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A-rated corporates manager eyes ratings agency arbitrage

A-rated corporates manager eyes ratings agency arbitrage

Savvy corporate bond managers should focus on the areas of the market ratings agencies overlook – not just in crossover credits – to find bonds that are being wrongly rated as junk.

That is the view of Citywire A-rated Bob Persons, who is co-manager on the $232.6 million MFS Meridian Funds – US Corporate Bond fund. He co-runs the fund with Citywire + rated manager Richard Hawkins.

Speaking to Citywire Selector, Persons said there had been a strong emphasis on the crossover credit/fallen angel market over the past two years but longer-term investors have spied strong opportunities here.

‘The corporate bond market is inefficient and we are focusing on the 5Bs space, BBB- and BB-rated, as we think there are structurally strong inefficiencies to exploit there. During my days at business school, we were taught the market was efficient and would normalise eventually but that is not the case, especially around the BBB/BB ratings area. 

‘Since many institutional investors have investment criteria that prohibit bonds that are not rated investment grade, many quality BB-rated companies with improving credit profiles are not eligible investments.

‘Our goal is to identify such opportunities before they are eventually upgraded by the rating agencies. These bonds benefit from higher yields than investment grade rated bonds, while also offering price appreciation as they become eligible securities for institutional investors.’

Persons said there are solid, quality companies sitting towards the upper limit of high yield, just out of the reach of institutional investors, which can reward investors without increasing undue levels of risk in the portfolio.

We believe you can find solid quality and yield within the upper limits of high yield without being over-stretched or drawn into single Bs,’ he said.

‘We are effectively looking at what the ratings agencies are saying and seeing where we disagree, where we can exploit that inefficiency in rating and reality. They rate more than 600 bonds, we just have to uncover 30-40 that are misrated. It's a matter of identifying an inefficiency and focusing on the opportunities.’

High-yield hopes

Persons is currently focusing his fund on investment grade bonds, which account for 80.2% of exposure, while he retains a remit that allows investment in high-yield bonds. He has 14% allocated here as at the end of September 2016, which he said is very carefully selected.

‘What we are focusing on in high yield is the cream of the crop. There is an element of value trap in there as the market say it is “cheap for its rating” but if you are looking at a BBB with a spread of 300 and the index is 175, you have to ask questions. That is either a company that has deteriorating fundamentals or other difficulties. That is where I would urge caution.’

At a sector level, Persons is currently avoiding high beta and highly cyclical investments. ‘We structurally focus the fund on companies that are growing, as well as generating sustainable cashflow.

‘This has led us to overweight consumer staples. We have positions in the beverages industry, for example, as well as healthcare, tobacco and pharmaceuticals. We are underweight energy, as well, and most European banks, as we would rather be in US banks on a quality basis.’

The MFS Meridian Funds-US Corporate Bond fund returned 11.68% in US dollar terms over the three years to the end of October 2016. This is compared with an 8.5% rise by its Citywire-assigned benchmark, the Citigroup US Gov Bond All Maturities Local Cur TR, over the same period.

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