As the Hermes Global High Yield, Global Investment Grade, Multi-Strategy and Absolute Return Credit strategies hit key milestones, Fraser Lundie CFA, Co-Head of Credit at Hermes Investment Management, explains how a rigorous investment process has allowed them to weather volatile storms.
Marking new milestones
This month, our Global High Yield Credit, Multi-Strategy Credit and Absolute Return Credit capabilities mark their eight-, five- and three-year anniversaries, respectively and in July, our Global Investment Grade Strategy will celebrate its eight-year anniversary. These four strategies have the following aims:
- Global High Yield Credit: generate a high level of income by investing primarily in a diversified portfolio of high-yield bonds. Since its May 2010 inception, it has consistently delivered top-quartile returns.
- Global Investment Grade: generate consistent, positive returns with low volatility by investing globally in investment-grade credit instruments.
- Multi-Strategy Credit: capture the majority of the high-yield market’s upside while minimising downside risk.
- Absolute Return Credit: consistently generate positive returns irrespective of the market direction, across asset classes and geographies with an investment-grade risk profile.
Note: Targets cannot be guaranteed.
Since the launch of these strategies, we have invested through tumultuous economic episodes and periods of geopolitical uncertainty while delivering on mandates:
Volatility is back (2018): In the first half of 2018, credit investors faced a period of heightened geopolitical risk, including the US-China trade dispute, North Korean nuclear tensions, and the re-imposition of US nuclear sanctions on Iran. Such risks contributed to the re-emergence of volatility in February – the fourth largest spike in volatility since 1995. Thanks to our proven investment approach, we were able to navigate through this period with optimal risk management and dynamic sizing of positions as regimes changed.
Calm between storms (2017): For credit investors, 2017 was largely characterised by rallying markets. In this benign environment, we aimed to optimise the convexity of our credit exposure to maximise upside capture. We increased returns by taking positions further along the credit curve and by finding attractive opportunities in unloved sectors, such as US retail.
Fundamental focus (2016): Through intensive bottom-up research, we executed contrarian trades such as our investments in the global mining sector in early 2016, which was still experiencing a cyclical downturn. Anticipating creditor-friendly moves by stronger companies to bolster their balance sheets by cutting dividends, reducing capital expenditure and selling assets, we increased our exposure to the sector. Throughout 2016, this contributed strongly to our overall return, showing the benefit of favouring fundamentals instead of prevailing sentiment.
Avoiding the lows of high yield (2015): In Q3 2015, amid growing certainty that the Fed would raise rates for the first time in almost a decade, liquidity fears spurred a global high-yield sell off that drove the market -4.50% lower for the quarter. In the preceding months, we increased our investment-grade credit and leveraged-loan allocation to 30% of the portfolio, and this exposure to higher quality assets preserved capital during a period of market stress and helped drive our 1.05% return for Multi-Strategy Credit in 2015.
Tapping the good oil (2014): In October 2014, oil prices began to fall precipitously after OPEC refused to halt production despite global oversupply. This adverse impact on the US shale market, where many producers were highly leveraged due to higher operational costs, would soon be felt in the credit market. Two months before oil prices began to slide, we cautioned that investors should be particularly selective in the North America shale oil and gas market as it featured many entrants with uncertain long-term prospects. We avoided these stressed companies and exploited the breadth of our universe by investing in more mature commodity businesses with proven operations and reserves, and in undervalued but robust oil companies in the politically beleaguered Russian market.
The taper test (2013): In Q2 2013, when the Fed first indicated that it would reduce quantitative easing after almost five years, the market’s acute sensitivity to changes in US interest rates became clear. Fear of a rate hike had already caused overcrowding in short-duration bonds, and this strong demand allowed issuers to introduce looser covenants and shorter non-call periods. We were unwilling to accept the consequent risks – high valuations, weaker investor protections and diminished upside – and invested in credit default swaps of companies instead to gain a similar short-duration exposure.
