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5 Years Best in Class

Thursday, July 21, 2016

Credit opportunities: Success is in the niche Interview with Anthony Smouha, CEO of Geneva-based Atlanticomnium S.A. and portfolio manager of a range of credit portfolios, Grégoire Mivelaz, co-fund manager, and Jeremy Smouha, CEO of Atlanticomnium UK.

Since the inception of the credit opportunities fund family five years ago, they are among the best in the credit peer group. What do you do differently to your competitors?

Anthony Smouha:
We focus on credits with the best risk/reward profile across sectors and market cycles, without the constraint of a benchmark. Our team specialises in the financial sector and in specialist areas, such as undated, floating rate and fixed-to-floating debt instruments, to find overlooked and often undervalued issues. This enables us to obtain the higher yields often attached to junior or subordinated issues. Crucially, by participating in the junior issues of quality companies, we can obtain the higher returns on offer – and that for the same default risk.

One advantage is that we are a boutique. Decisions are made quickly and brokers like that. Hence, they actively approach us with issues that are too small for the big houses or too specialist for mainstream investors. For example, when there is some turmoil in markets – and we have seen that numerous times in the past five years – we are able to benefit from the high volatility and can snap up some top-quality bonds with very attractive coupons when they briefly drop in price.

Why should one consider investing in your strategy now?

Grégoire Mivelaz:
With the yields available on government and senior corporate debt so low, the results we achieve look particularly attractive. When interest rates were higher, it was much easier to obtain reasonable yields on simple, good-quality bonds. Nowadays, however, it is much more difficult for fixed income investors to generate a sufficient income without taking additional credit or interest rate risk. That’s why our approach makes sense also for investors who prefer investing in the big household names: investing in higher-yielding subordinated debt of high-quality companies carries the same default risk as the more senior tranches issued by the same companies.

Let’s look at it another way: Bond investors are on a desperate search for yield. Investing in subordinated bonds of high-quality companies can provide these returns, whereas equities can disappoint. While investing in subordinated debt has always been rewarding, its higher income was more marginal compared to more plain vanilla bonds. Today, however, subordinated debt pays a multiple of senior debt. This means that the same capital can realise maybe three times as much income annually, which makes a huge difference for income-seeking institutions or individuals.

Is the current market environment favourable for your approach?

Jeremy Smouha:
The market environment is a difficult one for bond investors. Once interest rates start to rise, even if that may still be some while away, bond investors will start facing losses on their holdings. Our approach has three built-in buffers and hedges for that scenario: One is the high yield of 5% to 6% on our high-quality fixed-rate bonds. Interest rates would have to go up a lot for us to worry about suffering losses on those bonds. The interest rate hedge relates to our floating rate notes, which are trading at substantial discounts to their par value. When interest rates go up, this can generate capital gains, while their coupons will be re-fixed at higher rates. Finally, we also own a mixture of the two types of bonds mentioned, so-called fixed-to-floating securities. These pay attractive coupons, and the interest is fixed periodically, based on a certain spread above prevailing generic rates. Therefore, the interest rate risk exposure is limited to the time until reset, generally five to 10 years. Diversifying across these three types of securities should help anyone worried about the future path of interest rates.

Why are you not worried about defaults among your lower-rated bond holdings?

Gregoire Mivelaz:
While subordinated debt has lower ratings than its respective issuer, the majority of the holdings that we have in the fund are from strong investment grade companies. The examples given in the previous answer relate to the subordinated debt of high-quality investment grade companies. While we conduct our own fundamental analysis to judge whether they are good companies in which to own the debt, we can also be comforted by the investment grade ratings given to the companies’ senior debt by rating agencies, even if the subordinated debt is rated lower. Statistics show that the occurrence of bankruptcies among investment grade-rated companies is much lower than for high yield companies. And as long as they are not in distress, the subordinated coupons will be paid.

However, it is important to keep in mind that each issue is different and requires careful analysis of the terms of the issue. Each launch prospectus is different and requires very careful studying.

