Bond navigators: Secured bonds – capturing credit conviction

Secured credit has long sat at the heart of Royal London Asset Management’s differentiated approach to fixed income investing. At its simplest, it means lending with a charge against assets rather than lending unsecured, giving investors a tangible claim that can improve visibility, control and recovery prospects in difficult market conditions.

But the real opportunity lies not simply in owning secured bonds. The specific nature of the collateral and the adjoining covenants can all materially impact outcomes. Most critically, we believe that understanding how and why the market perennially undervalues these elements provides the basis for identifying opportunities and embedding them into credit portfolios.

Security as a clear credit enhancement

In fixed income, the risk and return profile is inherently asymmetric – the gain is contractually fixed, while the downside can be significant if things go wrong. Certain credit enhancements can reduce this skew. Security gives bondholders a claim over assets and can enshrine their position in the payment hierarchy, while protective covenants offer early warning mechanisms and dynamic controls if collateral values deteriorate or borrower behaviour changes. Get the right combination of security and covenants interacting effectively and in our view, the credit equation can be materially rebalanced in creditors’ favour. This is always useful, but particularly valuable during periods of heightened uncertainty.

In our view, the credit equation can be materially rebalanced in creditors’ favour.

However, secured credit is not a passive top-down allocation. Not all security is equal, and not all covenants work equally. The level of enhancement always depends on the legal enforceability of the security, the quality and appropriateness of the collateral, the robustness of cashflows, and the commercial and legal realities of the covenant package. This creates a higher research hurdle. However, in our view, the extent to which creditor conviction can be enhanced, relative to the range of potential outcomes for unsecured creditors, offers real return on the extra effort. And that’s before we acknowledge the most compelling aspect of secured credit – its underappreciation by the wider credit market.

Enduring market inefficiencies

The evolution of credit markets from an investment backwater to the critical engine room for cashflow and liability matching has also driven a commoditisation of corporate bonds. If you are trying to meet a defined solution in a spreadsheet, standardisation is seductive. As a consequence, familiarity and convention are cherished whilst idiosyncrasy and nuance are distrusted. In a market dominated by unsecured corporate bonds with point-in-time credit ratings that permit entry into a bond index – and onto the buying lists of burgeoning passive ETFs, fixed maturity propositions and annuity funds – heavily covenanted and secured credit is considered an oddity. 

The net result? More superficial characteristics are coveted, whilst truly supportive fundamentals can be overlooked. For active investors, with the motivation and ability to identify such mispricing, there is a clear opportunity to build credit funds off the most stable foundations, elevating both the resilience and level of potential returns.

Superficial characteristics are coveted, whilst truly supportive fundamentals can be overlooked.

From this base, portfolios can be further enhanced by eschewing the modern segmentation of credit markets. Investment silos that have emerged around corporate bond and ABS teams are an unnecessary and artificial construct, and there is real benefit from embracing the wider opportunity from diversity.

Specifically, while we believe that a portfolio combining secured and unsecured credit is already materially stronger than a conventional unsecured portfolio, selectively adding high-quality securitisations – ring-fenced and typically floating-rate securities – can improve diversification and resilience further. This also avoids the some of the risks that can befall rigid ABS-only funds, such as sector concentration, subordination and unanticipated payment extension.  

Embracing the credit opportunity

For our broad sterling credit strategy, secured bonds are a material part of the overall portfolio. For a ‘pure’ representation of our credit philosophy, the RL Diversified Asset Backed Credit Fund is perhaps the best example.  As a starting point, by hedging interest rate exposure, we can isolate and extract credit spread from a broader range of maturities and across both fixed-rate and floating-rate bonds – usefully expanding the opportunity set and allowing our credit specialists to focus on finding the best credits. From here, the fund’s core allocation is senior secured corporate bonds, diversified across a wide range of sectors including social housing, infrastructure, real estate and other asset-rich industries, supplemented by select, less commoditised securitisations and our highest conviction unsecured credit ideas.

The underlying approach has been developed by an experienced team motivated to identify opportunities from a wider array of bonds than is typically seen in narrower ABS and credit strategies. And at all stages, from its origin through to its design and execution, the fund has been built to convert deep credit conviction into resilient income and return. More details on this can be found in our fund centre.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. Reference to any security is for information purposes only and should not be considered a recommendation to buy or sell.

The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change. Forward looking statements are subject to certain risks and uncertainties. Actual outcomes may be materially different from those expressed or implied. 

The Fund is a sub-fund of Royal London Bond Funds ICVC, an open-ended investment company with variable capital with segregated liability between sub-funds, incorporated in England and Wales under registered number IC000797. The Authorised Corporate Director (ACD) is Royal London Unit Trust Managers Limited, authorised and regulated by the Financial Conduct Authority, with firm reference number 144037. For more information on the fund or the risks of investing, please refer to the Prospectus or Key Investor Information Document (KIID), available via the relevant Fund Information page on www.rlam.com.

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