A proven track record
Our dynamic approach to global credit has driven strong risk-adjusted returns across our diversified range of high-conviction strategies, as evidenced by their Sharpe ratios, despite macroeconomic and technical market shocks (see figure 2 and 3).
Figure 2: The performance of our strategies since inception
|Strategy||Inception date||Three-year cumulative returns (gross)||Since inception cumulative returns (gross)||Since Inception Sharpe Ratio|
|Global High Yield||1 June 2010||25%||91%||1.2|
|Multi-Strategy Credit||1 June 2013||15%||30%||1.6|
|Investment Grade||1 July 2010||15%||47%||1.3|
|Absolute Return||1 June 2015||7.0%||7.0%||1.5|
Source: Hermes as at 31 May 2018. Past performance is not a reliable guide to future performance. 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.
Although geopolitical risks, US dollar strength, and continued monetary policy normalisation by the Fed are the key forces at play in the current investment landscape, our focus will be on continuing to identify strategic and tactical opportunities to generate alpha and preserve capital.
Figure 3: Liquid credit net annualised returns
Figure 4: Rolling Performance
|Strategy||31/05/17 to 31/05/18||31/05/16 to 31/05/17||31/05/15 to 31/05/16||31/05/14 to 31/05/15||31/05/13 to 31/05/14|
|Global High Yield||2.42%||12.21%||-1.66%||3.36%||10.83%|
Source: Hermes as at 31 May 2018. All performance shown is in USD net of fees.
It should be noted that any investments overseas may be affected by currency exchange rates.
Where the strategy invests in debt instruments (such as bonds) there is a risk that the entity who issues the contract will not be able to repay the debt or to pay the interest on the debt. If this happens then the value of the strategy may vary sharply in value or result in loss. The strategy makes extensive use of Financial Derivative Instruments (FDIs), the value of which depends on the performance of an underlying asset. Small changes in the price of that asset may cause larger changes in the value of the FDIs, increasing either potential gain or loss.
Taking control of compliance: how FS institutions can keep up with the ever-changing regulatory landscape
By Charles Southwood, Regional VP – Northern Europe and MEA at Denodo
The wide-spread digital transformation that has swept the financial services (FS) sector in recent years has brought with it a world of possibilities. As traditional financial institutions compete with a fresh wave of challenger banks and fintech startups, innovation is increasing at an unprecedented pace.
Emerging technologies – alongside the ever-evolving concept of online banking – have provided a platform in which the majority of customer interactions now take place in a digital format. The result of this is a never-ending stream of data and digital information. If used correctly, this data can help drive customer experience initiatives and shape wider business strategies, giving organisations a competitive edge.
However, before FS organisations can utilise data-driven insights, they need to ensure that they can adequately protect and secure that data, whilst also complying with mandatory regulatory requirements and governance laws.
The regulation minefield
Regulatory compliance in the FS sector is a complex field to navigate. Whether its potential financial fraud or money laundering, risk comes in many different forms. Due to their very nature – and the type of data that they hold – FS businesses are usually placed under the heaviest of scrutiny when it comes to achieving compliance and data governance, arguably held to a higher standard than those operating in any other industry.
In fact, research undertaken last month discovered that the General Data Protection Regulation (GDPR) has had a greater impact on FS organisations than any other sector. Every respondent working in finance reported that the changes made to their organisation’s cyber security strategies in the last three years were, at least to some extent, as a result of the regulation.
To make matters even more confusing, the goalpost for 100% compliance is continually moving. In fact, between 2008 and 2016, there was a 500% increase in regulatory changes in developed markets. So even when organisations think they are on the right track, they cannot afford to become complacent. The Markets in Financial Instruments Directive (MiFID II), the requirements for central clearing and the second Payment Service Directive (PSD2), are just some examples of the regulations that have forced significant changes on the banking environment in recent years.
