Managing long duration credit across market cycles

As 2020 came to a close, our team looked back and discussed how fixed income managers might have weathered a turbulent period in the bond markets. As we look forward to an uncertain route out of the pandemic, we are focused on managing long duration credit portfolios with a goal to continue to add consistent alpha across market cycles.

Below we discuss some of the key tenets of our strategy and how they have helped us deliver for our clients across a variety of market environments.

First, managing long duration assets can be a little different to other spots on the yield curve.

When it comes to managing corporate bond portfolios, shorter and longer duration portfolios have a lot in common – Fundamental credit research is key to both, active management can exploit market inefficiencies and the ability to execute and implement trades can make the difference between a good idea and monetizing real returns. However, when it comes to consistently adding alpha, there is one key difference.

Long duration portfolio management is dominated by price return, not income return – In shorter duration portfolios, many managers look to out-yield the benchmark. They take on additional credit exposure by selecting issuers and securities where they believe the yield compensation outweighs the additional risk or liquidity profile that they are being compensated for. Over time, managers can expect to earn this additional yield premium and outperform the benchmark.

In long duration portfolios the benefits of additional yield in lower quality issues can easily be wiped out by small spread movements – The duration of the long credit benchmark (~14.5 years) means that even a moderate widening in spreads can cause a fall in price that erases multiple years of income returns. Therefore, moving down in quality, or liquidity, to chase extra yield or spread in the long end of the curve is not always a winning strategy. Instead, we believe exploiting pricing relationships between individual names, capitalizing on spread tightening and actively capturing those returns provides a more consistent approach to outperforming long duration benchmarks.

The chart below shows how we have outperformed while still keeping the average Duration Times Spread (DTS) for our long credit strategy below that of the benchmark – DTS is calculated by multiplying the spread-durations and the credit spread of each holding, creating a measure of overall credit exposure in the portfolio. Historically, we rarely look to outperform by simply having more credit risk than the benchmark. This is illustrated below by the ratio of DTS for the portfolio compared to DTS for the benchmark typically being less than one. We prefer to drive performance in a risk-controlled manner through security selection with the goal of higher risk adjusted returns and lower overall portfolio volatility.

Nimble active management without excess DTS

Second, “Long duration” does not only mean a long time horizon. 

As security selectors, we believe strongly in fundamental credit research. Our global research team of 39 analysts conducts deep dive credit research into the names in which we invest. However, there can be a misconception when managing long duration assets that the timeframe for those credit views is also extended. While we might exclude issuers and issues where we have longer-term worries about their ability to meet debt obligations, especially where these aren’t being reflected in pricing, the timeframe we look at for inclusion in a portfolio is often much shorter.

Our average turnover of close to 100% allows us to exploit short term pricing inefficiencies. Turnover of 100% means that on average, a bond has a lifetime in the portfolio of close to one year. While we are focused on the credit worthiness of an issuer over the longer-term, the buy/sell decision is also heavily influenced by shorter-term pricing relationships. This allows us to actively exploit pricing inefficiencies in the market that are often driven by technical relationships rather than by changes in the underlying credit fundamentals.

This approach typically leads to a higher information ratio through a portfolio that expresses many smaller active positions rather than a few large macro bets. Understanding pricing relationships means taking into account factors such as the levels of leverage, liquidity, ratings and where other names in the sector are trading. This style - balancing longer-term credit views with shorter-term price changes - has helped us to outperform in multiple market environments. For clients with an LDI focus, or those that utilize a multimanager arrangement, it can provide a diversified source of alpha against both liabilities and other managers.

Below is an example of a pricing relationship between two issuers in the retail home improvement industry. We may be comfortable holding both issuers in our portfolio based on longer-term credit fundamentals. The decision over which issuer is included in the portfolio reflects those long term views, but also how the pricing relationship is moving and whether we believe the technical factors driving it will reverse.

In December 2018, a U.S. retailer, rated A-/A3, announced plans to double its pace of share repurchases and increase leverage from ~2x to 2.75x, subsequently generating a downgrade by all rating agencies (Baa1/BBB+) and fundamentally changing the pricing relationship between Company A and Company B.

SLC Management has been managing long duration bond portfolios for pension plans and other long-term investors since 1991. We approach the long duration space by marrying strong credit research with efficient, nimble active management. On average, our investment team has had annual outperformance (net of fees)  in long credit strategies over that period, helping our clients to outperform their benchmarks and meet their long-term financial obligations.