MFS Global Aggregate Opportunistic Strategy - The Active Advantage

Anna Martin:

Over the last two decades, beta was the key driving factor for investors both on the equity and fixed income side. Now that fixed income sectors have re-rated, is the environment more favorable to active managers?

Pilar Gomez-Bravo:

Yes, it was. It's been challenging in a period of negative yields to convince a lot of asset owners that actually active management had a lot of value, so we saw a huge transition to passive. But once the Fed put is no longer there, then you really do need to have an active approach to avoid obviously the added credit risk and protect the capital of your portfolio, but to be able to navigate the different sectors and the different risks that you have in your portfolio because you don't really have somebody to step in and save you when things go wrong.

And so that changed the fact that the Fed is no longer there because of inflation to provide your put is something that I think the markets haven't caught onto yet because many, many years of loose monetary policy have created a moral hazard in the markets. And I think for the first time we're seeing very large institutional clients that are switching their portfolios from passive to active. And I think that's because again, they sort of start valuing this protection of the portfolio from the bottom up and they still want that exposure, but they want the protection and the defensiveness and the alpha generation that comes with active management rather than having just to take what’s in the benchmark.

Anna Martin:

Are there any parts of the market that you're worried about and how do you manage those risks in the global opportunistic fixed income strategy?

Pilar Gomez-Bravo:

I mean one other area that I think about is sort of the huge size of the leverage loan market. So that's grown again tremendously. It's usually to feed the CLO machines and the highest tranches of CLOs have tended to go into Japan. So one of the worries that I think about is, well, if Japan does exit this extreme loose quantitative policy and they start thinking about maybe moving the yield curve control target and suddenly the hedging costs for Japanese investors become really difficult in terms of going out and buying all these CLOs or regulatory intervention prevents them from buying these CLOs and you have leverage loans ratings decline, you could have another one of these unwinds. And the last comment on leverage loans that I think about as well is that what happens when investors decide that they don't want floating rate debt anymore?

Obviously if you think that yields are peaking, then you want to go on a fix the coupon. So where does all that money go? So in the back of my mind I always think about tail risks and tail risks have to do with unwind of leverage and sudden shifts in allocations from clients. So, the way that I think about it is now you're getting a pretty decent yield in sort of plain old vanilla public bond liquid markets and you can build portfolios with a healthy level of risk and yields. And so, I'm not quite sure that there's a need to go into very exotic areas or those that again have challenging paths because of the floating rate nature or the decline in credit quality that you might sort of see or covenant protection. So those are the things that I'm thinking about as well.

Anna Martin:

Local bank term deposits are offering very attractive returns to clients. Why might advisors consider fixed income over cash equivalence at this point in time?

Pilar Gomez-Bravo:

So that's a very good point and we do get asked, especially if we look at for example, US investment grade yields, they're pretty similar to treasury bills. But I think the opportunity cost of not being invested are quite high and I know that that's sometimes just basic finance 101 that you need to be invested. It is daunting frankly for investors particularly after such a brutal year last year that the nature of having that sort of attractive yield with no risk is an area but it's the first time that those investors can actually have money hidden under the pillow with actually a good yield. However, I think that what you're missing out is in obviously managers that can give you that extra alpha opportunity set from being invested in different markets and different opportunities as I mentioned with some of the dislocations that exist.

And also the one very difficult thing about being outside of the markets is that it's easy to be too late and you might miss some of the upside when you have that sort of inflection point in yields. And so if you think more of a longer term perspective, I think it makes a lot more sense to have fixed income exposure, diversified and depending on the type of risk that you want rather than sitting on cash. Because again, I think it's really difficult to capture exactly the timing on when you're going to be really benefit from some of the duration impact and the credit impact that those bonds provide.

Anna Martin:

For clients that are thinking about making an allocation to global credit, what do you think is the key question that they should be asking their global credit manager to really evaluate their skill?

Pilar Gomez-Bravo:

I mean one of the obvious questions is how do they construct a risk in their portfolio and how do they allocate it and how dynamically are they sort of looking at sector opportunities, but also more importantly, what is the strength of the research platform? How can they evidence security selection going into periods of stress? And more importantly, I think one of the key questions that these days asset owners should be asking their credit managers is how do they handle liquidity in their portfolio? Again, we know that it's an over-the-counter market and therefore when you're evaluating credit managers, you really need to assess how they think about liquidity in the portfolios and how do they navigate where they get compensated for liquidity risk and where they really want to maintain a more flexible approach to the holdings that they have.

Anna Martin:

You have spoken about the important role of an active credit manager in taking advantage of these locations and inefficiencies. What is the key part of the investment process that allows you to do this? And can you speak to an example of where you've been able to be nimble in executing?

