fixed income
Swiss credit: think twice before changing strategy
Higher interest rates in 2022 and unusual volatility over the past three years led some investors to seek more safety from bond portfolios while shying away from active management. We question the wisdom of those strategies, based on both a look in the rear-view mirror and future risk-return expectations.
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Risk aversion
After interest rates rose significantly in 2022, the resurgence of the bond markets received a great deal of attention. Not only did private investors suddenly seem interested in bonds again, but existing institutional investors considered it sensible to rethink their CHF bond strategy due to the dramatic changes in the market.
Some investors concluded that they would take less credit risk in the future because they were now receiving attractive compensation for better quality. In addition, they often linked this change in strategy to a switch from active investment solutions to more passive ones. Both strategy changes should be critically questioned, in our view.
The last three years were marked by an unusual amount of volatility, as well as relatively large performance setbacks. There was the Covid crisis in spring 2020, followed by the start of the war in Ukraine two years later. Finally, in March 2023, a banking crisis led to the fall of Credit Suisse. These events, as well as rising fears of an imminent recession, may have contributed to heightened aversion to credit risks and a desire among some investors for more security in their bond portfolios.
Comparing returns
But what does more security actually mean? In the investment year 2022, investors lost about 17% with `risk-free’ Swiss Confederation bonds. CHF corporate bonds with an investment grade rating lost about 9% and thus also performed better than the SBI AAA-BBB Index, which lost just over 12%.
Even when the comparison is extended to the last three years, which have been very challenging from a credit risk perspective, the picture is similar. With a loss of 8.4%, CHF corporate bonds outperformed from the end of 2019 through March 2023.
FIG 1. Comparative performance of Swiss bonds
Source: Bloomberg. Past performance is not a guarantee of future results.
The better performance stems mainly from the fact that CHF corporate bonds carry less interest rate risk on average than the SBI AAA-BBB Index or the Swiss Confederation Index. Of course, corporate bonds in general suffered somewhat more from the widening credit spreads, but the smaller interest rate risks meant that the overall loss was the narrowest. It is worth reiterating that in a well-diversified CHF bond portfolio, return fluctuations are driven much more by interest rate risk than credit risk.
Given that the strategy with less credit risk and more security usually leads to higher interest rate risks, the supposedly safer portfolio usually shows greater volatility in returns. However, the greater volatility risk is not rewarded with an additional risk premium. Due to the lower compensation for credit risk and the currently flat interest rate structure (where additional maturity risks are not compensated), the SBI AAA-BBB Index’s current yield to maturity is almost 0.5% lower than that of the SBI Corporate Index.
At the end of 2019, the advantage of corporate bonds was even smaller, at just over 0.2%. Therefore, why would an investor now choose to avoid holding corporate bonds for more safety if they did not choose to do so at the end of 2019? From a risk-return perspective, CHF corporate bonds are even more attractive today than they were then.
FIG 2. Comparison of yield to maturity
Source: Bloomberg. Yields are subject to change.
There is still the case to be made about longer duration, which is advantageous in the event of falling interest rates. However, with the yield curve currently flat and expected to steepen again if rates fall, the disadvantage of corporate bonds’ shorter duration is significantly lessened. In addition, the current higher compensation for credit risks with corporate bonds can compensate much more for the disadvantages of interest rate risks, especially with longer investment horizons.
If the quest for security relates less to volatility and more to default risk, it can be stated that the default risk for CHF bonds is still small despite the turbulence of the past three years and can be further minimised through a well-diversified credit portfolio.
Although the actively managed LO Funds (CH) – Swiss France Credit Bond suffered from the collapse in market liquidity during the pandemic, invested in Russian issuers and was affected by the fall of Credit Swiss, it still outperformed the SBI Corporate Index by approx. 0.5% in the period 30.12.2019-31.03.2023. Compared with the SBI AAA-BBB Index, it outperformed by almost 4%!1
Because the compensation for interest rate and, above all, credit risks is much higher again, investors currently have a much stronger protective cushion against market fluctuations. If, for example, one assumes a doubling of the current credit risk premiums, CHF corporate bonds already outperform the SBI AAA-BBB Index from an investment horizon of two years. For even longer investment horizons, the additional credit carry increasingly pays off.
FIG 3. Doubling of credit spreads. Scenario analysis over various investment horizons
Source: Bloomberg and LOIM. For illustrative purposes only.
Based on both a look in the rear-view mirror and future risk-return expectations, we see no strategic reason to exit corporate bonds in the CHF capital market and buy more quality with the SBI AAA-BBB index – especially since such a change of strategy would also involve considerable transaction costs.
From a medium and long-term perspective, a well-diversified CHF corporate bond portfolio with a duration of around five years still has the best risk-return profile.
Ideal environment
A volatile market environment with performance setbacks and defaults usually leads to increased risk aversion and closer scrutiny of active investment solutions. There is nothing wrong with that.
However, it is worth remembering that these are exactly the types of environments that offer the greatest opportunities for active solutions. After all, active management only works over the long term if there are price distortions in the market.
The CHF capital market has always inspired searches for opportunities due to its comparatively poor liquidity, but the choice is even greater in the current market environment. Of course, not every opportunity can be successfully exploited, but at least one of the necessary conditions for active investment solutions is met.
Success also relies on a sound and disciplined credit selection process and, above all, the necessary investment horizon. One reason why active investment solutions are often perceived to underperform passive ones is that the former can involve changing strategy at inopportune times. However, hastily changing strategy and realising losses can mean missing the chance to profit from the subsequent recovery.
The last three years have shown that holding onto credit risk based on a sound fundamental credit analysis – combined with an ongoing active search for new investment opportunities – provides a basis for participating in a recovery and ultimately even generating added value.
Active investment solutions pay off
Of course, financial markets do not always recover at the same pace. A common understanding of the investment process, trust in the investment team and the necessary investment horizon are important. Providers of active investment solutions must always balance conflicting objectives: they need to take active risks, but they also need to avoid large performance setbacks that can suddenly make the investment horizon become very short.
All these requirements mean little without the right performance, however. The LO Funds (CH) - Swiss Franc Credit Bond has significantly outperformed both the Corporate Index and the SBI AAA-BBB during the difficult last three years, as well as over the last 10 years. Compared with the SBI AAA-BBB index, for example, the fund has generated about 1% more return per year, with a comparable return volatility of about 4%.
Isn't that proof enough that active management can indeed work and generate the promised added value?
Source
[1] Past performance is not a guarantee of future results.
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