Keeping a handle on this legal minefield is only made more challenging by the fact that many FS organisations are juggling an unimaginable amount of data. This data is often complex and of poor quality. Structured, semi-structured and unstructured, it is stored in many different places – whether that’s in data lakes, on premise or in multi-cloud environments. FS organisations can find it extremely difficult just to find out exactly what information they are storing, let alone ensure that they are meeting the many requirements laid out by industry regulations.
A secret weapon
Modern technologies, such as data virtualisation, can help FS organisations to get a handle on their data – regardless of where it is stored or what format it is in. Through a single logical view of all data across an organisation, it boosts visibility and real-time availability of data. This means that governance, security and compliance can be centralised, vastly improving control and removing the need for repeatedly moving and copying the data around the enterprise. This can have an immediate impact in terms of enabling FS organisations to avoid data proliferation and ‘shadow’ IT.
In addition to this, when a new regulation is put in place, data virtualisation provides a way to easily find and access that data, so FS organisations can respond – without having to worry about alternative versions of that data – and ensures that they remain compliant from the offset. This level of control can be reflected even down to the finest details. For example, it is possible to set up access to governance rules through which operators can easily select who has access to what information across the organisation. They can alter settings for sharing, removing silos, masking and filtering through defined, role-based data access. In terms of governance, this feature is essential, ensuring that only those who have the correct permissions to access sensitive information are able to do so.
Compliance is a requirement that will be there forever. In fact, its role is only likely to increase as law catches up with technological advancement and the regulatory landscape continues to change. For FS organisations, failure to meet the latest legal requirements could be devastating. The monetary fines – although substantial – come second to the potential reputation damage associated with non-compliance. It could be the difference between an organisation surviving and failing in today’s climate.
No one knows what is around the corner. Whilst some companies may think they are ahead of the compliance game today, that could all change with the introduction of a new regulation tomorrow. The best way to ensure future compliance is to get a handle on your data. By providing total visibility, data virtualisation is helping organisations to gain back control and win the war for compliance.
TCI: A time of critical importance
By Fabrice Desnos, head of Northern Europe Region, Euler Hermes, the world’s leading trade credit insurer, outlines the importance of less publicised measures for the journey ahead.
After months of lockdown, Europe is shifting towards rebuilding economies and resuming trade. Amongst the multibillion-euro stimulus packages provided by governments to businesses to help them resume their engines of growth, the cooperation between the state and private sector trade credit insurance underwriters has perhaps missed the headlines. However, this cooperation will be vital when navigating the uncertain road ahead.
Covid-19 has created a global economic crisis of unprecedented scale and speed. Consequently, we’re experiencing unprecedented levels of support from national governments. Far-reaching fiscal intervention, job retention and business interruption loan schemes are providing a lifeline for businesses that have suffered reductions in turnovers to support national lockdowns.
However, it’s becoming clear the worst is still to come. The unintended consequence of government support measures is delaying the inevitable fallout in trade and commerce. Euler Hermes is already seeing increase in claims for late payments and expects this trend to accelerate as government support measures are progressively removed.
The Covid-19 crisis will have long lasting and sometimes irreversible effects on a number of sectors. It has accelerated transformations that were already underway and had radically changed the landscape for a number of businesses. This means we are seeing a growing number of “zombie” companies, currently under life support, but whose business models are no longer adapted for the post-crisis world. All factors which add up to what is best described as a corporate insolvency “time bomb”.
The effects of the crisis are already visible. In the second quarter of 2020, 147 large companies (those with a turnover above €50 million) failed; up from 77 in the first quarter, and compared to 163 for the whole of the first half of 2019. Retail, services, energy and automotive were the most impacted sectors this year, with the hotspots in retail and services in Western Europe and North America, energy in North America, and automotive in Western Europe
We expect this trend to accelerate and predict a +35% rise in corporate insolvencies globally by the end of 2021. European economies will be among the hardest hit. For example, Spain (+41%) and Italy (+27%) will see the most significant increases – alongside the UK (+43%), which will also feel the impact of Brexit – compared to France (+25%) or Germany (+12%).