Pilar Gomez-Bravo:

For me the key thing is to have really a proactive team of analysts that are providing you with the best ideas and it's an army of eyes that are looking at opportunity sets. And then obviously as a portfolio manager I have to look through those ideas and then figure out which one gives us the best bang for our buck as they say in terms of the risk adjusted return. So, it's essential to have the group of the research platform that gives you the ideas but also protects you from the downside. So, it's very easy to find dislocations in the market, but some of those are value traps. And the way that you can identify which ones are value traps and which ones are real opportunities is through those analysts that are really kind of telling you about a credit risk. 

So, one of the things that we've been really active in and we favor a lot is cross currency opportunities. So, for example, last year at one point in the summer we used to own a rail company in the US in dollars and we realized that the euro bonds sort of went down about 150 basis points relative to the US dollar. So looking at the history of that relationship, we decided to sell the dollar bonds and buy the euro bonds and after that, when those spreads compressed again, we unwound that trade.

So, we still continue to prefer to have exposure in the portfolio, but what we do is whilst keeping that exposure, we figure out ways in which we can again get that extra risk premium that's mispriced by the market. And so we've been doing that, we've been doing sort of similar trades with regards to capital structure and for example, relationships between some of the subordinate debt bonds and the senior bonds either in corporates or banks.

And we did something similar recently for example in a large real estate French company, where we again bought the dollar bonds which are really cheap compared to the euro bonds. 

And we've noticed that the Australian bonds are trading almost a hundred basis points cheap to the euro bonds or the dollar bonds, I mean to different degrees obviously. So that sort of wealth of opportunities, imagine is just generating extra alpha without necessarily changing the credit risk. You still have the exposure to the name, but you're being able to pick lots of little different basis points that are accruing to your alpha. So those dislocations we think is really also a very easy week to generate alpha without having to change the composition of risk in the portfolio.

Anna Martin:

How do you and the team think about energy supply dynamics and the implications for global credit markets?

Pilar Gomez-Bravo:

You have two pulling factors in energy markets and particularly obviously oil. The first one is a current paradigm of you have a war in Russia, you have caps and sanctions and you have China reopening at the same time. So that normally would lead to higher oil prices basically, at least in the short term. At the same time in the US they're building or rebuilding their storage, so their reserves, and that again sort of draws demand for oil higher. And on top of that you haven't had any new exploration because of green concerns around fossil fuels.

So, you could have a crunch in the very near term that leads to oil higher. However, in the longer term usually it's obviously a market that is driven mostly by global demand and supply considerations. So if your base case or if you're expecting a significant slowdown in global growth at some point and potential recession, then longer term you'd have to think that energy pricing comes down. One of the key things that we're looking forward to is really kind of continuing to engage with the energy companies that we talk to understand their CapEx plans as they think about this transition in energy policy going forward. And that again will sort of create maybe different options to energy that companies can use beyond just with traditional oil markets.

Anna Martin:

In Australia, as with elsewhere in the world, private credit has generated a lot of interest and investor capital. What is your view and do you think the market is taking into account the risks associated with investing in private credit at the moment?

Pilar Gomez-Bravo:

So, I usually have a pretty neutral opinion of most asset classes. I don't think that there's an asset class that by nature itself is bad or good. I think there's just bad and good managers of the asset class. And so one of the things that you have to consider in the growth of private credit markets, which by the way have funded the growth in private equity markets, is that very long extended periods of lose monetary policy create fragility in financial markets. And that's through the credit channel and through the asset price overheating. And private credit growth is at the heart of some of these issues. The challenge is obviously as we look around and identify risks to the credit markets and risks to general fixed income markets or even equity markets, the thing that's very difficult to capture is the hidden leverage.

And that's where the concerns are. The concerns are that because of the lags in pricing or repricing the books of private credit, that is really difficult to look under the hood overall and sort of understand really where that hidden leverage is. And so it is an area of concern in general because it could lead to basically a systematic unwind of leverage that would make some of these issues problematic.

So, I would suggest that those asset owners that are deeply involved in private credit that just again manage the allocation risk overall and importantly manage the diversification risk. One last comment is that normally participating in an illiquid product in front of a recession is not necessarily great because you're locking yourself in a vintage where the underwriting risk maybe is not as strong as it should be. And so that's the only thing that you would have to think about when you're looking to allocate now to private credit markets.

And one last point is that there is a growing pool of assets that are being created for secondary private credit opportunities. And to me what that tells me is that they're expecting significant stress in private credit if you're creating funds to buy distressed private credit exposure. So normally these markets look ahead and so if you're creating some of these secondary pools of money to buy stress private credit when it shows up, that means that I think that there's an expectation that we might have some issues in that market.

Anna Martin:

Absolutely. Well, thank you very much for your insights Pilar. That's been absolutely fascinating. Thank you for tuning in and hope to see you soon.

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