1.The potential benefits of buy and maintain credit strategies
2. How a buy and maintain strategy works
3. Why use buy and maintain strategies today
PRESENTER: Well, Lionel, let's start with a definition of buy and maintain. What exactly is this strategy?
LIONEL: This is a credit strategy, where all the bonds you buy, you intend to hold to maturity. The idea is harvest the credit spread on top of your government yield, while minimising performance leakage due to transaction costs.
PRESENTER: So lower bond market liquidity, is this a short or a long-term trend?
LIONEL: This is definitely a long-term trend. And probably one of the most used charts over the past few years has been the corporate bond inventory, readjusted to equivalent market size.
This graph hints at how bad liquidity has become since the crisis. Market making activity has shrunk since the financial crisis. This change is structural; there is no going back. Regulation has meaningfully reduced the ability of market makers to provide liquidity on the market – which means, as an investor, it's more difficult and more costly to trade in and out of a bond on the market.
PRESENTER: So how would you say then that lower bond market liquidity has changed how a manager runs a portfolio?
LIONEL: I think it has changed the whole industry. And I start with the execution desk traders. Traders are using more and more electronic platforms for instance. They are developing internal tools to identify pockets of liquidity, to identify market access. But also what has changed is the way portfolio managers run portfolios. The investment holding period, for instance, has increased over the past few years, and even for the most volatile bonds on the market, like emerging market bonds, where the investment holding period has more than doubled in the past few years. And to be able to increase your investment holding period, credit analysts have to change the way they do credit analysis, to include, for example, the identification of long-term trends which are going to impact businesses over the long term.
PRESENTER: So would you say then this trend perhaps has or should make managers more wary of buying and selling?
LIONEL: Definitely. portfolio managers know that there are three ways to outperform: be the first, be smarter or take more risk And we recognise, for us, the importance of making intelligent and pragmatic decisions. But some asset managers could just take more risks to justify fees. In this low yield environment, it's more difficult, and active managers have to take on larger strategies to achieve that necessary alpha target. And that along with poor liquidity in the market is a kind of double whammy: low yields and poor liquidity. I'm not saying that active management is dead. I'm just saying that it's now more difficult to trade on the market. And sometimes you might be justified to be aggressive on the market when it makes sense, but most of the value is to be created by strong defence, given the asymmetric nature of risks and returns in bond investing.
PRESENTER: So does this encourage more use of liquid derivatives then would you say?
LIONEL: Derivatives are used definitely when markets are not liquid. It's easier to turn the boat quickly. Traditionally, CDS (Credit Default Swaps) have been used as hedging instruments. Nowadays, investors are embracing CDS to get exposure to the credit market. Among all the market initiatives, the wider adoption will potentially provide a bit more liquidity on derivatives, with market makers adding less capital requirements on clear positions. Away from CDS, there are TRS for instance - total return swap - which are also used to get exposure to the market. But what has increased massively is the use of ETFs, bond exchange traded funds, which are used alongside cash credit (bonds) and credit derivatives, and provide liquidity on the market.
PRESENTER: How would you say the holding periods of bonds are changing?
LIONEL: So, and I alluded to this earlier, it's changing because you need to hold your bonds a bit longer. With every trade you implement, you need to recoup trading costs. So the investment holding period has increased over the past few years.
PRESENTER: So then what's the evidence that high turnover produces disproportionate cost to investors then?
LIONEL: No matter how you look at it, we've observed liquidity diminishing across markets. The transaction costs adjusted to the spread relative risk have increased. Transaction cost used to be 10% of the overall yield and now it's closer to 30%, even 40% of the yield of the sterling credit market for example.
PRESENTER: Why would you say transaction costs have grown over the past 15 years and how have you seen this happen?
LIONEL: So we've seen this happening because of regulation, because market making activities have shrunk. The fact that you have more regulation means it's more expensive for banks to warehouse positions, transaction costs have increased, and liquidity has faded away.
PRESENTER: So are there any market pressures and structures that encourage suboptimal high turnover behaviour by investors?
LIONEL: There is a lot of pressure, like shorter reporting time periods or the obsession with risk measures being in line with benchmarks, for instance, or potential financial incentives to beat benchmark set points. All of this definitely doesn't help. But the biggest threat is the obsession with benchmarks. There are a few reasons for benchmarks to be created. First is for asset managers to have a reference point against which their performance is measured. Secondly, it's to reflect what's going on in the market. And thirdly, it is for investors to be able to build well-diversified, low-cost portfolios. And on all three counts it doesn't work. It just doesn't work.
