Fraser Lundie (pictured), Co-Head of Credit at Hermes Investment Management, explains how the 16.8 per cent return of Hermes Multi Strategy Credit since its May 2013 inception has been achieved by implementing the team’s global, unconstrained approach.
“Hermes Credit aim to generate strong gains from our best credit ideas while dedicating part of our portfolio to defensive, short-biased strategies to minimise downside risk. Importantly, our return incurred far less volatility than the global high-yield market in a period characterised by economic and market shocks.
“Past performance is not a reliable indicator of future results and targets are not guaranteed. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
“The aim of Hermes Multi Strategy Credit is to deliver high-yield-like returns with lower volatility throughout market cycles. Seeking this outcome, we combine high-conviction investments with defensive trades by searching throughout the capital structures of issuers worldwide to identify which bonds, derivatives and loans offer superior return prospects or can be used to effectively mitigate risk. Since the launch of the strategy, we have invested throughout the taper tantrum, China slowdown, global high-yield sell-offs and the recent rise in corporate debt defaults to achieve our performance target. Our flexible approach has enabled us to capture opportunities while preserving capital throughout market shocks.
“In Q2 2013, when the Federal Reserve first indicated that it would reduce quantitative easing after almost five years of running the bond-buying programme, the market’s acute sensitivity to changes in US interest rates became clear. Fear of a rate hike had already caused overcrowding in short-duration bonds, and this strong demand allowed issuers to introduce looser covenants and shorter non-call periods. We were unwilling to accept the consequent risks – high valuations, weaker investor protections and diminished upside – and invested in credit default swaps of the companies instead to gain a similar short-duration exposure. We avoided two-thirds of the drawdown, returning -0.95 per cent compared to the high-yield market’s -2.76 per cent[2] in June 2013, the first month that the strategy was live.
“In October 2014, oil prices began to fall precipitously after OPEC refused to halt production despite global oversupply. This adverse impact on the US shale market, where many producers were highly leveraged due to higher operational costs, would soon be felt in the high-yield market. Two months before oil prices began to slide, we cautioned that investors should be particularly selective in the North America shale oil and gas market as it featured many entrants with uncertain long-term prospects. We avoided these stressed companies and exploited the breadth of our universe by investing in more mature commodity businesses with proven operations and reserves, and in undervalued but robust oil companies in the politically-beleaguered Russian market.
“In Q4 2015, amid growing certainty that the Fed would raise rates for the first time in almost a decade, liquidity fears spurred a global high-yield sell off that drove the market -0.7 per cent lower for the quarter. It ultimately returned -2.0 per cent by the end of the year[3]. In the preceding months, we increased our combined investment-grade credit and leveraged loan allocation to 30 per cent of the portfolio, and this exposure to higher quality and more secure assets preserved capital during the drawdown and drove our 1 per cent return for 2015.
“Through intensive bottom-up research, we have executed contrarian trades such as our investments in the global mining sector in Q1 this year, which was still experiencing a cyclical downturn. Anticipating creditor-friendly moves by stronger companies to bolster their balance sheets through cutting dividends, reducing capital expenditure and selling assets, we increased our exposure to the sector from 12.8 per cent to 19.1 per cent between Q3 2015 and Q1 this year[5]. Among the issuers we invested in were Vale and BHP Billiton, which benefited from strong asset quality and conservative financial policies. In the year to date, our exposure to mining companies contributed 1 per cent to our overall return, showing the benefit of favouring fundamentals instead of prevailing sentiment.
“Our flexible investment approach has driven the strong risk-adjusted returns of Hermes Multi Strategy Credit in its first three years, as evidenced by its Sharpe Ratio of 1.5 per annum for the period, despite macroeconomic and technical market shocks[7]. Amid the current risks – from Brexit, a potential US rate hike to the political turmoil in Brazil – we continue to find opportunities to generate attractive returns and preserve capital.”
