The macro environment has been deteriorating over the past few years and this has been exacerbated by the COVID-19 crisis. As a result, the credit market has been characterised by deteriorating credit quality and credit spreads.
The key credit cycle indicators that we look at confirms this market phenomena. These indicators include economic growth, inflation rate, current account position, interest rate cycle and bond yields.
The one indicator that has been contrary to the usual cyclical dynamics is inflation, which has declined to levels below the SA Reserve Bank’s target range of between 3% and 6%.
We believe, this lower-than- expected inflation is largely due to the curtailment of trade precipitated by COVID-19. In addition, our expectation is that the credit market will face more headwinds as long as the current crisis persists.
Credit spreads are widening due to the increased credit risk and excess supply of credit in the market. Therefore, as things stand, we are biased towards short credit duration and stronger credit quality.
Investment approach to credit
We are grounded on providing clients with sustainable long-term returns. In accomplishing this, we employ a quantitative risk-cognisant approach in asset allocation, pricing and managing credit portfolios.
We evaluate and select credit using this quantitative process to avoid default risk and limit credit spread risk. We employ three different quantitative models to predict a corporate’s probability of default using both market and fundamental data.
This framework accurately quantify credit risk, effectively price credit and compare credit quality across sectors without any human bias.
These quantitative methods culminate in an internal credit rating, which is overlaid with environmental, social and government (ESG) factors that are used to notch up/down the ratings.
We do observe and study external ratings agencies’ perspectives and other sectoral analysis but ultimately rely on our credit process to make the final investment decisions.
Identifying credit alpha-generating opportunities
We are premised on delivering risk-adjusted returns and our quantitative approach enables us to measure credit risk appropriately.
As a result, we source alpha through asset selection by identifying credit that offer higher risk-adjusted returns.
It is not about chasing yields at any cost since higher yields may often expose us to excessive risk. Conversely, counterparties with lower credit risk may yield excessively tight spreads.
What are you bullish, and what are you bearish on?
Certain sectors are likely to experience deeper crisis and slow recovery. These include the mining sector, real estate investment trusts (REITS) and industrials.
Despite the bearish view on these sectors, we still selects certain counterparties which are insulated from credit quality deterioration because of the strength of their business model.
We are bullish in defensive sectors, such as banks, insurers, telecoms, technology and food retailers.
These sectors have already shown their resilience during the COVID-19 crisis. They have continued to operate and there has been less of an impact on their cash generation capacity relative to other sectors.