What to expect in a low spread environment
The European corporate bond market has performed very strongly in recent years. As a result, credit spreads have tightened to low levels and differences in the creditworthiness of companies are to a large extent no longer reflected in spread levels. In such an environment, some investors may be tempted to take on more risk in an effort to capture higher spreads and returns. The credit team at Kempen, however, is of the opinion that remaining disciplined and committed to our conservative investment process is essential and that, instead of taking on more risk for limited additional spread, the right strategy in this environment is to high-grade the quality of our portfolios.
How has the European corporate bond market developed?During the past few years, the yield on European corporate bonds has persistently declined to the historically low level of 1% (see figure 1). Risk premiums (credit spreads) have also declined to levels approaching those last reached shortly before the economic crisis of 2008-2009. There are a number of factors behind this development. First, there has been a meaningful economic recovery and, in the first stages of this recovery, companies were focused on strengthening their creditworthiness. Second, the problems afflicting the banking sector have been addressed, primarily through a combination of capital injections and disposals of non-performing loans. This has not only diminished the risk of large-scale banking failures but also supported a recovery in lending activity to the non-financial sectors of the economy. Finally, the very loose monetary policy and corporate bond buying program of the ECB have triggered a hunt for yield amongst investors.
Not only have credit spreads declined in recent years, the differences in spread levels between sectors, companies and different rating categories has narrowed as well. One of the ways these differences in spread levels can be measured is through spread dispersion. In figure 2, the marked decline in spread dispersion in recent years is shown. A lack of dispersion suggests a number of worrying developments. First, investors are becoming less discerning when determining the additional spread premium they require to lend to a weaker rather than stronger companies. Second, investors are no longer demanding meaningfully higher spread premiums for lending out capital for longer as opposed to shorter periods of time.
How does Kempen view the current market environment?
In an ideal market, investors are sufficiently critical when judging the credit profiles of companies. They demand higher spread premiums for those companies possessing weak balance sheets or challenged business models while accepting lower spread premiums for the financially and strategically strongest companies. Unfortunately, the current market is far from ideal. Credit spreads are near historically low levels and companies are increasingly focused on pleasing shareholders rather than bondholders with all the negative consequences this implies for companies’ balance sheets. Companies that have adopted shareholder friendly measures (e.g. share buyback programs, special dividends, debt-funded acquisitions, corporate break-ups) are not seeing spreads on their debt instruments widen materially.
How is Kempen positioning itself in the current market environment?
There is always a temptation in a low spread environment to take on more risk and thereby increase potential returns and outperformance in the short-term. Kempen does not believe in adopting such a strategy. We are, instead, convinced that in the current market environment it is essential to remain disciplined and committed to our conservative investment strategy.
The Kempen Euro Credit team maintains a disciplined investment process, which we refer to as “alpha by control”. With this process we aim to deliver a consistent outperformance (alpha) through a controlled allocation of risks on the basis of a top-down vision of the market and bottom-up selection of companies and their most attractive debt instruments. Remaining committed to this investment process has a number of consequences, including:
- Lower spreads affect the potential alpha generation (outperformance) for any given risk budget. For example, assuming our portfolio would have a risk budget (or “beta”) of 130% (compared to 100% for the benchmark) and the benchmark spread would be 200 basis points (bps), our portfolio would have an extra spread of 60 bps. By contrast, if the benchmark spread would only be 100 bps, the extra spread in the portfolio applying the same risk budget would be 30 bps. Applying the same risk budget would, therefore, lead to a lower yield in a market environment characterized by stable, lower spread levels.
- Lower dispersion results in less interesting investment opportunities and less possibilities to utilize the risk budget and find attractive issuers and bonds.
- A lower dispersion not only results in less opportunities, the upside potential for any identified investment opportunity is also lower. For example, assuming a stable risk budget (“beta”) of 2, the upside potential of a trade is 25% less when the index spread is 75bps (see figure 3) than when the index spread is 100bps (see figure 4).
