Independent Thinking^®

Q&A with Muzinich

Editor’s note: Evercore Wealth Management supplements its core investment capabilities with carefully selected outside funds across the range of the firm’s asset classes.

Here is the second Independent Thinking interview with Michael McEachern, the manager of the Muzinich Credit Opportunities Fund; the last was in 2015. This fund seeks to deliver high-yield income and capital appreciation by investing in corporate bonds, both below-investment grade and investment grade, and in bank loans and floating rate loans issued by U.S. and foreign corporations. We believe this fund complements Evercore Wealth Management’s proprietary, high grade, tax-exempt bond strategy by dynamically managing global corporate credit exposure.
 
Q: Let’s start with the interest rate outlook. As a global fixed income portfolio manager, what are you thinking now about negative interest rates? Are you concerned about the inverted yield curve?
 
A: Negative interest rates are a dominant issue in managing global fixed income. The questions now are: “How long will European and Japanese rates stay negative?” and “Will U.S. interest rates follow?” It seems to us that, for the foreseeable future, developed global economies will be in a negative yielding/low rate environment. We see global growth slowing as the economic cycle matures; coupled with a benign inflation outlook, our overall conclusion is to be longer duration. We are concerned about the yield curve showing bouts of inversion; however, given that this current late cycle lacks the typical late cycle investor concerns about inflation and growth, we feel the yield curve shape could remain in this generally flatter structure for some time and may not necessarily provide a clear signal about an impending recession. Nonetheless, the yield curve is signaling caution, and credit portfolios should be positioned accordingly.
 
Q: How do you see the role of fixed income in balanced portfolios changing in an era of persistently low global yields?
 
A: Central banks are encouraging more risk-taking in stocks and bonds with their negative/low interest rate policies. This has created an environment where absolute yield levels are historically low and look relatively unattractive. We believe that while interest rates will stay relatively low for the foreseeable future, market volatility will not, and fixed income will therefore continue to play a meaningful role in balanced portfolios. We think that while opportunities are relatively limited in credit at the moment, credit spreads will continue to be affected by economic and geopolitically driven volatility, which would provide opportunities for credit investors over time.
 
Q: The exposure to interest rate risk in the fund is at an all-time high since the fund’s inception in 2013. Why are you positioned this way, and what would cause you to move to a lower interest rate duration?
 
A: The strategy reflects our view that we are in the later stages of a prolonged economic cycle. Global growth is slowing, and inflation remains subdued. Interest rates have fallen globally this year, reflecting both the lack of inflation and central bank efforts to stimulate economic growth. We identified this “slowdown” theme late last summer and began moving duration out, using a combination of high-quality corporates and U.S. Treasuries.
 
While we continue to believe this theme represents our base long-term assumption, we review a mix of macroeconomic data and bottom-up company-specific data to understand if a growth theme might be possible. If we were to conclude that longer-term growth could turn higher, then we would reduce the duration range in which we manage the strategy. In addition, if long-duration corporate credit spreads were to move from attractive to unattractive as measured by our fundamentals, technicals, and valuation review process, we would reduce our spread duration. This is all part of our tactical credit process for best positioning the portfolio for what we think lies ahead.
 
Q: The fund can invest internationally, in domestic, European and emerging markets, and also across sectors, including high-yield and investment-grade corporate bonds, leveraged loans and Treasuries. On what basis do you determine the fund’s positioning among these different geographic regions and sectors?
 
A: We use a top-down approach as the basis for a good portion of the portfolio positioning. While we use the phrase “topdown,” our real emphasis is on identifying emerging top-down themes developing across or within the global credit markets. Macroeconomic trends are definitely an important part of our investment decision process; our global growth outlook, central bank policies, and geopolitical frictions influence our broader allocation to credit risk. But identifying emerging credit themes developed from both the top-down perspective and bottom-up credit analysis are where we feel we have the most success.
 
Q: The fund can invest in companies based anywhere in the world but does not take on foreign currency exposure. How does that work?
 
A: Muzinich typically hedges currency using a series of 1-4 months rolling forward, back to an account’s base currency. We note, importantly, that we are only speaking about hedging hard currency purchases (USD, EUR, GBP, and CHF typically) as for emerging market credits; we avoid local currency issues where we would be less confident that results actually reflect company credit risk that we can measure – and get paid for appropriately. We also have clients who, in a separate account, prefer currency remain unhedged as they use a currency overlay manager, or those who ask us to hedge to a global benchmark blend. However, we consider the cost or benefit of hedging transactions in thinking about total return potential in different markets in which we invest. Currency is generally not an active source of investment income. We believe there are far more efficient platforms for betting on currency markets, and that our preference for delivering low-volatility returns can be better managed through a credit-intensive approach.
 
