In a credit fund, credit losses are inevitable

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The managers of the BCI Income Plus fund emphasise risk management.

During 2020, there were 23 credit defaults across the world. The BCI Income Plus fund was exposed to 16 of them.

However, the diversification in the fund kept the impact to a relative minimum.

Five of the defaults were in instruments within the Itraxx Xover index, which includes the 75 most liquid sub-investment grade credit issuers in Europe. A further 11 were the CDX North America High Yield index.

The BCI Income Plus fund is exposed to both of those indices. However, the Itraxx Xover accounts for 8% of the fund overall, and is equally weighted between its 75 constituents. The CDX North America High Yield index makes up about 4.5% of the fund, and contains 100 names.

‘So, there wasn’t a great impact on the fund,’ said Fairtree’s Louis Antelme (pictured), who co-manages the portfolio with Citywire A-rated Paul Crawford.

For 2020, the BCI Income Plus fund was up 6.5%. Over the year to the end of April, it gained 11.2%.

Loss avoidance

‘Credit investing is a strategy of loss avoidance, or at least catastrophic loss avoidance, rather than stock picking,’ Citywire A-rated Antelme said. ‘Because, at the end of the day, the best we can hope for is to receive our coupon stream and get our capital back at the end.

‘If you are managing a credit fund, you are not going to be able to avoid credit losses,’ he added. ‘It is inevitable that they are going to happen. But by prudent portfolio construction, diversifying the fund as much as possible with uncorrelated assets, and pricing these instruments correctly, that risk becomes manageable. So that, net of all defaults, we end up with positive alpha.’

The most significant default last year as far as the fund was concerned was, however, a local one. The portfolio has a 1.4% exposure to Land Bank.

‘Land Bank had an implicit government guarantee, and investors thought that in the event that it ever got into trouble, the state would step in and bail investors out,’ Antelme said. ‘That has proven not to be the case. So, we have all been funding Land Bank too cheaply.’

A tale of two banks

He contrasted this investment with one made in African Bank as it came out of curatorship nearly five years ago.

‘It was clearly a very risky instrument then. The bank had just emerged from curatorship, its subordinated debt was trading at a discount, but at a spread of 1,320 basis points, we thought it was a risk worth taking,’ Antelme said.

‘We brought these assets into the fund in a similar sort of weighting to Land Bank, at 1.2% to 1.4%. At the time, on five-year paper, Land Bank would have paid you about 300 basis points. African Bank was paying us 13.2%.’

Last week, African Bank paid back the capital in full. It has also never failed to pay the coupon.

‘And, interestingly enough, that spread never tightened,’ Antelme said. ‘It remained at 1,320 basis points.’

He added that it is worth bearing in mind that the restructuring of African Bank is still not finalised. Contrasting this experience with the Land Bank default is a good illustration of how crucial it is to manage risk in credit.

‘Perceived risk – priced and non-priced risk – is what it’s all about,’ he said.

Mark downs

As yet, what bond holders will get for their Land Bank assets remains unresolved. Fund managers are also dealing with their holdings differently.

‘There is no agreement on how these things should be written down,’ Antelme said. ‘At the moment, they have been suspended on the exchange, and currently sit at around 95 cents [in the rand].’

He said that least one manager has written down the value of their Land Bank assets to 89% of their original value.

‘If we marked ours down to 89%, that would be around eight or nine basis points on the fund,’ Antelme said. ‘I think that if they left it to trade on the exchange, the market would find a level. That would be a much better in my opinion, because one fund is marking down, another is not. So, the performance numbers are all out of kilter.’

But this once again emphasised the need for diversification.

‘Last year, we had four sovereign defaults – Ecuador, Zambia, Lebanon and Argentina. Sovereigns are usually treated as risk free. So, everything, given time, will default. That is our view. Which is why we make sure we don’t get too comfortable having a big position in any particular name, no matter how secure it looks at the time we buy it. Because once trouble appears you will not sell that asset.’

By Patrick Cairns –

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