Last updated: 13:43 / Thursday, 12 December 2019
Interview with Nicoló Bocchin

Azimut Believes The Spreads on Hybrid Bonds and Subordinated Debt Can Tighten Further During Q120

Imagen
  • Hybrid bonds and financial subordinated bonds sare issued for different reasons but have common features
  • “The investor is rewarded for the subordination, in a title with greater volatility, but with a spread similar to that of the High yield segment and an investment grade default risk ”
  • "We think that negative rates is a distortion of the market and perhaps in 2-3 years’ time with a bottoming out of growth and a pick up in inflation ,which can occur, interest rates will slowly go from negative back to zero, ”
  • The fund's current positioning is that they have a long credit portfolio but short interest rate sensibility
  • Since the team started to manage the fund the percentaje of issuers that meet ESG criteria has increased from 75% to 95%
  • The fund manager thinks there is still room for further sprads reductions, especially during the first semester 2020
  • “ During 2020 is the year where you should appreciate the fact that this type of instruments have a carry. We don’t expect a big spread compression, although there will be some, and the performance will be basically the yield of the portfolio”

A year ago, when Nicoló Bocchin, Head of Fixed Income of the Italian manager Azimut, started to manage the AZ Multiasset Sustainable Hybrid bonds fund, one of the main changes he introduced was to add subordinated bonds of financial companies, especially insurance companies, to its portfolio of corporate hybrid bonds.

"Hybrid bonds allow European issuers to finance themselves without jeopardizing their rating, if they follow the methodology established by the rating agencies, while insurance companies issue subordinated bonds for solvency reasons, but have features in common”, explains Bocchin in an exclusive interview with Funds Society.

Thus, by introducing insurance subordinated bonds, they enhance diversification thanks to instruments “that have almost the same structure as a corporate hybrid bond and provide the same spread,” explains the manager.

For this same purpose, the manager explains that recently they have also added AT1 instruments, known as CoCos in the portfolio, because it is “an asset class that we use tactically to enhance the return of the portfolio and that we like a lot. It is more volatile that hybrid and insurance but again it provides us with diversification nad coupon flows that are very helpful for the time being,” explains Bocchin.

Currently, the portfolio of the AZ Sustainable Hybrid fund is composed of 45% corporate hybrid bonds, 27% subordinated bank bonds and 24% insurers. Bocchin explains that there is generally one or two notches difference between the hybrid or subordinated bond rating and the issuer's rating, depending on the degree of subordination and that in this type of asset “the investor is rewarded for the subordination, in a title with greater volatility, but with a spread similar to that of the High yield segment and an investment grade default risk.”

Short on underlying interest risk

Another characteristic of its investment style is that it is managed based on spreads, not yield, which implies that the two components that make up the total yield are broken down. The quality of the issuer and the macro environment and the impact on the government yield are analysed separately. Consequently, based on this approach and its current outlook for interest rates, they have recently reduced the sensitivity of the portfolio.

“In Europe we are in negative yield environment in the German curve which we think is not fully justified. We have mid to long term view in the way we manage our portfolio,we think that negative rates is a distortion of the market and perhaps in 2-3 years’ time with a bottoming out of growth and a pick up in inflation, which can occur, interest rates will slowly go from negative back to zero,” says the manager.

Consequently, its current position is that they have a long credit portfolio and short underlying interest rate risk Bocchin explains, “the current duration of our portfolio is 4.5 years, but the interest rate sensitivity of the portfolio is less than 3 years because I am almost 2 years short in futures both in the German curve and the small component in the Italian curve."

Implementation of ESG Criteria

Another differentiating aspect of his management style is the application of ESG criteria in selecting the securities that are part of the portfolio. “Since we started managing the fund, the percentage of issuers that meet ESG criteria has increased from 75% to 95%," says the expert, who applies this filter based on the criteria established by his external provider Vontobel.

In the same line the manager adds that, although these types of instruments are mostly issued by European entities, he predicts a great development of ESG issuers in emerging markets in the coming years and confirms that Azimut has the necessary resources and experience to take advantage of this opportunity.

2020: A year to Benefit from the Carry

In terms of return of this type of assets, the fund has had a very significant one during the year, although Bocchin points out that the profitability of the year 2019 has to be seen together with that of 2018 due to the strong  spread widening at the end of 2018 and its subsequent recovery during 2019. Based on this good performance, in July 2019 they slightly reduced the risk of the portfolio by decreasing its exposure in AT1 and reinvesting in corporate hybrids and some insurers.

With respect to 2020, the manager points out that the profitability of 2019 will be very difficult to replicate. However, although the spreads are at levels close to 200 basis points, the manager believes that there is still room for further reductions, especially during the first half of 2020.

" With the QE the ECB is buying Investment Grade credit so investors see a squeeze in spreads and yield among IG, and they need to look for yield in the lower part of the capital structure," explains the manager.

In short, by 2020 they expect a return between 2-4% in euros (that is, between 4.6% and 6.6% in dollars) under optimistic scenarios, although they do not rule out periods of volatility caused mainly by disappointment regarding Chinese growth .“2020 is the year where you should appreciate the fact that this type of instruments have a carry. We don’t expect a big spread compression, although there will be some, and the performance will be basically the yield of the portfolio”, concludes the manager.

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