Key takeouts

• Investing in credit assets provides an additional source of low-volatility income when both individual credit selection and portfolio construction decisions are effective.
• The credit market reacted immediately to the Covid-19 crisis, with asset quality and demand falling and spreads between corporate and bank instruments widening, due to higher perceived risks for corporate paper.
• Current market dynamics are stabilising against the backdrop of a slow economic recovery.

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How do we think about credit in an economic recovery?

Attention has now shifted to  economic recovery. Asset class returns from equities and listed property stand to benefit meaningfully from improved prospects for economic recovery, with higher share prices, the resumption of dividends and the ability to realise gains on positions that have recovered from crisis lows.

Credit assets, on the other hand, are primarily exposed to downside risk: namely the risk that borrowers will not repay interest and principal in full and in a timely manner. The relative illiquidity of South African listed credit assets (as opposed to listed equities and listed property) means that the timely realisation or monetization of sizeable gains on credit positions is not always possible.

It is this asymmetric risk profile that underscores the importance of analytically sound and robust credit risk management processes that can take a through-the-cycle view of credit quality in positioning the appropriate long-term response to the economic recovery for client funds.

Individual credit selection remains important when constructing credit portfolios. In the present crisis, changes in creditworthiness differ by sector and subsector to a greater degree than they arguably did in previous recessions, which further underscores the importance of bottom up, fundamental research. However, understanding how these individual credit selection decisions come together in a portfolio context matters just as much as exposures to individual counterparties.

What are we doing in client funds? 

The initial credit reaction to the Covid-19 induced economic shock was swift and immediate credit rating and market pricing adjustments to take into account heightened credit and liquidity risk. We believe the credit response to the nascent signs of economic recovery requires a disciplined adherence to our investment philosophy of considered evaluation of through-the-cycle credit quality and selectively raising our exposure to credit assets at the right price.

We are active managers and continue to be selective in adding credit assets to funds managed on behalf of clients. We have heightened our focus on identifying counterparties within sectors that are well-positioned to benefit from the recovery.

Our approach to position sizing and exposure management has been enhanced to consider appropriate medium- to long-term exposure targets for certain sectors. We are actively using tools available to us (concentrated exposure management, maturity management and, to a lesser extent, secondary market trading) to right-size exposures to funds based on our assessment of through-the-cycle credit quality.

Difficult economic cycles call for more, rather than less, diversification. A key focus area for the team is actively expanding our credit coverage universe to ensure that we can identify diverse counterparties that pass our credit quality screening, whether on financial or non-financial (including Environmental, Social and Governance) risks.

Whenever we participate in primary credit auction markets, we bid where we see value, and as a result may not receive our full demand. We are comfortable with this outcome, as it demonstrates consistency with our internal credit process.