Unconstrained Credit Fund
Celebrating three years
Here’s how we did it…
Federated Hermes Unconstrained Credit invests across the global credit spectrum using an unconstrained, high-conviction approach.
The fund is designed to give investors access to the credit markets in a way that is not bound by traditional benchmarks or traditional ways of investing. The fund’s strategy aims to better reflect the fact that the corporate credit market has evolved dramatically in recent years.
Delivering strong risk-adjusted returns since inception
During what has been a challenging three years for investors, our Unconstrained Credit Fund has outperformed its peer-group average, while simultaneously avoiding the most volatile parts of the credit market.
In down markets and crises, we have shielded our credit positions with a unique derivative overlay that acted as a powerful hedge, protecting our clients’ capital at the times when they needed it the most.
Performance: three years annualised (%)
Performance: one year annualised (%)
Rolling year performance, net (%)
31/05/20 to 31/05/21 | 31/05/19 to 31/05/20 | 31/05/18 to 31/05/19 | 31/05/17 to 31/05/18 | 31/05/16 to 31/05/17 | |
|---|---|---|---|---|---|
Federated Hermes Unconstrained Credit Fund | 10.94 | 8.84 | 6.25 | – | – |
Past performance is not a reliable indicator of future results.
Performance shown is the F share class US Dollar Accumulating net of all costs and management fees since seeding on 30 May 2018. Subscription and redemption fees are not included in the performance figures. Source: Federated Hermes as at 31 May 2021. Morningstar Peer Group Median for Global Flexible Bond (USD Hedged) is sourced from Morningstar as at 31 May 2021.
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.
Key fund facts
(annualised since inception)
Source: Federated Hermes, as at 31 May 2021. Morningstar peer group ranking has been sourced from Morningstar, as at 31 May 2021.
The pillars of our promise
Fund characteristics
Incorporating our London-based credit team’s long-standing credit relative value investment process, the fund combines bottom-up skill with top-down oversight to allow investors to access alpha opportunities across the full spectrum of global credit. Our best credit ideas are combined with downside defence from our dynamic derivative overlay.
Source: Federated Hermes, as at 31 May 2021. ¹The Federated Hermes Credit investment process considers the relative attractiveness of investing across the full credit spectrum, from decisions about which sectors or rating categories offer most value, through to selecting the optimal security within an issuers capital structure. The team believes that capturing superior relative value depends as much on finding attractive securities as identifying creditworthy companies.
From sell-off to lockdown
How we successfully navigated the key challenges of the last three years
Three years ago, we sought to maximise long-term total returns by combining unconstrained, high-conviction credit selection with a hedge against adverse market conditions. By investing on a ‘through-the-cycle’ basis, and maintaining an element of dynamism and nimbleness, we have delivered on this objective for our clients. We have achieved this by merging flexibility with precision, and using the following tools helped us to provide a level of downside protection:
Derivative overlay including CDS Index and options
Structural downside protection via defensive credit
Diversification across different credit classes
Dynamic allocation across types of credit
Monitoring idiosyncratic single name risk
Duration management through treasuries and futures
Three years, four market moments
The fund’s derivative overlay comes to bear during the most meaningful periods of market stress. The overlay, first and foremost, gives the fund provides a level of downside protection and our managers the confidence to go into a dislocated marketplace and buy opportunities at their most attractive prices.
Past performance is not a reliable indicator of future results.
Performance shown is the F share class US Dollar Accumulating net of all costs and management fees since seeding on 30 May 2018. Source: Federated Hermes as at 31 May 2021.
Imperfect storm (Market sell off)
At the end of 2018, markets closed out their worst year since the global financial crisis as trade tensions between the US and China, monetary policy easing and a slowdown in global growth triggered a bruising market sell off.
Andrew Jackson,
Head of Fixed Income
How we responded
In Q4 2018, the fund’s derivative overlay fulfilled its role as a powerful hedge: it helped us manage the downside risk during the market sell-off and allowed us to maintain exposure to our high-conviction long positions. The overlay significantly reduced the strategy’s long positioning throughout November and December, helping to mitigate overall fund losses as well as making money itself. This was vital as it gave us the chance to spend December and early January buying severely dislocated bonds from around the world at a time when other funds were seeking to reduce risk. And there were lots of attractive opportunities to buy.
