shift in markets we have described which we believe will persist and could even accelerate requires a change. We believe now is the right time to relax the minimum credit rating to an average of BBB at portfolio level, but it is important to stress this does not signal a shift in either MIBF’s risk profile or underlying investment approach.

With the proportion of A and above rated debt in long-term decline, maintaining the minimum A was a challenge even when the Fund moved across to Liontrust in 2017 but two factors have enabled us to do so up to this point. Our favoured subordinated bank and insurance sectors have continued to provide opportunities in A-rated bonds, and we have also synthetically increased overall portfolio credit quality via credit default swap (CDS) indices. As an example, we have been short high yield indices and long investment grade.

Recent events have undermined both of these options, however, with renewed risk of a hard Brexit and the impact of Covid-19 reversing the improving trend in credit ratings across UK financials. Rather than expecting further upgrades to UK banks and insurance companies to those we saw in 2019, all the primary agencies have now downgraded credit ratings by one notch and/or put many issuers in these sectors on a negative outlook. While we have no concerns over the ongoing viability of the issuers we hold, the impact of these marginal downgrades would likely result in us having to reduce exposure to bonds we view as very attractive.

So far, while our portfolio has not been immune to recent conditions, we have not seen any downgrades to sub-investment grade, reflecting the quality of the issuers held. The risk over the coming months, however, is that further downgrades in our favoured sectors will make it difficult to maintain the A minimum without compromising our ability to deliver income and outperformance from MIBF’s credit portfolio.

In terms of CDS exposure, the Fund is already near its limit so there is no further capacity to use this as a counterbalance in the event credit ratings do continue deteriorating. Our CDS position has been positive over recent years as we expected high yield to underperform investment grade bonds and this has continued in recent months, with elevated default levels in the former (31 in the US over recent months equating to $64 billion of debt). But with many of these weaker high yield companies defaulting, the survivors will likely fare well in a recovering market and our CDS positions could therefore undermine future total returns.

What this means in practice

As a result of these developments, we have relaxed the minimum A restriction to a portfolio weighted average credit rating of a minimum of BBB. We believe this will enhance returns to investors over the medium to long term, giving the team the ability to outperform in all markets; without relaxing the restriction, the Fund can only ever be overweight credit quality.

This will also allow us to reduce or collapse existing CDS positions. Less derivative exposure will mean a modest fall in dealing costs but a more significant reduction in basis risk, which is the price difference between cash bonds and CDS. It will also eliminate or at least reduce the negative cost of carry on CDS and also collateral requirements. If necessary, we can reintroduce CDS protection during any future periods of market uncertainty or stress.

As stated, our intention is not to alter the long-term risk profile of the Fund and the bond portfolio will not change significantly overall. We have an average issue rating of BBB+ (matching the index) and, across bond holdings and total portfolio, this will never fall below mid-BBB, supported by our high yield restrictions. MIBF maintains maximum net high yield exposure of 10% and no positions in any issuers rated below BB-. Excluding existing CDS positions, the current high yield weighting is 4.3% and the minimum issuer rating is BB. The weighted average issuer rating remains at single A/A-.

These changes will also have no impact on the yield of the Fund (at the end of July, the distribution yield on MIBF was 4.6%). Income is generated exclusively by the bonds held and, as stated, we do not expect these to change materially due to relaxing the A target.

Our sector weightings are also not set to shift immediately, given that valuations continue to support our favoured areas such as insurance, telecoms and banks. The change will improve our investment flexibility, however, and give us the opportunity to expand our allocations to a broader range of sectors (subject to valuations and companies/sectors passing our sustainability criteria).

MIBF retains its long-term commitment to high-quality issuers and there is no change to the stock selection or wider investment process. Credit and our proprietary sustainability analysis remain key to identifying robust issuers.

On top of the high yield restrictions, the Fund also has no exposure to emerging market debt and a maximum aggregated weighting to CoCo bonds of 7%.

To sum up, relaxing the average credit weighting will allow us to run MIBF as we have since launch. Without this, given the ongoing downward migration in UK credit ratings, it would be increasingly difficult to meet our key objectives of maximising income and total returns from a short duration fund.

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Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well-regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities - fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.

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Tuesday, September 8, 2020, 11:30 AM