The combination of low spreads and low dispersion limits the alpha potential of any single position within the portfolio. This results in us adopting an increasingly conservative positioning within our portfolios. In such a scenario, we prefer to high-grade our portfolios by trading-up in quality. The fact that the credit market does not adequately differentiate between strong and weaker companies offers us the opportunity, for a very limited reduction in near-term returns, to enhance the robustness and quality of our portfolio. We are also focused on limiting downside risk and are, therefore, willing to accept temporarily lower spreads to accomplish this while remaining focused on relative value opportunities. Finally, by retaining sufficient liquidity in the portfolios, we are well placed to swiftly take advantage of an eventual market correction whilst in the meantime maintaining a high-quality portfolio.
Kempen Credit Funds
Through our “alpha by control” investment process, we have been able to generate consistent outperformance with limited risk under varying market conditions in recent years. This is reflected in our high information ratio. Our conservative investment process prevents us from taking excessive risks in a market environment when spreads have significantly declined. This has resulted in a conservative risk profile, combined with attractive realized alpha. This profile has added value in the current market environment. Nonetheless, our varied product offering ensures that we can meet investors’ differing needs for return.
- Kempen (Lux) Euro Credit Fund
This fund primarily invests in investment grade corporate bonds. The track-record of this fund over the period April 2008 to September 2017 shows a consistent outperformance versus the iBoxx Euro Corporate Index in combination with limited risk, contributing to an information ratio greater than 2. The fund aims to generate a gross alpha of 1% annually compared to the iBoxx Euro Corporates index.
- Kempen (Lux) Euro Credit Fund Plus
This fund is comparable to the Kempen (Lux) Euro Credit Fund, albeit with more investment flexibility. In addition to Euro-denominated corporate bonds, the fund can invest in credit default swaps, USD-denominated bonds and GBP-denominated bonds. Credit default swaps enable portfolio managers to protect themselves against widening spreads. At the same time, the spread difference between credit default swaps and cash bonds of similar issuers provide opportunities for additional return in the portfolio.
- Kempen (Lux) Euro High Yield Fund
This fund offers investors exposure to the high-yield market, albeit with a lower volatility and more limited downside risk than traditional high yield. The fund combines investments in non-financial corporations carrying BB-category ratings with investments in subordinated debt instruments issued by financial and non-financial institutions. Limited use of credit default swaps is allowed in this fund to adjust risk positioning. The fund aims to generate 1.25% gross alpha annually versus the BofA Merrill Lynch Q964 customised benchmark.
DisclaimerKempen (Lux) Euro Credit Fund, Kempen (Lux) Euro Credit Fund Plus en Kempen (Lux) Euro High Yield Fund (the “Sub-Funds”) are sub-funds of Kempen International Funds SICAV (the “Fund”), domiciled in Luxembourg. This Fund is authorised in Luxembourg and is regulated by the Commission de Surveillance du Secteur Financier. Kempen Capital Management N.V. (KCM) is the management company of the Fund. KCM is authorised as management company and regulated by The Netherlands Authority for the Financial Markets. Paying agent and representative in Switzerland is RBC Investor Services Bank S.A., Esch-sur-Alzette, Zweigniederlassung Zürich, Badenerstrasse 567, P.O. Box 1292, 8048 Zürich. The Sub-Fund are registered with The Netherlands Authority for the Financial Markets under the license of the Fund.
The information in this document provides insufficient information for an investment decision. Please read the Key Investor Document and the prospectus. These documents as well as annual report, semi-annual report and the articles of incorporation of the Fund are available free of charge at the registered office of the Fund located at 6C, route de Trèves, L-2633 Senningerberg, Luxembourg, at the offices of the representative in Switzerland and on the website of KCM
(www.kempen.com/investmentfunds). The Subfonds are registered for offering in a limited number of countries. The countries where the subfunds are registered can be found on the website. The value of your investment may fluctuate. Past performance provides no guarantee for the future.