This week we have been focusing on a new tactical trade idea for Qantas. We…
People often forget the underlying differences between equity and credit. While stock selection is all about picking winners in the equity market, the goal of credit selection is to avoid losers. First and foremost credit is about getting your money back and being adequately compensated for the risk of not getting your money back. In many ways this is the same as a bank assessing a loan. Credit analysis is about assessing this potential downside or risk of a security transaction and to ensure a fair rate of interest is returned consistently over the life of the loan given the risk.
There are two major objectives when investing: growth and income. Growth assets such as equities provide capital appreciation at higher levels of risk while income assets focus on capital preservation and provide regular income. Income assets should be utilised for stable returns while maintaining the original capital invested. The key objective to successful credit investing is avoiding losses while maintaining a steady yield.
Successful equity investors may pick seven out of ten winners and the overall portfolio would be a success but for a credit investor these losses would significantly diminish the overall return and objective of the portfolio. From the borrower or issuer’s perspective it is beneficial to have solid growth prospects for its equity investors. However, it is more important to maintain liquidity to pay income on it’s debt or credit securities. For income investors the focus should be on the probability of the credit of a borrower deteriorating, identifying whether the yield offered compensates for this risk and then allocating investment to that security according to your risk appetite. This is the fundamental framework of credit analysis and can assist future investment decisions.
For example, consider two portfolios. The two portfolios are exactly the same except portfolio one has one security (which has a neutral performance in comparison to the market) replaced for a security that has blown out. To demonstrate what happens, we have indexed the two portfolios and shown their performance below. As you can see, the end result is not pretty. The final value of portfolio two is substantially less than portfolio one and this was all because of one poor performing security.
Generally, the volatility of credit on day-to-day basis it is significantly less than equity. However, the relative absolute return on this asset class can make credit portfolios vulnerable if the credit spread or margin represents a large proportion of the return. Negative events are less likely to occur when investing in credit (lower risk), but the impact on portfolio returns can be substantial if proper due diligence is not undertaken. The efficient management of a portfolio becomes even more crucial in a low interest rate environment where credit markets offering lower yields. Independent credit research will provide the investor with a valuation on the probability of credit deterioration of an issuer and help protect stable portfolio returns.
The idea of avoiding losers in credit portfolios is based on the asymmetric payoff in securities with optionality. While stocks go up or down, credit instruments usually have limited upside but substantial downside. This reiterates the importance of independent credit research and lowering risk via diversification.
Overall, credit is an effective investment diversification tool that offers an alternative investment solution to equities at a lower risk and provides superior returns to deposits. At the end of the day the goals of investing in this asset class are capital stability and income. However, the asymmetry of returns means poor credit selection can heavily impact portfolio returns. Credit (or risk) is misunderstood by many investors and the correct approach is to protect the downside rather than blindly chase yield.