We know that benchmarks are designed to subscribe value. They are poorly constructed. And there is performance leakage due to silly rules. We estimate that global crediting the external value on an annual basis is close to 20%, due to these silly rules like selling on downgrades. Barclays estimates at 25 basis points the annual costs over the last 30 years of being forced to sell bonds that have been downgraded to high yield, and that's within the largest corporate bond index in the world, the US market. And these costs can be avoided. Simple answer, you leave benchmarks.
With our (AXA Investment Managers) approach, we are trying to avoid this performance leakage. We don't follow the behaviour of passive rules. And we have an events bucket within the portfolio to allow usto retain our holdings if we think that these high yield bonds are going to be money good and we are going to get par at maturity. And one example of this we have this on this slide - that's the bond price before and after a downgrade to sub-investment grade. You see that actually before the downgrade to high yield, bonds tend to underperform and the worst time to sell a bond is when a bond has dropped out of the index: after that the price drops because the investor base changes from investment grade strategies to high yield strategies. And then the price recovers. So we want to benefit from that upside if we think that the bonds are going to be money good in the future.
PRESENTER: So we're going to talk about measuring the success of your investment. Talk me through this.
LIONEL: So if you move away from benchmarks of course you need some new performance indicators. And for some long-term strategies, the investment strategy is of course capturing the return, but also avoiding defaults and downgrades, for instance, maintaining the average quality of the portfolio over time. Minimising turnover is under another key performance indicator that you have to look at, and of course maintaining the desired characteristics of the portfolio so they are in line with the fund objectives.
PRESENTER: OK, so the buy and maintain strategy then, how does it work exactly?
LIONEL: So a buy and maintain strategy starts from the structure of the portfolio where we have the diversification really embedded on day one, at the top-down level. We've a top-down risk framework. We make sure that at the region level but also at the broad sector level we have an optimum diversification to mitigate market shocks. Then we maximise value by doing a cross-currency relative analysis to pick up the cheapest bonds on the curve without adding risk, adding maturity risk. And finally we make sure that we minimise transaction costs by having sufficient cashflows coming from maturities and coupons. That way, we benefit from further opportunities and refresh the relative value within the portfolio without having to sell a bond on the market.
PRESENTER: How relevant is this strategy today because you said you go from a top-up approach, so considering all the political and uncertainty, the volatility that we have at the moment, I mean is this a really good time for this strategy?
LIONEL: So I think that's a really good question. And buy and maintain is built for the long term but it's actually very suited to the current environment. When we build a strategy and when we populate the portfolio we want to make sure that we populate the portfolio with robust names, which can go through the market cycle. And I talked earlier about this top-down framework to make sure we have optimal diversification; we want this optimal diversification on the weights between cyclicals, financials and defensives to remain constant over time, because we don't want to have a kind of a bias towards one or the other.
Now, when you have a long-term approach, you need to implement some long-term themes in the portfolio. An example might be the tobacco sector for instance. We know that's a sunset sector. We might lend to tobacco companies for the short term but we're not going to lend to the tobacco companies over the long term. We know that this subsector will face some structural changes going forward. The same goes with cyclical companies, like the media companies; we're not going to lend to a media company for the next 30 years because the subsector will be impacted by technology. It's very difficult to have visibility over the cashflows and visibility over the strategy of the company for the next 30 years. So we put cyclicals at the short end while we increase the allocation to utilities for instance, to consumers, to more defensive sectors at the long end. So this is a cautionary and conservative approach to credit.
PRESENTER: We also hear a lot about buy and hold, how does that differ from the buy and maintain strategy?
LIONEL: Buy and hold, it's a run-off portfolio. That's a portfolio where actually you buy bonds and you intend to hold them to maturity but there is no refresh of relative value. In Buy and maintain, the maintain bit is crucial. It's really important to make sure your portfolio can go through the market cycle. I talked about the risk framework, the top-down framework, and the mitigation against the issue of a specific risk. You want to make sure that these risks are kept in check. So we monitor the risk of the portfolio, create a matrix of companies to avoid concentration risk. For instance, if they go away from the tolerance limit, we don't want to end up with concentration at the share level, over the life of the portfolio. And importantly we refresh the relative value of the portfolio, investment ideas. We top-up where we see value by maximising the spread capture, using the natural cashflows coming from coupon payments and maturities.
