By Daniel Dolan and Roger McEniry, portfolio managers of the OYSTER US Core Plus fund
Bonds may be about to get interesting again. Continuing Covid-19 and inflation concerns have given credit investors a reminder of how fragile markets can be. Credit spreads have been volatile, delivering a potential foretaste of what 2022 may bring.
During November, market tremors sent spreads, the yield premium investors demand to retain corporate bonds over U.S. Treasuries, higher than at any point since the beginning of the Covid-19 pandemic.
Among the factors driving the volatility were fears a vaccine-resistant variant could plunge the world back into an economic lockdown. But what is also fuelling the potential tailspin is a sense the Fed might have to normalise monetary policy quicker than the market expects. This potential reversion to the mean could have negative consequences for investors in poor quality credits.
End of an era?
For a long time, credit investors have been pouring money into high-risk areas of the credit market, counting on the Fed as a backstop. But recent volatility may foreshadow what lies ahead. After all, nothing lasts forever, including sustained and forceful quantitative easing.
Eventually, the Fed and other global central banks will have to pry the punch bowl off the table – then highly leveraged cash-dry companies may be at the mercy of the markets and inflationary forces. Investment cases built of the unsustainable foundations of easy money may look decidedly flimsy. If there is a credit blow-out, it will all seem so obvious, but it always does in hindsight.
All of this is why we choose to ignore the macro weather and resist the impulse to react to short-term exigencies. Our job is to protect principal and interest for our investors regardless of market condition.
We do not base our investment decisions on current or projected interest rates, or trends in corporate credit spreads – although volatility in the latter might provide attractive entry points for quality credits. It is not that we ignore the big picture – we monitor economic and monetary developments closely – but they do not influence the core thesis of our investment process.
Instead, we have a laser focus on credit quality, the cash flow and balance sheet characteristics of individual issuers, and the prices we must pay for each security. At the heart of our investment strategy is an assessment of credit quality and the relative price attached to it by the market. Since our firm’s inception in 1997, we have been searching for the same thing for our investors: safe bonds that trade at relatively cheap prices. For us, value resides at the intersection of safety and price no matter the prevailing market conditions.
It has been harder to find attractive quality credit from a valuation perspective for some time. Nevertheless, we remain steadfast in our process – determined to avoid the misstep of reaching for yield with unsteady issuers. When the inevitable reversion to the mean happens, we believe that we’ll be well positioned to redeploy capital into bonds with more compelling valuations.
A decline in average issuer credit ratings indicates higher default potential, while credit investors are beginning to feel the chill wind of eroding covenants and leveraged capital structures. Amid growing concerns about declining credit and looser covenants, the chickens may be coming home to roost.
We were similarly conservative in our portfolio construction going into the pandemic. This gave us the opportunity to buy bonds in our universe at very wide spreads during the spring of 2020. We are hopeful that the market will present similar opportunities in 2022 and believe we are well positioned to capitalize on them.
One of the metrics that demonstrates the safety of our holdings is free cashflow coverage of interest payments. We insist on wide margins of safety when evaluating credits – the kind where cashflow can be cut in half and in half again and still there would be lots of headroom.
This level of comfort, combined with our intermediate duration and quality of credits, makes us welcome any reversion to the mean due to a new rate environment, continued worldwide issues with Covid-19, or anything else. While some yield-hungry asset allocators have been moving away from fixed income and into riskier areas of the market, we aim to offer something that, in our opinion, is becoming a rarer and rarer commodity: a “sleep-at-night” bond strategy with a repeatable process that strives to deliver dependable returns over the longer term.
History may not repeat, but it certainly rhymes. This feels very much like 2007 to us, but the reality is that not enough investors are listening: the siren song of risk-free return is pushing investors closer and closer to rocky shores.
“It’s only when the tide goes out that you learn who’s been swimming naked.” That is a quote from a legendary equity investor and person of great influence on our investment strategy, Warren Buffett. Macro-economic factors of course also catch up with fixed income bathers. We are very comfortable in our trunks and welcome the changing of the tide.