Credit ratings and fallen angels

For CO the typical sweet spot for credit ratings is BBB flat to BBB minus. A single B minus would only be rarely traded on a tactical basis and not for carry. Investments in “fallen angels” – formerly investment grade names – have been based on careful bottom-up case by case selection and not a statistical or basket type approach. “We are mindful of refinancing risk for some fallen angels such as Auchan or Atos that are in a downward trajectory fundamentally, and this is more important than going up or down a notch on credit ratings,” points out Ploton.

Regular cash recycling

Short-dated bonds are always throwing off cash from coupons and bond redemptions. “We are constantly rolling pools of bonds to help limit trading cost frictions, which can become very high in stressed markets. We have received EUR 20-30 million of cash over the past 5-6 days in April. We might get 6-10% of the fund in cash one month and 3-5% the next month,” says Docq.

The timing and quantum of cash to recycle varies with the maturity of bonds, which is partly influenced by the yield curve. “When the curve was inverted 18 months ago, we earned extra yield from short-dated paper around 6 months maturity. Recently we have been mainly buying paper with 12-18 months’ maturity because we expected the ECB to cut rates,” says Ploton.

Wagering on calls

The fund generally holds bonds to maturity, which does usually mean maturity, but the managers also take a view on anticipated call dates prior to maturity. “We can even invest in perpetual hybrid paper where we have a high degree of confidence in it being called. The reasons include keeping an equity credit to optimize credit ratings in the agencies’ methodologies, and avoiding an expensive rate reset if bonds are not called. We can have as much as 10-25% of the portfolio invested in super junior paper issued by firms such as Enel, Orange or Vodafone. Issuers will call 99% of the time,” says Docq.

The team also spotted an interesting special opportunity for calls when interest rates were negative. “It was possible to earn as much as 1% over 30 days in banks’ AT1 bonds being called after other holders of these bonds wanted to rotate to other investments with more upside. We had total confidence as these bonds were already refinanced and they were issued by the biggest SIFI banks,” recalls Ploton.

Mindful of maturity extension risk

This was highly exceptional, however. “We would not normally take call risk on AT1 because banks have more discretion over the decision, and they can run into trouble very quickly as we saw with Credit Suisse. Banks also have less incentive to call AT1 than corporates despite often higher resets than hybrids as they are not incentivized by the equity credit mechanism,” explains Ploton.

“As soon as a bond gets out of the yield to call zone, duration and spread sensitivity suddenly jumps. If the bond market implied call probability diminishes enough, it could see a sharp decline in price on maturity extension risk,” Ploton warns. This happened to one bond in 2022: German real estate issuer, Around Town, which dropped as low as 30 cents but has eventually recovered to par. “We discussed it with our credit research team and decided to keep the bond. It initially recovered to 70 cents and offered a 5-cent coupon premium to exchange and extend maturity. What matters is how we handle these situations,” says Ploton.

Fundamental cashflow analysis

The strategy has an event driven element in anticipating calls, but the core of the approach is traditional fundamental cashflow analysis. “We limit the relatively high jump to default risk of a short duration fund through fundamental analysis of balance sheets,” says Ploton.

For instance, auto makers may seem risky to an investor in perpetual equity, but some of their debt seems much less risky. “Our short-dated focus means that we might find value in an industry such as car makers because we think they have plenty of cash to cover their shorter dated bonds,” says Docq.

The managers draw upon the expertise of a global credit team mainly in the US and Europe, but also in Asia where necessary. There are also weekly calls with the Global Fixed Income Teams.

Low or no leverage, and CDS

The strategy could be defined as unleveraged based on the long book since long exposure would not exceed 100% of NAV. Gross exposure can surpass 100% when short CDS is being used.

In theory the fund has the freedom to over-hedge long exposure, but this is unlikely; historically short CDS exposure has ranged between about 20% and 50%. Shorts are in effect financing longs rather than providing leverage.

Single name and index CDS can be used though the managers take care over absolute ex-ante volatility for index hedges.

“iTRAXX indices can be used as a broad portfolio level credit spread hedge, but we are mindful of the mark to market and correlation risk because there is a mismatch between our portfolio and the iTRAXX composition,” says Ploton.

Corporate CDS can sometimes provide a very cheap hedge, but sovereign CDS is not so easy for a UCITS. “UCITS regulations make it difficult to use sovereign CDS as a hedge. Since the 2011 sovereign debt crisis it has not been possible to be net short, the CDS would need to be covered by a cash bond,” explains Ploton. Prime brokers are used for CDS and security borrow.

