Because the credit market is large and complex, managers must evolve their investment processes to improve client outcomes.
We believe four principles — insight, conviction, discipline and active risk-taking — are necessary to meet clients’ alpha and beta goals.
Layering quantitative analysis with human talent may improve security selection, portfolio construction and risk/return profiles.
Active Credit Management, Enhanced for a Multifaceted Market
Corporate credit investors face a vast, complex market. In the U.S. alone, the corporate credit market is large and diverse, with more than $10 trillion in total outstanding debt.1 Globally, outstanding corporate debt totals more than $40 trillion.2
Successful active credit management requires effective security selection, whether the market is tightening or widening. In our view, enhancing traditional fundamental research with quantitative tools creates a credit investment process that can repeat its success in various market conditions. Carefully crafted quantitative tools are imperative to pursue alpha and successfully manage risk through credit cycles.
This article presents our model for combining sector specialists and quantitative tools into an effective active credit management process. Incorporating insights, conviction, discipline and active risk-taking, our approach strives to:
Improve client outcomes.
Originate effective trade ideas in the vast and complex credit universe.
Build conviction in active positions.
Mitigate the risk of being wrong and the threat of market selloffs.
How We Seek to Improve Client Outcomes
When investing with an active credit manager, clients expect outperformance relative to a representative index — ideally with better downside protection. We seek to achieve these goals by building conviction through active security selection and incorporating quantitative tools into our process.
Select Securities With Alpha Potential
Given the size and diversity of the credit market, we believe individual credit selection results in superior alpha outcomes for investors. Overweighting high-conviction securities can significantly enhance active returns. At the same time, active managers can add alpha by avoiding relative losers.
Adding value through credit selection requires building high-conviction positions on individual issuers and securities that are mispriced relative to their fundamentals. A nimble and highly active approach is critical as individual issuer risk or security price changes. The manager must decide when to buy, sell and reallocate capital.
Incorporate Quantitative Tools
However, the scale of the bond market and the complexity within the investment opportunity set present challenges. Enhancing a fundamentally oriented credit selection process with quantitative tools' consistency, efficiency, scale and guidance can overcome these challenges.
Quantitative tools help identify opportunities, develop conviction and exercise discipline, resulting in a more evolved approach to active risk-taking. Coupling the sector specialists’ fundamental insights with a quantitative process highlights market dislocations. From there, a disciplined risk management process can lead to high-conviction positions.
We believe managers can sustain alpha throughout credit cycles through high-conviction security selection, credit-curve positioning, and nimble position management. In our view, a traditional fundamental investment process needs enhancement from quantitative tools to generate alpha consistently.
Bottom line: To reliability and consistently improve risk/return outcomes when managing credit, managers must engage in active security selection and embrace quantitative process enhancements.
How We Select Securities in the Vast and Complex Credit Universe
While investing in corporate equity typically involves just one security, bond investing is more complex. Borrowers issue debt across various maturities, legal entities, seniorities and optionalities. As a result, bond investors generally encounter more risks than equity investors, who predominantly face earnings risk.
Bond investors must manage tenor risk (time to maturity), liquidity risk and structural risk on top of earnings risk. These added risk dimensions make the credit universe more complex and security selection exceptionally challenging. But this is precisely why security selection can generate alpha.
Proprietary Tool Enhances Credit Management
In our view, traditional fundamental credit research alone is insufficient to tackle the market’s complexity and size. Identifying alpha opportunities consistently, efficiently and repeatedly requires additional skills.
Accordingly, we developed a proprietary and quantitatively driven credit tool dubbed CREDIT (Credit Risk Evaluation and Debt Investment Terminal). This comprehensive database and analytical tool helps us better execute our style of active credit management.
The investment process begins with analysts’ fundamental research, which leads to our internal ratings. Our quantitative enhancements allow the analysis to go much further. For instance, CREDIT translates our fundamentally derived internal ratings into quantitatively estimated target spreads for each security of the rated issuer.
Merging Quantitative Data and Analyst Views
The investment team uses the tool to filter the sizable bond universe and partition it into manageable chunks. This enables the team to easily sort by the distance between the spread target and market levels. This sorting, depicted in Figure 1, directly informs decision-making and action.
Figure 1 | Our Process Filters the Investable Universe
Scenario: Exploring Electric Utility Opportunities to Add Less Cyclical BBB Exposure
Source: American Century Investments.
This cooperation between human talent and machine technology generates a list of market dislocations, with bonds landing on a valuation spectrum from cheap to rich. However, we don’t invest broadly in every dislocation. Instead, this list becomes the starting point for identifying high-conviction investment opportunities.
Bottom line: Our proprietary quantitative tool significantly improves our ability to cover the broad credit universe, leading to more efficient and effective security selection.
How We Build Conviction in Active Portfolio Positioning
In our view, mixing machine inputs and human talent develops conviction. Figure 2 highlights the specific strengths of each. We believe a combined model that capitalizes on all strong suits is superior.
