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Credit analysts, canaries in GFC mineshaft, could reprise that role when next sell-off unfolds

Credit analysts played a "canary in the mineshaft" role in the run-up to the global financial crisis, helping a number of money management firms position their portfolios to better weather the storm and grow strongly coming out of it.

Those analysts might be poised to reprise that role when the next crisis dawns, amid an anticipated dearth of liquidity that could make bond markets far more volatile, some industry veterans said.

The global financial crisis "started as a fixed-income problem" long before equity markets barreled to record highs in October 2007, said Michael Roberge, the CEO and chief investment officer of MFS Investment Management, Boston.

MFS executives didn't anticipate the ferocity of the crisis, but the firm's structured credit group spotted the signs of stress in fixed-income markets and "communicated that across our whole platform" — a benefit of the integrated nature of MFS' bond and equity teams, Mr. Roberge said.

As a result, the firm's bond and equity portfolios didn't have exposure to ill-fated companies such as New York-based mortgage lender Countrywide Financial Corp. or Seattle-based Washington Mutual Inc.

MFS came through the crisis with benchmark-beating performance, positioning the firm to take market share over the past decade, he said.

Over the three years through the end of 2009, annualized returns for MFS' core U.S. equity, global equity and international equity composites exceeded their respective benchmark indexes by between 4.68 and 5.09 percentage points, while its U.S. credit composite bested the Bloomberg Barclays U.S. credit bond index by an annualized 1.28 percentage points.

MFS reported assets under management of $491.1 billion at the end of 2017, up close to 150% from $197.7 billion a decade before.

Edward C. Bernard, vice chairman of Baltimore-based T. Rowe Price Group Inc., told a similar story.

Susan Troll, a T. Rowe credit analyst, "made the rounds" of large mortgage originators and the firms packaging those securities, and found so much creative underwriting by late 2006 and early 2007 that she warned colleagues not to get anywhere near subprime, Mr. Bernard said.

And they listened. "We essentially had no exposure to subprime debt in our fixed-income business," he said, adding that Ms. Troll continues to do great work for the firm.

T. Rowe's fixed-income portfolios outperformed during the crisis, and its equity portfolios likewise beat their benchmarks by four or five points — relative outperformance in what was still, certainly, a painful year, he said.

At the bottom of the crisis, T. Rowe's AUM, which was around $400 billion in October 2007, dropped to $267 billion. "We're at a trillion now," said Mr. Bernard, a healthy gain for a period where passive money managers have been the dominant asset gatherers.

Thomas Finke became chairman and CEO of Babson Capital Management LLC in December 2008, promoted from president and, before that, head of the firm's U.S. bank loan team. Mr. Finke said his investment team — amid growing signs of distress in fixed-income markets — began positioning the firm's portfolios defensively through 2006 and 2007.

When market volatility exploded in 2008, Mr. Finke said the biggest question for him — in managing sizable Babson businesses in segments such as collateral loan obligations and high-yield bonds — was: "Do you manage through this or sell it all out?"

Helped by Babson's defensive positioning in the lead-up to the crisis, "we managed through it," he said.

For example, some CLO managers got badly hurt allocating 20% to 25% of their portfolios to second-lien loans — which offer relatively high yields but can claim a bankrupt company's assets only after first-lien paper holders are made whole. The typical Babson CLO had only 3% exposure, said Mr. Finke.

While not exactly a comfortable situation to work through, "we felt we knew what we were doing," he said, adding, "I had all the confidence in the world in our team to effectively manage their defaults when they came about."

The CLO business of Babson — now Barings LLC, following a September 2016 merger of Springfield-based Massachusetts Mutual Life Insurance Co.'s four money management affiliates — stands around $22 billion today, within a global high-yield business of more than $60 billion, up from $15 billion in CLOs going into the crisis, Mr. Finke said.

If adopting a defensive posture in credit markets was a key to doing relatively well as the crisis unfolded, taking advantage of that sector's bargains as asset owners dumped their holdings throughout 2008 set the stage for heady gains going into 2009, market veterans said.

At Mercer LLC, "we were (looking) for risk-return opportunities that arose (and one) that we started talking about at the end of 2008 was investment-grade bonds," said Deb Clarke, Mercer Investment Consulting's London-based global head of investment research. "We got a lot of clients into that and they did very well," she said.

Market veterans say having bond market veterans who can sniff out impending storms could prove useful again in the not-too-distant future, even if the events seen in the lead-up to the last crisis are unlikely to repeat themselves.

The next war will be different from the last one, predicted Brian McDonnell, the Boston-based head of Cambridge Associates LLC's global pension practice. The U.S. banking system is "massively" healthier today — far less leveraged and backed by much higher quality assets, he said.

But the same regulatory framework that has made banks less vulnerable has made the fixed-income market itself less liquid, with banks no longer maintaining big proprietary market positions, said Mr. McDonnell. And with so many investors reaching for yield in credit markets now, there is growing concern about the implications that diminished liquidity could have the next time the market cycle turns, he said.

MFS' Mr. Roberge cited reasons to be concerned. Corporate debt today is "significantly higher than it was" a decade ago, and leverage "is ticking back up to 2007 levels" even as fixed-income liquidity is lower than it was in prior cycles, he said.

A systemic crisis is unlikely, but the next cycle could be "tough," Mr. Roberge said.

That prospect has left MFS "really, really focused on the downside now" — willing to position its portfolios defensively even if that weighs on short-term performance. "You give up a little bit of return but if you're right, you can significantly outperform," he said.

Other fixed-income veterans said they're preparing for higher volatility and lower base-case returns. "In 2006, we reduced risk aggressively," noted Daniel Ivascyn, chief investment officer at Pacific Investment Management Co. in Newport Beach, Calif. "We aren't nearly as cautious today but we are alert about it," he said.

"You have to be early," said Mr. Roberge. "What happens is going to happen quickly."

He noted that MFS' compensation structure — emphasizing three-, five- and 10-year returns — allows the firm's portfolio managers and analysts to take the long view.

Senior reporter Rick Baert contributed to this article.