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The short answer is yes. Many fund managers get away with small bond teams, for reasons we do not fully understand. Take the SA Multi-Asset Low Equity fund sector: the source of many flows. These funds have equities capped at 40%, which, by definition, makes them primarily bond funds. And, yet, almost all of the managers who gain the biggest flows have equity backgrounds and small bond teams. Is this reasonable?
Probably not is the short answer. Bonds, we think, are a very different asset class to equities and they benefit from deep, non-scalable, bespoke research. This is largely because bonds have their upside capped (at the interest, plus capital repayments) and their downside is zero (if they default). Equities, while they can default, should reward you for the risk of bankruptcy because of their ability to deliver growth. And equities reward optimism: the manager selects stocks because he sees greater upside in the companies he/she owns. Equities also reward acts of commission (making good investments), while bonds reward acts of omission (avoiding the defaults). This makes the mindset different, in our view – and the expectation on team size quite different.
Evaluating bond credit is hard, laborious work and should not be overlooked or under resourced. Good corporate bond analysts are eternal pessimists and look for any reason to factor in disaster. And this is particularly useful today, when we see most market participants favouring corporate bonds over government bonds. Such bonds are higher yielding and, naturally, higher risk. So – the one critical factor is – do the underlying analysts do the work in sufficient detail and well enough to avoid lending capital to those companies that default? Because if they do a good job and avoid defaulting bonds, they are guaranteed to outperform (because they own more risky bonds than the index).
We have spent the last 5 years within the UK market and the credit coverage of most of the global bond managers is very impressive. We seldom find analysts with dual roles: for both equity and bonds, for example. That is because the mindset for bonds needs to be different. Good bond analysts need to be more pre-occupied with the liabilities of the company, rather than the assets (which are often the greater focus of equity teams). Clearly both sides of the balance sheet matter, but bond credit analysts, need to prioritise the risk of failure over upside because of the asymmetric payoff profile we mentioned earlier.
Lets use some examples to explain the mindset we look for. Below is an excerpt of the sorts of investigative analysis we expect to see performed by credit analysts, all focused on evaluating potential financial disaster, (rather than upside):
|–||Debt facilities, maturity, terms. Are these favourable and will they change when they mature?|
|–||Ratings agency triggers. What are these? Could future borrowing be impeded by a ratings downgrade?|
|–||Management attitude to debt. Are they committed to repaying it as a priority, or do they use it in an ill disciplined way, say to fund bonuses.|
|–||Currency mismatches. Are revenue and costs in the same currency?|
|–||The liquidity of their assets. Can they muster up reserves promptly in case of emergency – are there emergency cash cushions? Does the balance sheet cover their debt adequately?|
|–||Unforeseen liabilities (guarantees and underwriting perhaps) or contingencies and off balance sheet items. Are there any big-ticket items hidden from view, like derivative contracts, pension liabilities or law-suits?|
|–||Cashflow dependencies: any product biases, any major contracts, any customer or counterparty dependencies.|
|–||Regulatory risks. Are there increases in capital adequacy? Can they be fined? Can their clients sue them? Is there adequate insurance cover?|
We think bond managers in South Africa need to be continuously challenged on the depth of credit resourcing. Generally we find very small bond teams. In addition to this we often find equity managers buying bonds and SA focused bond investors buying global bonds. Needless to say, we expect a very high level of individual credit evaluation, and we think to do this effectively, size is often a factor.