Figure 2 | Process Benefits From a Mix of Skills
Advantage: Quantitative Model
Rare Events Assessment
M&A Risk, Lehman, 9/11
Source: American Century Investments.
Sector Specialists Drive the Process
The experience of our sector specialists is the cornerstone of our investment process. Having firsthand knowledge of the specific dynamics of past credit cycles and managing risk through those cycles is crucial for a fundamental credit investment team.
Furthermore, ongoing dialog between our credit sector specialists and the management teams of bond issuers generates great insights into the following:
Debt issuance scheduling.
Business risk management.
ESG policy development.
These understandings may substantially influence our fundamental credit view, particularly when considering market dislocations of equal spread tightening potential. In this scenario, our company-specific insights can help us determine which opportunity has the highest probability of a positive outcome with limited downside risk.
We believe we achieve a superior investment model by building the investment process around quantitative analysis and human insights. Our quantitative tool highlights market dislocations while our credit professionals’ perceptions help sharpen our focus on high-conviction holdings. Our conviction-building process helps determine position sizing and when to reduce or eliminate an investment.
Bottom line: A process that combines fundamental credit analysis with quantitative analysis generates a superior, more focused list of high-conviction positions.
How We Mitigate the Risk of Being Wrong and Constant Threat of Market Sell-Offs
Because market volatility includes downside risk, high-conviction investment positioning requires discipline. We recognize that conviction levels change over time, and we will not always be right. Discipline helps mitigate the resulting risks.
Disciplined active management necessitates consistent monitoring of each position to ensure pricing still reflects a dislocation. Implementing CREDIT to track changing risks and prices helps us achieve this consistency and discipline.
Providing portfolio managers, traders and analysts immediate access to timely information is the first requisite for disciplined high-conviction investing. Because none of the existing industry tools met our needs, we developed a proprietary, highly customizable credit tool to enhance our discipline.
Disciplined portfolio management also requires a robust understanding of the potential upside and downside of every holding. As Figure 3 demonstrates, by working with CREDIT we can instantly assess where a security trades relative to:
Its short-term ranges.
Other bonds from the issuer.
The market’s historical tight and wide spreads.
Figure 3 | Our Process for Gauging a Bond’s Attractiveness
Analyzing a New Bond Issue and What to Sell in Exchange
Source: American Century Investments.
The disciplined use of CREDIT equips our portfolio managers with a timely and robust assessment of each holding’s prospects and risks. As a result, we’re able to construct high-conviction portfolios while maintaining nimble and highly active credit management.
Bottom line: Extracting consistent outperformance from high-conviction active management demands discipline, and quantitative tools are integral to a disciplined process.
Principles Pilot Our Security Selection Process
In building and managing portfolios that reflect client goals, American Century Investments relies on four primary principles:
Insight: Gathering intelligence to develop fundamental views and values at the issuer, sector and macro levels.
Conviction: Appropriately capitalizing on the most promising market dislocations.
Discipline: Consistently monitoring risks and positions to ensure value still exists and downside exposure is tempered.
Active risk-taking: Remaining nimble and active in response to market moves and changing investment views to seek outperformance in any market environment.
We believe that delivering alpha in corporate credit portfolios hinges on the portfolio manager’s ability to capitalize on market dislocations. In our experience, properly combining quantitative tools and fundamental analysis provides a critical advantage in effectively identifying opportunities among those dislocations.
The four pillars of our process — insight, conviction, discipline, and active risk-taking — are designed to identify opportunities throughout a market cycle. We believe we have a more consistent, efficient and repeatable process by enhancing our fundamental analysis with CREDIT. This innovative, proprietary tool augments our risk oversight throughout the investment process.
Through this quantitatively enhanced, robust and repeatable process, we seek to provide our clients with attractive risk-adjusted performance in all market environments.
SIFMA, third quarter 2022.
International Capital Markets Association, third quarter 2022.
Risk management does not imply no risk.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
No offer of any security is made hereby. This material is provided for informational purposes only and does not constitute a recommendation of any investment strategy or product described herein. This material is directed to professional/institutional clients only and should not be relied upon by retail investors or the public. The content of this document has not been reviewed by any regulatory authority.
Many of American Century's investment strategies incorporate the consideration of environmental, social, and/or governance (ESG) factors into their investment processes in addition to traditional financial analysis. However, when doing so, the portfolio managers may not consider ESG factors with respect to every investment decision and, even when such factors are considered, they may conclude that other attributes of an investment outweigh ESG considerations when making decisions for the portfolio. The consideration of ESG factors may limit the investment opportunities available to a portfolio, and the portfolio may perform differently than those that do not incorporate ESG considerations. ESG data used by the portfolio managers often lacks standardization, consistency, and transparency, and for certain companies such data may not be available, complete, or accurate.