Derivatives and other complexities in Man GLG Dynamic Income

masonic

You will know from our previous discussions my view on the inclusion of BBB in IG. The fact it makes up nearly 50% of the global corporate bond index and nearly 40% of the sterling index, is a source of consternation for me. But leaving that aside for now...

If your concern is how a fund would hold up, then volatility is intrinsically linked to credit spreads and things are not going to be quite as simple with duration and interest rate sensitivity. The reason being that cashflows associated with borrowing on bond markets involve a series of small coupon payments followed by a final bullet repayment of principal. The difference when compared to a sovereign bond issued in a currency controlled by the issuing government is the uncertainty over that final cashflow. A company in distress may struggle to greater or lesser degrees to keep up coupon payments, but it is the final repayment that presents a much greater challenge. I know you know this, but for the sake of completeness, when credit spreads widen or interest rates rise, the company still pays the same coupon; it is the price of the bond that falls to increase the yield, and that is what drives the unit price of a bond fund downward (much more than actual holdings defaulting in most cases).

With these mechanics, the company is at greatest risk when it has bonds that are close to maturity during a recession. So there may not be a straightforward correlation between duration and volatility as the risk of default becomes non-negligible.

You also have to consider what else happens to a struggling bond issuer as it enters a challenging period. Likely its earnings will fall and so will its general finances and credit rating. Since a company is often capable of limping along for many months or even years of tough trading conditions, there is plenty of time for the market, and its rating, to adjust to its new trajectory. the article you've linked acknowledges that issuers cycle between IG and junk, and those doing particularly badly will probably move several notches down before anything terminal happens. A fund has a choice how to respond to this. They can either sell upon a re-rating (as many IG funds would have to do), or continue to hold. If they generally sell bonds re-rated lower and buy bonds re-rated higher, then that is buying high and selling low - which will be a drag on performance. If they HODL, then they are exposed to greater volatility and greater credit risk than a static analysis of specific ratings would suggest. The holy grail is obviously to move up the credit rating ladder before a downturn and down it at the next part of the cycle. If you can predict those.

All of that to say, I think it is probably misleading to make generalisations about bond funds based on index data for specific credit ratings.

aroominyork

Conscious I am moving discussion from funds to individual bonds... when interest rates rose in 2022, there was forum discussion about the impact on corporate loans imminently maturing and needing to re-finance at, suddenly, much higher cost. It therefore seems curious that defaults were as low as the previously linked article suggests (even taking into account pre-default downgrades). 

Presumably the next round of re-financing challenges are unlikely to face another base rate rise of 5% and may be linked to an economic slowdown, presenting a different scenario and potentially more defaults.

masonic

aroominyork said:

Conscious I am moving discussion from funds to individual bonds... when interest rates rose in 2022, there was forum discussion about the impact on corporate loans imminently maturing and needing to re-finance at, suddenly, much higher cost. It therefore seems curious that defaults were as low as the previously linked article suggests (even taking into account pre-default downgrades). 

Presumably the next round of re-financing challenges are unlikely to face another base rate rise of 5% and may be linked to an economic slowdown, presenting a different scenario and potentially more defaults.

The low level of defaults for those credit ratings would be consistent with a decline in credit rating prior to default. But it's likely a decline in credit rating will be preceded by a fall in bond price as company news is release to the market. So I don't think you can avoid making losses by carefully monitoring the credit rating of the bond issuers.

It's fairly clear that corporate bond funds loaded up with BBB suffer substantial falls during economic downturns. An efficient market in which long term default rates are so low as to be labelled 'N/A' would not discount these bonds to such a degree unless there was some mechanism for default that wouldn't show up on the BBB statistics.

Assuming refinancing costs went up in 2022, as I'm sure they did, if a business is presented with this, then it has an opportunity to refinance even if it causes it financial difficulties down the line. Whereas if the financial difficulties have already materialised, then perhaps it will be unable to convince lenders to take up its debt at any cost. That's when it's crunch time. The situation in 2022 was quite a confusing one, as businesses were receiving unprecedented levels of support in response to Covid, and it took some time for this support to be scaled back. There was also still rhetoric at that time about the world entering into a new "Roaring 20s". So even if a company had bigger problems, it likely could have hid behind a global pandemic and optimistic outlook if its numbers came under any serious scrutiny.

aroominyork

Very helpful, masonic. So the 2022 chickens might not yet have come home to roost. If so, time will presumably tell whether Jonathan Golan's 'margin of safety' approach is being effectively implemented.