Why do you have a strong overweight in financial companies?

Anthony Smouha:
We invest in the most promising opportunities we can find. This has resulted in a strong bias to the structurally improving financial sector. The sector comprises hundreds of banks and non-banks, ranging from universal banks, to asset managers, brokers, life insurance and non-life insurance companies. We are diversified across all of these areas. Looking at banks in more detail, we think that they have improved significantly since the financial crisis and structural changes in the sector will offer a degree of protection should another shock occur.

Can you give us more detail on how banks have improved?

Grégoire Mivelaz:
Following the global financial crisis, the Basel III regulation has made banks much safer due to increased capital requirements. Banks had to simplify their business model, shutting down risky investment banking and trading departments, and now have to use more capital to underpin their remaining activities. This means that if the financial system comes under pressure again at some point, there is now a much bigger buffer of protection because the capital levels on risk-rated assets are much higher.

What is positive for us is that our legacy junior bonds, which had been issued under Basel II, are grandfathered securities, with no extension risk and no new supply making them like gold dust. Hence, the ongoing process of balance sheet strengthening has given our holdings a strong boost.

How do you manage risk in your funds?

Anthony Smouha:
Without going into too much detail: First of all, we only invest in what we understand and we avoid anything that we don’t understand. The understanding part also involves a detailed study of the issuance prospectus of each security.

Another key point is to keep it simple. Our funds are not leveraged. We don’t use derivatives to hedge our positions. Instead, if we don’t like a position anymore, because we have some doubts about how it might perform, we will simply sell it. In a complex and uncertain world, where you have at the same time in different parts of the world both inflation and deflation, both growth and recession, both loose and tight monetary policy, it is important to follow a simple strategy. We have been doing this for more than 30 years.

Finally, diversification is crucial for us: For example, within the financial sector we own a wide variety of businesses, such as insurers and reinsurers, asset managers, private banks and advisory companies. This philosophy was reinforced by the events of 2008. We have learnt some lessons and have further refined our research and risk management process. Individual holding sizes are smaller than they used to be and diversification is even more a priority. That way, we want to be prepared for whatever happens.

Any thoughts on Brexit? How do major unexpected negative events like this one impact your funds?

Jeremy Smouha:
We have seen events like Brexit already numerous times in the past. What typically happens is that we will see a short-term decline in fund values as uncertainty and volatility spike. We will then witness a rebound once some calm is returning to markets. And this is also what has occurred in the weeks following the Brexit vote.

We will usually swiftly take advantage of these sell-offs by picking up high-quality holdings whose prices are unjustifiably depressed by forced sellers. Our brokers know that we have the liquidity and are willing to buy at times when everyone else is selling. At times like these, having around 80% of issuers in the investment grade bucket also makes a huge difference when we see a flight-to-quality move in the market.

Looking back five years, how did the success story of the credit opportunities funds start?

Anthony Smouha:
The three funds were launched in 2011 in UCITS III format. This was to make them available to a much larger investor audience. The original funds, which had been in existence for many years before that, were offshore vehicles and hence not suitable for broad distribution. The introduction of the more flexible UCITS format allowed Atlanticomnium and GAM to convert the offshore funds into strictly regulated products that could be sold widely.

And finally, looking even further back, can you briefly talk us through the history of Atlanticomnium?

Anthony Smouha:
Ever since my father Richard Smouha founded Atlanticomnium in 1976, the approach was to find bond investments that offer the best future return potential, while being currently mispriced. It is a well-known fact that the reason for a mispricing often lies in investors’ perception. Something is being viewed as risky, because no effort is being made to properly analyse the asset. In the early years, this was the case with convertibles, later with other securities like dual-currency bonds, perpetuals and floating rate notes.

In 1985, the co-operation with GAM started with the launch of one bond fund. My brother Jeremy was a founding member of GAM in 1983. In 1992, I joined the firm to help with the rapid expansion of the business, taking on the role of co-managing the funds. In 2009, Grégoire Mivelaz joined the company to further broaden our investment capabilities.


Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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