PRESENTER: That was going to be my next question, what do you do with the income that's coming off the bonds? I mean is it reinvested? Where is it reinvested?
LIONEL: With the natural cashflows, we use it to refresh values within the portfolio. We have the top-down framework, but again we have plenty of flexibility at the subsector level to allocate where we see value. So it might be benefiting from the primary market, where actually you don't endure the transaction costs, for example. So we maximise that market. But also we top up using bonds which are attractive using the cross-currency relative value analysis.
PRESENTER: So then perhaps increases the chances of surviving defaults?
LIONEL: So in terms of monitoring of name exposure at the credit level, at instrument level, it's important that when we say buy and maintain, that we monitor credit risk and we monitor name exposure. And if there is a problem with a credit, a name which has deteriorating credit metrics, if there is a change in recommendation from our credit analyst, that’s a trigger for us to sell if the price of the bond and the risks of the bond are not reflected in the bond’s price.
PRESENTER: Well we spoke just before about the uncertainty in the markets at the moment and geopolitical instability that's happening at the moment, so how far can you decide a bond is a good long-term investment, you know, given this environment?
LIONEL: This approach is not an approach where we are trying to second guess where we are in the cycle. What we want is to make sure is that this approach can go through the market cycle. With this uncertainty, it's important to diversify the portfolio. That's why I talked about the optimum diversification that we have when we build the portfolio and when we maintain that portfolio over time. But also it's important at the regional level, with these geopolitical events, that you have a diversification in terms of the regional level but also at the subsector level.
PRESENTER: So talk me through some of the graphs we have here, so proactively managing credit risk. I mean what are we seeing here?
LIONEL: I talked about the fact that we monitor credit quality. If there is a change in the recommendation of one of the names, we act on it. So it means that in buy and maintain, we don’t hang on to our position whatever happens. And one example is what happened to one of the credits we own in our portfolios. That's the semi-public company, Petrobras, the Brazilian company, and we decided to act on the change in recommendation from our credit analyst. And the recommendation was based on the economy in Brazil starting to contract and enter a recession, with political risk as well that we talked about earlier, and also in this low oil price environment credit metrics were deteriorating for Petrobras, and to top it all off there was a corruption scandal.
So we decided to sell our holdings because there was too much uncertainty, rather than waiting until after the downgrade, because when the bond downgrade to high yield, that's the worst time to sell a bond. So we decided to sell at the best price possible, because sometimes it's not worth the risk.
But on the opposite side, A deterioration in credit metrics and downgrade to high yield happened to the state-owned company Russian Railways. And in this case, we had a short dated maturity, a short-dated bond and our analyst was very comfortable about the liquidity of that name, about the cash that Russian Railways had on the balance sheet, which covered the maturity on the bonds of this company. So we decided to retain the holdings because we thought at the time that these bonds were still ‘money good’, and we got par at maturity, so sometimes it pays to sit tight.
LIONEL: With our approach, we are trying to avoid this performance leakage. We don't follow the behaviour of passive rules. And we have an events bucket within the portfolio that allows us to retain our holdings if we think that these high yield bonds are going to be money good and we are going to get par at maturity. And one of the examples we have this on this slide, which shows the bond price before and after a downgrade to sub-investment grade.
You see that actually before the downgrade to high yield, bonds tend to underperform and the worst time to sell a bond is when a bond has dropped out of the index. The price drops because the investor base changes from investment grade strategies to high yield strategies. And then the price recovers. So we want to benefit from that upside if we think that the bonds are going to be money good in the future.
PRESENTER: So let's touch on diversification now. Of course, nobody can predict the future, as you alluded to earlier, so how would you go about spreading the risk?
LIONEL: So diversification, I think, we talk about this diversified approach at the regional level, broard sector level, but also at the name level, where we have an equally weighted allocation at the name level to minimise drawdown risk, because what happened to Petrobras with the corruption scandal could happen to other companies, and there are some risks which are very hard to predict. So to minimise this drawdown risk, we have an equally weighted approach across issuers to avoid concentration risk, and that's what we monitor as well. That's what we maintain over time within the portfolio.
Diversification is helpful to minimise drawdown risk but not only this. Diversification is really useful and helpful when there is no liquidity on the market. Relying on three names or three trades to perform, when actually there is no liquidity, it's a problem. So you want to make sure you have plenty of opportunities to choose from, and to sell, and that you have smaller positions to shift. This allows you to be more nimble on the market.