IG versus HY

The balance between investment grade and high yield exposure has varied substantially: investment grade has ranged from less than half to nearly all of exposure.

“The perceived risk of the macro environment influences our decisions. When IG paper is cheaper, we can buy more. As spreads compress, we may find BB rated offers a better risk/reward,” says Docq.

Finding positive yields under ZIRP

Unlike some other funds, Allianz were disciplined in sidestepping negative yields before 2022. “During the period of negative interest rates, at one stage all senior corporate investment grade bonds out to 5 years were negative yielding and we just avoided them, even though our cash benchmark was also in negative territory. We instead managed to find some positive yields in BBB and crossover rated issuers offering a slightly positive return,” recalls Docq.

The fund would not entertain negative yielding paper for several reasons. It intends to hold until maturity and would generally not do a speculative short-term trade in the hope of profiting from “rolling down the curve”, partly because bid/offer spreads can eat up a lot of return in a shorter dated strategy. Leveraging at a more negative rate than the negative bond yield to try and extract a spread was also not feasible since, as aforementioned, the fund does not leverage its long book.

Incidentally, central bank asset purchases during the negative rates era have been of marginal importance. “The end of the European Central Bank’s ECB Corporate Sector Purchase Programme (CSPP) has not been especially relevant since most of the bonds owned were not eligible,” says Docq.

Rarely hedging rates

The fund does not normally take a non-consensus view on rates or the yield curve, partly because its duration exposure is so low anyway and any mark to market losses will usually be recovered within some months, or a year or two at most.

Opportunistic tactical strategies

The fund also runs some tactical and relative value strategies, but they are not always present because the opportunity set fluctuates.

One tactical strategy involves subscribing for new bond issues and selling them soon after issue. Incidentally, where monthly letters might show a 10-year bond this is probably a tactical new issue. New issue ‘flipping’ is quite counter cyclical. “Issuers generally need to offer a discount during challenging credit market conditions such as 2022. The discount is of course a moving target because there is a two-way feedback loop between primary and secondary markets: sometimes, new issues can reprice the secondary market,” observes Ploton. And sometimes the opportunity just disappears in both benign and challenging credit markets; there were no primary deals in the first week or so of April amid the tariff panic.

Cash versus CDS basis is another trade type with a somewhat intermittent opportunity set and it needs to heed the liquidity of single name CDS. “Liquidity is generally good for investment grade names but can vary a lot more for high yield. Cash versus CDS was used more previously when the fund was smaller,” says Docq.

Mean reversion and trend following trades on pairs of names are somewhat quantitatively based but also depend on the market regime and some fundamental bottom-up judgment. “If one sector is challenged, we do not want to play mean reversion,” says Ploton.

Mainly Eurobonds

The fund invests primarily in Euro denominated bonds. Even when other currency issues might appear to offer a premium after hedging back to Euros, the FX basis risk of fluctuating cross-currency swap spreads can eat up a lot of the yield for shorter dated paper. “The FX basis risk can change abruptly, especially at the front end, where there is also less of a credit spread that does not always compensate for costs of rolling hedges every one to three months,” points out Ploton. Euro-denominated bonds could include Eurobonds issued by US companies, such as cash rich Ford.

Additionally, the managers perceive that the extra return on UK or Nordic high yield as an illiquidity premium, which they would not take. “Specifically, the NOK and SEK bonds do not always meet our liquidity criteria of at least EUR 300 million of market capitalization and at least 7-8 dealer quotes,” explains Docq.

Risk limits survived Covid and 2022

The risk monitoring team can flag up potential breaches through a “shoulder tap” but this has not proved necessary so far. “Even in March 2020 and in 2022, the fund did not come close to its 2% volatility cap in terms of either forecast or realized volatility and easily paid some redemptions on time,” says Docq. Mark to market losses in 2022 were all recovered in 2023, which also benefited from a significant roll down and it was possible to reinvest in higher quality bonds at very cheap levels.

More value emerging

In early March 2025, European high yield credit spreads briefly touched the tightest levels since 2007, prompting the team to reduce exposure to some degree and add a small crossover index hedge. “The correction in risk assets, partly related to US tariffs and recession fears, is welcome in that better value can now be found at the front end,” says Docq.

Easy transition to SFDR article 8

On March 28, 2025, the fund transitioned to disclosing under the EU Sustainable Finance Disclosure Regulation (SFDR) article 8. This did not require any portfolio changes but will involve some more reporting of KPIs and DNSH (Do No Significant Harm) criteria. “We do not expect SFDR 8 will have any bad impact on performance,” says Ploton.