Companies are restarting trade, often providing open credit to their clients. However, there can be no credit if there is no confidence. It is increasingly difficult for companies to identify which of their clients will emerge from the crisis from those that won’t, and whether or when they will be paid. In the immediate post-lockdown period, without visibility and confidence, the risk was that inter-company credit could evaporate, placing an additional liquidity strain on the companies that depend on it. This, in turn, would significantly put at risk the speed and extent of the economic recovery.
In recent months, Euler Hermes has co-operated with government agencies, trade associations and private sector trade credit insurance underwriters to create state support for intercompany trade, notably in France, Germany, Belgium, Denmark, the Netherlands and the UK. All with the same goal: to allow companies to trade with each other in confidence.
By providing additional reinsurance capacity to the trade credit insurers, governments help them continue to provide cover to their clients at pre-crisis levels.
The beneficiaries are the thousands of businesses – clients of credit insurers and their buyers – that depend upon intercompany trade as a source of financing. Over 70% of Euler Hermes policyholders are SMEs, which are the lifeblood of our economies and major providers of jobs. These agreements are not without costs or constraints for the insurers, but the industry has chosen to place the interests of its clients and of the economy ahead of other considerations, mindful of the important role credit insurance and inter-company trade will play in the recovery.
Taking the UK as an example, trade credit insurers provide cover for more than £171billion of intercompany transactions, covering 13,000 suppliers and 650,000 buyers. The government has put in place a temporary scheme of £10billion to enable trade credit insurers, including Euler Hermes, to continue supporting businesses at risk due to the impact of coronavirus. This landmark agreement represents an important alliance between the public and private sectors to support trade and prevent the domino effect that payment defaults can create within critical supply chains.
But, as with all of the other government support measures, these schemes will not exist in the long term. It is already time for credit insurers and their clients to plan ahead, and prepare for a new normal in which the level and cost of credit risk will be heightened and where identifying the right counterparts, diversifying and insuring credit risk will be of paramount importance for businesses.
Trade credit insurance plays an understated role in the economy but is critical to its health. In normal circumstances, it tends to go unnoticed because it is doing its job. Government support schemes helped maintain confidence between companies and their customers in the immediate aftermath of the crisis.
However, as government support measures are progressively removed, this crisis will have a lasting impact. Accelerating transformations, leading to an increasing number of company restructurings and, in all likelihood, increasing the level of credit risk. To succeed in the post-crisis environment, bbusinesses have to move fast from resilience to adaptation. They have to adopt bold measures to protect their businesses against future crises (or another wave of this pandemic), minimize risk, and drive future growth. By maintaining trust to trade, with or without government support, credit insurance will have an increasing role to play in this.
What Does the FinCEN File Leak Tell Us?
By Ted Sausen, Subject Matter Expert, NICE Actimize
On September 20, 2020, just four days after the Financial Crimes Enforcement Network (FinCEN) issued a much-anticipated Advance Notice of Proposed Rulemaking, the financial industry was shaken and their stock prices saw significant declines when the markets opened on Monday. So what caused this? Buzzfeed News in cooperation with the International Consortium of Investigative Journalists (ICIJ) released what is now being tagged the FinCEN files. These files and summarized reports describe over 200,000 transactions with a total over $2 trillion USD that has been reported to FinCEN as being suspicious in nature from the time periods 1999 to 2017. Buzzfeed obtained over 2,100 Suspicious Activity Reports (SARs) and over 2,600 confidential documents financial institutions had filed with FinCEN over that span of time.
