Alternative credit hedges risk while boosting returns

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

* * * 

Gino Di Censo, vice-president of global fixed income, CIBC Asset Management 

* * * 

How does rate hedging unlock the pure play return potential in alternative credit? If you think about the source of returns in a fixed-income portfolio, most of the volatility in a corporate bond exposure comes from the underlying interest rate risk, not the credit spread risk. This is despite the fact that interest rates are producing less than the majority of the return. They are producing more than their share of volatility. 

And so what a rate-hedging strategy is designed to do is isolate the credit spread return in a portfolio so that it’s really a pure play credit investment. We would argue that the driver of interest rates can vary greatly and are not purely driven by economic outcomes or the health of an underlying company, for example. 

You have things like central bank thinking, you have political pressure in the current environment, geopolitical risk — all of these can influence and impact inflation and interest rates. Making a call on these things is very hard to do in the most docile of environments, and we would argue, even more so in the current environment. Having a strategy designed to isolate out that risk, we think, is an attractive investment opportunity. 

* * * 

Where does alternative credit fit in a portfolio when rates are volatile? When rates are volatile, it’s exactly when you want to own an alternative credit strategy, or position in an alternative credit fund, because what you’re effectively doing is isolating and minimizing that rate risk. What we’re trying to do in our alternative credit product is really create an all-weather strategy that’s designed to outperform across different market cycles. 

In a market environment where spreads are wide, where credit valuations look relatively cheap, to capitalize on attractive opportunities, we will increase exposure to higher data, more economically sensitive names, [and] we may take on a bit more leverage, etc. 

In a highly rich or expensive market, such as one we’re in currently, where spreads are at all-time tights, we would change our approach. What that means is reducing the overall leverage in a portfolio, looking at less-sensitive names that are a bit less sensitive to the economic environment. 

When I think about where an alternative credit strategy fits in a portfolio, I think it can be a core part of a portfolio as a complement to an existing core bond allocation. They really provide that additional source of credit return while eliminating any additional volatility. 

If you look at our alternative credit fund, or alternative credit in general, you’ll see it’s delivered a less volatile return profile versus something like Canadian equities, Canadian bonds. It really delivers that smoother return profile over time. 

If you look at a chart of cumulative returns, you’d see equities at the top, see bonds lower, just given the nature of what bonds are designed to do, and what you’d see in between the two really is all alternative credit funds. It’s that nice, sweet spot between the two from a risk-return perspective. And from a relative return, we think alternative credit offers an advantage over core bonds, while also reducing that risk from traditional equities. 

Adding an allocation to an alternative credit strategy alongside major bond categories, whether it’s government investment-grade long-only bonds, we have seen that this has reduced return volatility and increased the total portfolio return. So, it really is a great complement to an existing bond allocation in an investor’s portfolio. 

* * * 

What are the practical benefits of a hedged alternative credit allocation? There are a number of benefits. One is lower volatility from an interest-rate perspective, in that it’s hedging out the interest rate risk, and so less exposure and less volatility coming from that component of the market. We think the relative return offers an advantage over core bond portfolios as well, also reducing risk from traditional equity exposures. 

And so really, an alternative credit strategy may not completely avoid drawdowns, but we think it can provide larger upside potential in recoveries. And we think given its underlying characteristics, use of leverage, [and] hedging of interest rate risk that it really provides a good complement to a private market exposure, which exhibit less upside coming out of market shocks. This hits that sweet spot between public and private, [and] provides a good opportunity to add additional diversified return. 

* * * 

What types of opportunities are driving returns in alternative credit right now? I’d characterize this market as extremely rich from a valuation perspective when we look at credit. So, spreads are extremely tight. What this means is that you want to be mindful of your positioning in an alternative credit strategy, and maybe adjust your timeline to be tactical in your investment allocations. 

There are single-name stories that we think are very attractive and worthy of investment. What I would say is, given how rich the environment is, how tight credit spreads are, we’re looking at higher-quality investment-grade names, rather than something a bit more cyclical. So, you know, something like a pipeline, whether it’s an Enbridge or a bank, from a financial perspective. 

Some of the more stable investment-grade quality credit is where we see attractive opportunities despite the richness and valuations. And really this is A) because we see value in the underlying company, but B) this is a strategically protective decision, given that valuations are very rich, and we want to be mindful in case there is a spread widening event. 

And we also want to have enough liquidity on the sidelines so that when spreads do widen, inevitably, we can tactically take advantage and increase our investments in maybe more cyclical names, or increase our leverage, which is currently about half of where it can ultimately end up. 

We’re being very tactical. And I’d say again, in terms of where we see attractive opportunities, it is those high-quality investment-grade names, which we think are providing consistent returns and providing a defensive approach in the current environment. 

The nice thing about alternative credit and our strategy is that because we can focus on pure play credit, we can look for things like company health, sector dynamics, company-specific issues, versus having to worry about things like interest rate risk, and where we’re positioned from a duration perspective. Those obviously factor in all of our investment decisions, but if we really like an underlying issuer and truly understand the underlying fundamentals, we can have a high conviction that we can invest in this company, and people take advantage of the pure credit without having any extraneous factors, such as interest rates, impacting that overall credit. 

It really lets us hone in on what we do well, which is identify really strong issuers and underlying portfolio companies without having to be impacted by any of the extraneous economic factors that might indirectly impact that credit. 

Corporate bonds remain a very highly inefficient market. And so with an alternative credit strategy, in our current thinking, we see a multitude of relative value opportunities as valuations move in the market.

* * *

This program is intended for Advisor Use Only. The views expressed in this material are the views of CIBC Asset Management Inc., as of the date of publication unless otherwise indicated, and are subject to change at any time. CIBC Asset Management Inc. does not undertake any obligation or responsibility to update such opinions. This material is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice, it should not be relied upon in that regard or be considered predictive of any future market performance, nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this material should consult with their advisor. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “estimates”, or other similar wording. In addition, any statements that may be made concerning future performance, strategies, or prospects and possible future actions taken by the fund, are also forward-looking statements. Forward-looking statements are not guarantees of future performance. These statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results and achievements of the fund to differ materially from those expressed or implied by such statements. Such factors include, but are not limited to: general economic, market, and business conditions; fluctuations in securities prices, interest rates, and foreign currency exchange rates; changes in government regulations; and catastrophic events. The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors carefully. CIBC Asset Management Inc. does not undertake, and specifically disclaims, any obligation to update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise prior to the release of the next management report of fund performance. Past performance may not be repeated and is not indicative of future results. The material and/or its contents may not be reproduced without the express written consent of CIBC Asset Management Inc. ^® The CIBC logo and “CIBC Asset Management” are registered trademarks of CIBC, used under license.