Liontrust’s fixed income team of four joined the firm in March last year, bringing with them a European hedge fund they have run for over a decade.
They launched the credit absolute return Sicav in March and expect to add an onshore long-only offering to the range heading into 2011.
Team head Simon Thorp says their process combines fundamental analysis of corporate and financial debt with the ability to price it in the market, identifying improving credit for the long book and deteriorating for the short side.
“Overall, credit has a symmetric risk profile, with upside capped and bonds able to fall to nothing if the newsflow is bad, so it is an interesting area in which to have long/short powers,” he says.
By the nature of this approach, Thorp and team tend to find most of the changing credit profiles in the high-yield area, with bigger investment grade companies unlikely to see huge spread movements.
Apart from the shorting capacity, another key strategy on the portfolios is hedging out interest rate and credit risk, allowing the team to protect investors’ capital.
This proved vital in recent bear markets, with the team’s hedge fund making money in 2002 and also able to navigate the credit crunch period of 2007/08.
Importantly, the fund also participated in last year’s powerful rally in the credit sector, despite tending to avoid strong directional bets and limiting net long or short positions to just over 30 per cent. More recently, Thorp has been buying more defensive assets after the market shakeout in May and June, picking up short-duration paper in companies with plenty of liquidity.
“If you buy short-dated bonds, it is easier to calculate exactly how bad things would have to get at top-line level for the company to run into difficulty,” he says.
In aggregate, the manager says companies largely came into the credit crunch in decent shape – a marked contrast to widespread debts heading in 2002 – and have used improving liquidity to shore up balance sheets.
“The macro picture remains uncertain but with low yields on government debt and negligible returns available on cash, competing assets remain unattractive compared with credit,” he adds.
“Our view is that investors are still very keen for income and high yield currently offers a considerable yield pick up over government paper and cash, with 7.5-8 per cent against 1.3 per cent on five-year German bunds.
“If you take out the credit crunch year of 2008, the worst annual return from high-yield was -4.3 per cent in 1990 so investors are actually being overcompensated for the additional risk.”
With that in mind, the Liontrust team is happy to be long credit at present, with the current macro background actually positive for bonds as it promotes general conservatism in the boardroom.
“On the flipside, we have struggled to find good short ideas in this environment, with few companies seeing their credit quality deteriorate,” comments Thorp.
Over the last 15 months or so, banks have come into Liontrust’s high-yield universe and now make up the biggest sector position in the portfolios.
Thorp says: “We always felt credit would have a solid 2010 but have been surprised how well investment grade has done, largely due to falling government bond yields.
“Our central case is for a period of low growth and interest rates, which is a good scenario for credit so we are happy to run a long position.
That said, our mandate allows us to use some of the return to buy protection, with rising interest rates if growth proves better than expected the most obvious risk.”
Several commentators have also raised concerns about falling credit yields as a wall of income-hungry money continues to poor in, particularly as government yields keep falling.
Thorp says: “With high yield currently offering around 8 per cent, there is a risk this could collapse if demand continues to rise, with little supply at present after most companies refinanced last year.
“But we actually feel this is unlikely as companies that borrowed through leveraged loans a few years back will need refinancing soon so reasonable supply should come through.”
Overall, he says that falling yields mean a more volatile market where there are too many risks to be massively long credit, with the key to be nimble enough to react to conditions as required.