Roundtable – Fallen angels risk and liquidity for transfers. Long

term, they tend to have their strategies in place and are not looking for short-term shifts. High in their consideration for short and long term, will be how regulators view investments in fallen angels.

PI: Anand, as an insurer you prefer invest- ment-grade debt, but would you consider investing in a bond at risk of becoming a fallen angel? Anand Kwatra: We are heavily regulated by the Solvency II environment, so follow a conservative buy-and-hold strategy. In our world, we are penalised by defaults and downgrades. We have a low appetite

for BBB-risk

because if it is downgraded and becomes a fallen angel our capital requirements increase substantially.

The only way we would consider invest- ing in the BB or B spaces is if there was some form of credit protection. For exam- ple, if there is a highly rated sovereign or multilateral development bank, such as the World Bank, guaranteeing the debt. This protects us from credit risk on the underlying.

PI: Have you increased your exposure in the past year, Manuel? Hayes: We have. There are a lot of oppor- tunities. In every month in the past year there has been a downgrade, except for January which was unusually quiet. Even as we speak, downgrades are taking place. The biggest appeal for us is the discount that they come into the high-yield space at. Credit markets are an inefficient market structure. You are either an investment grade portfolio manager, trader, analyst or a high yield manager, trader or analyst. There are not too many places where you have synergies across the spectrum. Some active investors are forced to sell because

of capital constraints, while

indexers sell if a bond is no longer in an index. Force selling causes discounts.

44 | portfolio institutional | April 2021 | issue 102

These bonds are coming into the high yield area cheaper than they should be.

PI: Such bonds were downgraded for a reason, so how do you assess a new fallen angel? Hayes: We use a quantitative systematic approach where we look to harvest a diversified profile across our fallen angel and high yield strategies. This allows diversification and not too much idiosyncratic risk. From a portfolio design perspective, it allows us to harvest the structural premia, buy it and imple- ment it cheaply. Trow: It is a type of arbitrage and you are looking for returns that you cannot get from the BB space. People are afraid of the funding requirements or do not want to be around a name associated with bad news.

BB is not a million miles away from BBB in terms of credit quality, so if you are pre- pared to do the work and sort the wheat from the chaff you do not want to buy something that is BB but is about to be B. It is a relative value trade as much as any- thing else. Hollis: The fallen angel premium is created by investors reacting to the artifi- cial break between investment grade and high yield. Because it sets up structural cheapness, a strategy that invests system- atically in fallen angels, should earn excess returns over the long term, but returns will be concentrated in periods like now, where there has been a large wave of downgrades. Kwatra: Ultimately, it is integrating the range of concepts surrounding how you manage risk and return. You need to have a rigorous security selection in this space where there is heightened risk. It is important to question why the debt has been downgraded: is it part of the sell off or are the fundamentals weakening? You also need to have sound internal pro- cesses because the volatility may present you with opportunities which require you to be agile to take advantage of any tempo-

rary dislocations, like we saw in March 2020.

Another consideration is managing downside risk. If you are in this high yield strategy, you need clear

parameters, like capping your applica- tions to lower ratings such as B.

PI: How are you navigating defaults? Hollis: There are very few companies that go

smoothly from investment risk appetite


straight to default. When that happens, it is normally associated with fraud, like Wirecard.

I am not saying it cannot happen, but generally downgrades are associated with financial or operational activities that the rating agencies are able to monitor and signal their concerns in advance using their outlook flags. There are normally signs that something is about to be down- graded. It is not that everyone has been caught on the hop.

A fallen angel strategy is improved by having a screen for companies that are suddenly downgraded by several notches because it is a signal that there may be something nasty hiding in the woodshed. It is not a perfect defence, but it is better than nothing. Weeks: Marks & Spencer is a fallen angel. It has seen a long-term decline in market capitalisation, which is a worry. A poor range of merchandise, which is a worry. A reliance on an outdated property portfo- lio, which is a worry.

British Airways, in contrast, has seen short-term turmoil but some bounce back is probably ahead. Some people say that Virgin Money’s brand image is a bit tarnished compared to previous years, so there may be a long- er-term problem there. Finally, a decline in advertising revenue at ITV is probably more serious.

PI: If defaults are usually signposted, are other factors higher up your agenda when looking at fallen angels, Manuel? Hayes: Risk mitigation is key. Fallen

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