What does it take to excel in credit investing?

So, how can investors best leverage the value factor to consistently deliver outperformance across the market cycles?

The answer lies in embracing a contrarian investment approach. Credit markets are often shaped by behavioral biases, leading to periods of over- and undervaluation. Investors frequently overreact to market or macroeconomic events, driven by home-market preferences and a stronger emotional response to losses than to equivalent gains. This fear-driven selling, often at any price, exposes market inefficiencies – and it is within these inefficiencies that contrarian investors can uncover compelling value opportunities.

When seeking alpha, we avoid following the herd. We have been employing a contrarian investment strategy for the past 15 years, supported by comprehensive top-down macro research and in-depth company analysis. Our ability to add credit risk in volatile, cheapening markets, while reducing exposure in markets that are expensive, has been crucial in achieving consistent outperformance throughout different market cycles.

The chart below illustrates our top-down risk (beta) positioning in our global investment grade credit strategy over the last decade. A beta above 1 indicates that the portfolio holds more credit risk, measured by duration times spread (DTS), compared to the broader market. Conversely, a beta below 1 signifies that the portfolio carries less credit risk than the broader market.

With a long-standing tradition of applying contrarian strategies to uncover opportunities in credit markets, the following two examples illustrate how value was effectively harnessed during periods of market disruption.

When the Covid-19 pandemic struck at the start of 2020, governments responded by locking down economies, and financial markets reacted sharply, causing equity and corporate bond prices to plummet. Using the Credit Quarterly Outlook as a starting point we began to identify value opportunities in global credit markets. Given the commitment of governments and central banks to support the economy through financial aid measures and easing monetary conditions, we were confident that larger, well-managed investment-grade companies could withstand prolonged lockdowns.

Consequently, we started investing in high-quality corporate debt in the US and Europe. As a result, the beta of the portfolio increased from below 1 at the start of the year to 1.5 by the end of March 2020. Following the initial shock and subsequent interventions to support the economy and markets, we observed a significant rebound in financial markets, and the corporate bonds we acquired performed exceptionally well. As these corporate bond holdings reverted to normal or fair value, we took profits and reduced our positions. Then, the portfolio’s beta was brought back to below 1.

In March 2023, following a series of failures among US regional banks and the forced rescue merger of Credit Suisse with UBS, subordinated debt (AT1 CoCo) was completely written down. The market reacted sharply, placing pressure on bank debt, in particular AT1 CoCos. In line with our contrarian investment strategy, we started adding risk to larger, well-diversified European banks, where our bottom-up credit analysis indicated no fundamental concerns and bond valuations became very attractive. We avoided troubled US or European banks, focusing instead on larger, stable institutions. Following the initial shock, once it was clear that the larger diversified banks were not affected, we observed a strong rebound in the prices of bank debt, benefiting our performance. As our holdings in AT1 debt from these large, diversified banks outperformed the market, we gradually took profits.

Being contrarian goes both ways. When credit markets or segments in the credit markets trade weak, we are actively looking to add risk in undervalued corporate bonds. However, when markets appear to have priced in all the good news and become complacent, we take risk off the table and wait for better value opportunities.

This contrarian approach is deeply embedded in our investment strategy, extending beyond portfolio-level risk adjustments to individual securities. If corporate bonds weaken due to market overreactions, such as profit warnings, we view this as a potential buying opportunity – provided our credit research confirms they are not value traps. Similarly, when corporate bond prices become overinflated due to excessive optimism, we reduce exposure.

By diligently applying this approach daily, alongside strong risk management, we aim to deliver consistent outperformance through market cycles while maintaining controlled risk.