Our Hyper Active series explores how GAM Investments’ portfolio managers – across both equities and fixed income - aim to harness the potential of active management to deliver better results for clients.
27 September 2024
Our previous Hyper Active editions drew on our experience as an active asset manager, highlighting how Flavio Cereda, Niall Gallagher and Paul Markham look to capitalise on the power of active management in luxury brands, European and global equities respectively.
In this fourth edition, Romain Miginiac explains how he and his colleagues look to apply the active management advantage in the management of bond portfolios.
An active fixed income advantage: capitalising on extension risk in AT1 bonds
AT1 CoCos (Additional Tier 1 Contingent Convertible bonds) are perpetual bonds with call dates typically every five years. In theory, AT1 investors face potential extension risk, ie the risk of bonds not being called, especially when market conditions deteriorate and the cost of issuing a new AT1 becomes too expensive for banks. AT1s not being called tends to be seen as negative, as investors would require a higher yield to compensate for the longer holding period. In practice, however, European banks have a strong track record of being bondholder-friendly – as 95% of AT1 CoCos have been called at their first call date since the birth of the market. The rationale behind the sector’s behaviour is that maintaining strong relationships with bondholders should lead to lower funding costs over the long-term. Moreover, banks have significant flexibility to manage upcoming calls, eg issuing new AT1s six or 12 months before the call date to take advantage of market conditions, or even calling without refinancing.
The actual risk of non-call or extension for bondholders has been very limited. However, prices of AT1 CoCos have been very sensitive to the market’s perception of extension risk. At times when market sentiment is very strong, the majority of AT1 CoCos are priced to the first call date as investors assess a very low risk of non-calls. This leads to a rally in bond prices, as the required yield declines. Conversely, when market conditions are poor, investors require a higher yield to compensate for the higher perceived extension risk, leading to a drop in prices as bonds re-price to perpetuity. Market pricing of extension risk tends to be highly inefficient, as we have seen a repricing to perpetuity of the majority of AT1 CoCos several times over the past decade, despite 95% of AT1 CoCos that have always been called at first call date.
As active managers, we can exploit these inefficiencies by buying undervalued bonds when we believe that extension risk is overpriced. This mispricing presents an opportunity to generate alpha, as the potential upside has historically been very large when extension risk peaks. Moreover, when extension risk bottoms (very low levels of extension risk priced in), this provides a strong indicator that markets are priced to perfection, and that AT1 CoCos are vulnerable in case of weaker sentiment. Active managers can also take advantage of such market conditions by being positioned more defensively, for example moving up the capital structure (senior bonds, Tier 2s). Being more conservatively positioned not only reduces the potential downside risk, but also provides the ability to take advantage of potential price volatility as markets price in more extension risk.
Extension risk is a great buy or sell indicator
Chart 1: Percentage of AT1 CoCo market priced to perpetuity
Source: Atlanticomnium and Bloomberg, March 2024.
Past and current trends should not be relied upon as an indicator of future trends. The views are those of the manager and are subject to change. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.
Past and current trends should not be relied upon as an indicator of future trends. The views are those of the manager and are subject to change. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice.
Hence, periods of uncertainty can present attractive positioning opportunities for active managers to exploit, capitalising on the mispricing of extension risk and potentially generating significant alpha for investors employing an active management approach.
Romain Miginiac co-manages credit and climate bond strategies for GAM Investments
Keep following our Hyper Active series to learn more about the philosophy behind active management and how GAM Investments’ portfolio managers put the approach to work for our clients.
Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein 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 contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index.
The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein 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 contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index.
The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.