Around this time, investment-grade credit in aggregate was trading below par cash price for the first time since the financial crisis. But it seemed like most other investors didn’t recognise this as they were focusing their attention on spreads.
No room to grow (high yield convexity)
Credit markets delivered impressive returns in 2019 and, by the fourth quarter, global High yield bonds traded close to, or at their full valuation. Future price rises were capped by potential call activity and investors were unlikely to earn the full yield to maturity. Negative convexity in this market was at its worst level since the 2013 taper tantrum.
The situation was made worse by the prevailing bear market. If these bonds were repriced to their final maturity, they would probably suffer disproportionately in relation to non-callable securities. In short, it was a no-win situation for many developed-market high-yield bonds
Frasier Lundie, CFA,
Head of Credit
How we responded
Many investors were taking a risk position through credit-default swaps (CDSs) rather than bonds. But CDS premia were expensive and didn’t seem, to us, a good way to proceed. Amid very poor convexity, high-yield loans usually trade well above par. But continued outflows saw them trade at about $99. This provided an opportunity to switch from bonds with extreme negative convexity into loans with a better convexity profile. But capitalising on this opportunity required a nuanced approach. To benefit, investors needed to take a holistic look at a company’s entire capital structure to decide whether to access the loan.
At the time, high-yield bonds offered very little upside. But as we found with secured bank loans, opportunities did exist elsewhere in the capital structure. Through our range of flexible-credit strategies, we had the mandate to act nimbly and identify high-conviction, idiosyncratic stories that had the potential to deliver superior risk-adjusted returns.
Pandemic shock (lockdown)
The coronavirus outbreak forced governments across the world to lockdown their economies, and the inevitability of recession wiped billions of dollars off global market in the most alarming sell-off since 2008.
Against the looming crisis, the economic shock was compounded by a collapsing oil price and a mass offloading of risk assets. Fixed income markets were subject to considerable volatility as investors sought to reverse any risk-on positioning within the asset class.
In the US, investment grade credit spreads hit the widest level since 2008, rising from 99bps to 373bps in just 22 days¹.
Andrew Jackson,
Head of Fixed Income
How we responded
We actively adjusted the derivatives overlay as the market moved downwards, taking profit on positions and ensuring the strategy had a degree of protection should the market continue to sell off. As spreads widened and derivatives moved into the money, we took profit and rolled positions into a longer dated, bigger notional, further out of the money contracts. Active management of the derivatives book allowed us to crystallise profits. Total contribution of the hedge overlay to the Unconstrained Credit Fund over the period was 9.35% on a gross of fees basis, whilst the Global High Yield index fell -14.38%, gross of fees².
A good news sell-off (rates sell off)
The rapid roll-out of the Covid-19 vaccine across many developed countries and the approval of US president Joe Biden’s $1.9trn stimulus package stoked expectations of higher global growth and inflation. This pushed US treasury yields higher. The frenzied sell-off in government bonds leaked into the corporate bond space, leaving company borrowing costs to their highest levels since the pandemic began.
Fraser Lundie, CFA,
Head of Credit
How we responded
With rates at historic lows, negative real yields and the threat of a taper tantrum one of our key risk concerns, our view from the Credit Strategy Meeting on rates going into 2021 was very negative. Due to a material underperformance of cash bonds versus CDS at the start of the year we were able to take advantage of the opportunity to switch some of our bonds into CDS positions where we saw flat or even positive basis. This flexibility to select the best instrument enabled us to reduce the fund’s exposure to interest rates, since CDS only represent an exposure to credit spread of an issuer. We were also able to look to the structured credit market where we saw attractive relative value opportunities versus traditional bonds. The floating rate nature of structured credit helps to reduce our exposure to rates. Overall, this meant we were able to come out of Q1 relatively flat in terms of performance.
Fund asset class allocations
1 Source of market data: Bloomberg.
² Source: Federated Hermes, 31 March 2020.
³ Source of market data: Bloomberg.
⁴ Source of market data: Bloomberg.
Presenting the Federated Hermes Unconstrained Credit Fund
We look at the fund from five angles to see how it stands out among its peers by combining unconstrained credit selection with a hedge against adverse market conditions.