Similar such leaks have occurred previously, such as the Panama Papers in 2016 where over 11 million documents containing personal financial information on over 200,000 entities that belonged to a Panamanian law firm. This was followed up a year and a half later by the Paradise Papers in 2017. This leak contained even more documents and contained the names of more than 120,000 persons and entities. There are three factors that make the FinCEN Files leak significantly different than those mentioned. First, they are highly confidential documents leaked from a government agency. Secondly, they weren’t leaked from a single source. The leaked documents came from nearly 90 financial institutions facilitating financial transactions in more than 150 countries. Lastly, some high-profile names were released in this leak; however, the focus of this leak centered more around the transactions themselves and the financial institutions involved, not necessarily the names of individuals involved.
FinCEN Files and the Impact
What does this mean for the financial institutions? As mentioned above, many experienced a negative impact to their stocks. The next biggest impact is their reputation. Leaders of the highlighted institutions do not enjoy having potential shortcomings in their operations be exposed, nor do customers of those institutions appreciate seeing the institution managing their funds being published adversely in the media.
Where did the financial institutions go wrong? Based on the information, it is actually hard to say where they went wrong, or even ‘if’ they went wrong. Financial institutions are obligated to monitor transactional activity, both inbound and outbound, for suspicious or unusual behavior, especially those that could appear to be illicit activities related to money laundering. If such behavior is identified, the financial institution is required to complete a Suspicious Activity Report, or a SAR, and file it with FinCEN. The SAR contains all relevant information such as the parties involved, transaction(s), account(s), and details describing why the activity is deemed to be suspicious. In some cases, financial institutions will file a SAR if there is no direct suspicion; however, there also was not a logical explanation found either.
So what deems certain activities to be suspicious and how do financial institutions detect them? Most financial institutions have sophisticated solutions in place that monitor transactions over a period of time, and determine typical behavioral patterns for that client, and that client compared to their peers. If any activity falls disproportionately beyond those norms, the financial institution is notified, and an investigation is conducted. Because of the nature of this detection, incorporating multiple transactions, and comparing it to historical “norms”, it is very difficult to stop a transaction related to money laundering real-time. It is not uncommon for a transaction or series of transactions to occur and later be identified as suspicious, and a SAR is filed after the transaction has been completed.
FinCEN Files: Who’s at Fault?
Going back to my original question, was there any wrong doing? In this case, they were doing exactly what they were required to do. When suspicion was identified, SARs were filed. There are two things that are important to note. Suspicion does not equate to guilt, and individual financial institutions have a very limited view as to the overall flow of funds. They have visibility of where funds are coming from, or where they are going to; however, they don’t have an overall picture of the original source, or the final destination. The area where financial institutions may have fault is if multiple suspicions or probable guilt is found, but they fail to take appropriate action. According to Buzzfeed News, instances of transactions to or from sanctioned parties occurred, and known suspicious activity was allowed to continue after it was discovered.
How do we do better? First and foremost, FinCEN needs to identify the source of the leak and fix it immediately. This is very sensitive data. Even within a financial institution, this information is only exposed to individuals with a high-level clearance on a need-to-know basis. This leak may result in relationship strains with some of the banks’ customers. Some people already have a fear of being watched or tracked, and releasing publicly that all these reports are being filed from financial institutions to the federal government won’t make that any better – especially if their financial institution was highlighted as one of those filing the most reports. Next, there has been more discussion around real-time AML. Many experts are still working on defining what that truly means, especially when some activities deal with multiple transactions over a period of time; however, there is definitely a place for certain money laundering transactions to be held in real time.
Lastly, the ability to share information between financial institutions more easily will go a long way in fighting financial crime overall. For those of you who are AML professionals, you may be thinking we already have such a mechanism in place with 314b. However, the feedback I have received is that it does not do an adequate job. It’s voluntary and getting responses to requests can be a challenge. Financial institutions need a consortium to effectively communicate with each other, while being able to exchange critical data needed for financial institutions to see the complete picture of financial transactions and all associated activities. That, combined with some type of feedback loop from law enforcement indicating which SARs are “useful” versus which are either “inadequate” or “unnecessary” will allow institutions to focus on those where criminal activity is really occurring.
We will continue to post updates as we learn more.
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