‘Value’ and ‘safety’ strategies in credit market

Portfolio manager says environment is extraordinarily calm, explains fund’s philosophy

‘Value’ and ‘safety’ strategies in credit market

‘Value’ and ‘safety’ approaches are powerful indicators in driving outperformance in the credit market, according to a portfolio manager.

Geoff Castle, who oversees the Pender Corporate Bond Fund, which has just passed its three-year anniversary, said the credit environment is extraordinarily calm right now compared to the third-quarter market of 2015 and wonder whether stormier weather lies ahead.

With that in mind, Castle outlined his fund’s philosophy when it comes to identifying factors that will increase the probability of success.

Citing a recent study by Ronen Israel and two colleagues in the Journal of Investment Management, which looked at two decades worth of US corporate bond market data, the first effective strategy was called a “value” approach.

This is a method by which credit investors chose bonds with the highest spread relative to the issuer default probability.

Castle said: “The researchers suggest that a mechanical application of a value approach in credit over the years 1997-2015 delivered over 1% incremental total return in comparison to the credit index generally, considering all coupons, credit costs and other factors.”

He added that this tallies with his own approach of seeking very high levels of return per unit of default probability. The second most successful strategy the researchers highlighted was investing chiefly in well-covered credits that were near to maturity, a method referred to as “safety”.

Castle said: “To the extent that we have pulled back slightly from value-type credit positions this year, we have done so in order to increase our weightings in what is in our opinion, the safest spectrum of corporate credits.

“A simple stress-test we do to measure safety in the holdings in our fund is to perform a quick ‘divide by two’ calculation on fund holdings. The test assumes that the market wakes up tomorrow morning and decides to cut the value of the entire ‘capital stack’ of our issuers (that is the market value of all debt plus all equity value) to 50% of the current trading level.

“In that event, our corporate credit positions are weighted approximately 92% in securities that would experience no principal impairment in liquidation by a 50% total business valuation cut. When we do the same analysis on the 70 largest high-yield index components that are related to a publicly listed equity, only 52% would survive the stress test without impairment on liquidation. Put simply, we have more equity buffer underpinning our positions than the index has.”