PRESENTER: This approach, this can work all around the world?
LIONEL: So this approach works in every single market. I think the purest form of buy and maintain, when you can re-diversify, benefits from global opportunity risk across the curve. That's a global approach, a global portfolio. But every single portfolio can be global with the regional allocation. And this buy and maintain and through pooled vehicles for instance can be tailored and adapted to one, two specificities of each local market. In sterling, for instance, we on top of the broad sectors that we have like cyclicals, defensives and financials, we have the securitisation broad sector, where we have ABS utilities, PFI for instance or selling these back transactions.
PRESENTER: Can you think of buy and maintain as a factor such as value on momentum, size?
LIONEL: Buy and maintain can be one of the most efficient factors, especially for multi-asset portfolios. In terms of factors, we use and we consider quality and value to populate and maintain our portfolios. The factor actually you just mentioned, momentum, is very difficult to implement , especially in investment grade, especially when you have high transaction costs. And size, we think that in fixed income, size is irrelevant. Potentially what you can say is that growing sectors tend to underperform over time, but over-allocating to names which have small exposure in the indices is not a good way of allocating capital and getting exposure. Why? Because a small exposure in an index doesn't mean that this company has low leverage or is not well covered from a research standpoint.
PRESENTER: Before we run out of time, let's look at the dangers that bond investors are facing, talk me through them?
LIONEL: In terms of outlook, maybe I can start with the value of investment credit spreads at the moment, as we think that investment credit spreads are quite attractive, especially in this low yield environment. It used to be 10% of the overall yield of a corporate bond, but now it's close to 50%, which makes investment credit spreads very attractive, and brings your overall yield to an attractive level. And if rates go up it adds a bit of a cushion, a bit more carry in your fixed income bond portfolio, as you've got this spread on top of your government yield. But there are underlying risks, definitely, and underlying risks at the issuer level, at the micro level. We leverage in corporates with more LBO (leveraged buyout), shareholder friendly activity, that's why it's important to have kind of a diversified approach, especially when we are the bottom of the default cycle. And when you see that spread dispersion is quite low, fairly low, it means that you're not compensated to add risk within your portfolio.
PRESENTER: So we're seeing here on the graph that you've brought in more defaults on the horizon then?
LIONEL: Exactly, and that's something that you have to make sure that you avoid: the losers in your corporate bond strategy, because it's not about identifying the winners, what's important is the defensive nature of your corporate risk and communication, because that's where you're going to make the majority of the value. And away from these risks at the micro level and looking instead at the macro level, there is the rise of ETFs, for instance, and the fact that credit as an asset class has moved towards becoming an asset class largely owned by mature funds. And we talked about liquidity, we talked about the fact that investors are more comfortable with risk from that source, fuelled by central banks and by central banks’ policies, and if the market turns, I think it's hard to make sure that ETFs will provide liquidity on the market, especially the more thinly traded ones.
Why? Because volumes of these ETFs are five times bigger than real ETF flows and every single flow has to go through a market maker. And let's say what remains to be supposedly liquid might not trade if the market turns, and that's why I think we have a lot of communication around ETFs when the market wobbles a bit. To make sure that people understand that these ETFs are liquid and that no one is running for the exit for instance. And at the macro level as well, I mean you talk about the rise of ETFs and credit which is an asset class owned by mutual funds, but at the same time we have the end of QE (Quantitative Easing). I mean the end of QE is approaching. Central banks have expanded their footprint into credit and investors have been more comfortable with risk. And markets have been driven by technicals rather than fundamentals, and I think going forward, because we are at a turning point, fundamentals and responsible investments will matter even more in the coming years.
PRESENTER: So let's finish with your market environment going forward. We can see from this chart you mention central banks and the growth of central bank assets, what are we seeing here, you touched on ETFs before?
LIONEL: So yes I mean that's just because central banks have expanded into credit, the end of QE, the Fed has already announced a shift towards the end of QE, and other central banks might follow suit, which means that you're going to have less support, less technical support on the corporate bond market, and that might potentially impact the markets. Spreads could potentially widen but especially idiosyncratic risk might come back, going forward.
PRESENTER: So, finally, to recap then, what are the benefits of the buy and maintain strategy?
LIONEL: This is a strategy which is built with the longer term in mind, which is particularly suited in the current environment. The fundamental objective of this strategy is to harvest the yield on the credit market more efficiently with less downside risk.
PRESENTER: Lionel, thank you.
LIONEL: Thank you.
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