The increasing attractiveness of ‘buy and maintain’ credit strategies
The structure of the corporate bond market has changed. Following the Global Financial Crisis, increased regulation and higher capital requirements have seen many of the large market makers scale back their operations. As a result, liquidity in corporate bond markets (i.e. the ability to buy and sell bonds) is in sharp decline, while transaction costs have ratcheted upwards.
In an asset class where returns are asymmetric, with very limited potential upside even on successful bond purchases, this higher level of transaction costs is making it increasingly difficult for active managers to make decent returns net of fees without significantly increasing risk levels. Illiquid markets have thus made active management more difficult, both in terms of implementation and in terms of delivering a positive return.
In this environment, low turnover ‘buy and maintain’ strategies have become increasingly attractive. Fund managers with a focus on minimising turnover and, where possible, utilising low-cost entries to the market (e.g. the new issue market) could use this approach to cope with the structural illiquidity that can be seen in markets.
The inherent inefficiencies of corporate bond indices
The dramatic increase in transaction costs since the financial crisis has also shone a spotlight on the inefficiencies of market capitalisation-based credit indices – and, by extension, passive index trackers. Market capitalisation-based bond indices are inherently inefficient, as the most debt-burdened entities are by definition the most prominently represented within them. In an asset class where returns are asymetric, making the largest allocations to the most indebted companies and sectors (as passive index trackers do) is unlikely to be the most prudent way to construct a diversified portfolio of bonds. Smart ‘buy and maintain’ strategies aim to provide a more diversified exposure to the market (across issuers, sectors and countries), thereby mitigating downside risk and the effect of market shocks and defaults on investors.
Investment grade corporate bond indices also incur unnecessary transaction costs by rules-driven (often illogical) behaviour, including the forced selling of all bonds one year before they mature, and also the forced selling of all bonds whose credit rating is downgraded to sub-investment grade. In the latter case, an index (and an index tracker) sells all downgraded names at the end of each month, irrespective of their price – including those that will never actually default. As an illustration, on average over the past 15 years, this has amounted to 25 basis points of performance leakage for a representative investment grade corporate bond index* . Smart ‘buy and maintain’ strategies do not automatically sell on downgrade if the fundamental credit quality is sound, thus avoiding unnecessary performance leakage.
Sticking to one’s principals
In a world in which it is increasingly difficult to implement changes to active positioning and where the costs of doing so often offset any potential upside from trading, picking the right bond at the outset and holding it to maturity becomes more attractive. A ‘buy and maintain’ strategy can be an effective way for long-term investors to gain exposure to the returns generated from a broad, diversified portfolio of investment grade bonds, in a less volatile, low-cost way. Far from being a passive strategy, however, it requires active decisions about which bonds to buy and which to avoid and, importantly, it requires continuous active maintenance of key risk and return factors. This is primarily achieved using natural cashflow derived from income and the regular return of principal from maturing bonds, assuming there are no defaults.
The characteristics of AXA Investment Managers’ ‘buy and maintain’ approach
Designed explicitly to address clients’ growing frustrations with both the high cost of active credit management and the inefficiencies of passive index tracking, our ‘buy and maintain’ credit strategy sits in the middle of these two approaches and combines the best of both – the skill and added-value of AXA Investment Managers’ (AXA IM) active credit process, and the low-cost edge of passive management.
- Does not blindly follow an inefficient index
- Deals explicitly with the risks inherent in the return asymmetry of bond investing, through smart diversification
- Dramatically reduces turnover, and hence transaction costs compared with other approaches
- Adds value with proprietary credit research to select the best bonds
Under this approach, the starting point is a diversified basket of bond issues that the investment manager believes are ‘money good’. That is, they have a high probability of meeting the payment of interest and repayment of the principal, and the investment manager intends to hold them until maturity. At the sector and regional level, the manager places an emphasis on long-term themes which he believes will deliver over the course of a full market cycle. While the scope for trading is reduced under a ‘buy and maintain’ approach, the importance of quality portfolio management remains as important as ever. The investment manager’s credit analysis skills are still necessary in selecting ‘money good’ issues, both at inception and for the reinvestment of coupons and maturity proceeds.
This communication is for professional clients only and must not be relied upon by retail clients. Circulation must be restricted accordingly. Any reproduction of this information, in whole or in part, is prohibited. This communication does not constitute an offer to buy or sell any AXA Investment Managers group of companies’ (‘the Group’) product or service and should not be regarded as a solicitation, invitation or recommendation to enter into any investment transaction or any other form of planning. It is provided to you for information purposes only. The views expressed do not constitute investment advice, do not necessarily represent the views of any company within the Group and may be subject to change without notice. Whilst every care is taken, no representation or warranty (including liability towards third parties), express or implied, is made as to the accuracy, reliability or completeness of the information contained herein. Past performance is not a guide to future performance. The value of investments, and the income from them, can fall as well as rise and investors may not get back the amount originally invested. Due to this and the initial charge that is usually made, an investment is not usually suitable as a short term holding. The capital of the AXA Sterling Buy and Maintain Credit Fund is not guaranteed. Counterparty Risk: failure by any counterparty to a transaction (e.g. derivatives) with the Fund to meet its obligations may adversely affect the value of the Fund. The Fund may receive assets from the counterparty to protect against any such adverse effect but there is a risk that the value of such assets at the time of the failure would be insufficient to cover the loss to the Fund. Credit Risk: the risk that an issuer of bonds will default on its obligations to pay income or repay capital, resulting in a decrease in Fund value. The value of a bond (and, subsequently, the Fund) is also affected by changes in market perceptions of the risk of future default. Investment grade issuers are regarded as less likely to default than issuers of high yield bonds. Derivatives: derivatives can be more volatile than the underlying asset and may result in greater fluctuations to the Fund’s value. In the case of derivatives not traded on an exchange they may be subject to additional counterparty and liquidity risk. Interest Rate Risk: fluctuations in interest rates will change the value of bonds, impacting the value of the Fund. Generally, when interest rates rise, the value of the bonds fall and vice versa. The valuation of bonds will also change according to market perceptions of future movements in interest rates. Liquidity Risk: some investments may trade infrequently and in small volumes. As a result the Fund manager may not be able to sell at a preferred time or volume or at a price close to the last quoted valuation. The Fund manager may be forced to sell a number of such investments as a result of a large redemption of shares in the Fund. Depending on market conditions, this could lead to a significant drop in the Fund’s value and in extreme circumstances lead the Fund to be unable to meet its redemptions. Before making an investment, investors should read the relevant Prospectus and the Key Investor Information Document, which provide full product details including investment charges and risks. The information contained herein is not a substitute for those documents or for independent advice. Some of the investment vehicles mentioned may not be available in certain jurisdictions. Please check the countries in which they are registered with the asset manager. Issued by AXA Investment Managers UK Limited, which is authorised and regulated by the Financial Conduct Authority in the UK. Registered in England and Wales No: 01431068. Registered Office: 7 Newgate Street, London EC1A 7NX. Telephone calls may be recorded for quality assurance purposes.