Currency hedges have been systemic – not strategic – in the portfolio. We are always targeting being nearly 100% hedged, such that hedges are largest when we are most committed to the value added by investments in non-USD currencies. Currency hedging is not a strategic decision undertaken by the portfolio manager but is rather conducted systemically by members of the risk team. Portfolio managers make investment choices with consideration of the anticipated total return of a bond or market, including the cost or benefit of any required currency hedging, in their hunt for best relative value.
 
Q: How do you manage risk within the portfolio?
 
A: From an investment strategy perspective, Muzinich considers the most significant areas of investment risk, in order of importance, to be asset allocation risk, company-specific credit risk, industry risk, credit spread duration, interest rate risk, geographic risk, and liquidity risk.

• Asset allocation risk: The strategy’s tactical nature gives it the flexibility to move in and out of asset classes in response to shifting market conditions and risk levels. The firm’s asset allocation process is an output of the investment team’s analysis of bond markets based on relative value views across and within sectors of the fixed income markets. In addition to their fundamental research, the investment team also implements a Z-score analysis to target objective evaluation of the relative value of different asset classes and to distinguish valuation inefficiencies between asset classes. The Z-score analysis shows how today’s price (spread) compares vs. the average price over the last 180 days (smoothed price). It relies on the theory of mean-reverting behavior of asset classes relative to their historical average. It serves as a monitoring tool and is supplemental to the firm’s fundamental research.
• Company-specific risk: Key to risk control is the proper selection and monitoring of the individual securities in each portfolio. Muzinich uses its research capabilities to proactively manage company-specific risk by monitoring our financial projections of the issuers against actual financial performance. We also monitor each company’s liquidity and operating sources and uses of cash to ensure that the business plan is fully funded under various economic/ industry scenarios. Additionally, we hold regular discussions with management.
• Industry risk factors: From an industry risk perspective, we evaluate criteria including, but not limited to, the cyclicality of the end markets, supply and demand dynamics, competitive landscape within the industry, changes in consumer preferences, and the regulatory environment. We monitor daily news flow for the investments and industries we follow. We seek to mitigate industry risk by achieving meaningful diversification, which is enforced through industry limits.
• Credit spread duration: The portfolio managers will calibrate the portfolio exposure in accordance with our views on credit spread direction, and whether current levels of credit spreads reflect the actual level of credit risk and are over or under-compensating investors for taking credit risk. For example, in cases where we have a high conviction that credit spreads will widen, reducing credit spread duration exposure may be achieved by tilting the portfolio toward higher rated credits or through a focus on selecting credits with a lower credit beta and/or short-dated bonds.
• Interest rate risk: Muzinich seeks to reduce the risk to the portfolio from rising interest rates, which will typically result in falling bond prices, by investing in securities with shorter durations. The portfolio’s “duration-to-worst” profile is managed typically within a band of 0-6 years, where duration is a measure of a portfolio’s sensitivity to interest rate changes. While duration can generally be extended without limit, we tend to extend only when – as now – we believe that interest rate risk is benign and may, in fact, be rewarded by the market’s search for yield when credit spreads are compressed. Overall, due to market fluctuations, the average “duration-to-worst” profile of the portfolio may vary to insulate the portfolio from duration risk or extend duration risk where we believe rates could decline.
• Geographic risk: In portfolios that invest globally, geographic discrimination can be a key source of added value at specific times. Markets do not necessarily offer the same balance of risk and reward, and may experience different levels of correlation over time. While much of Muzinich’s credit selection remains bottom-up even in a global context, the investment team looks for what they believe is attractive relative value across a wider opportunity spectrum and across credits that interact positively or negatively with local factors. Muzinich seeks to exploit relative value dislocations not only between different credits in the same industry located in different places, but also to exploit relative value dislocations between bonds issued by the same company in multiple jurisdictions or multiple currencies.
• Liquidity risk: We focus typically on issues over $250 million to help preserve liquidity, from companies with normalized EBITDA of at least $100 million. Muzinich prefers bonds for which multiple brokers can provide quotes and that demonstrate a history of volume-based trading and attractively tight spreads. Our traders monitor liquidity risk on a daily basis by tracking the trading volume for each of our securities, the “tightness” of the bid/ask spread, and the number of market makers. The firm’s independent risk function tests liquidity of positions firm-wide at least monthly by viewing the number of bids in the market, recent trading volumes, and spread, and will run tests at irregular intervals in response to market news. We can also track the historic beta of individual issues in the market to provide the trading team with insight into a credit’s typical behavior in reaction to rapid market changes or headline news.

 
For further information about the Muzinich Credit Opportunities Fund and other funds on the Evercore Wealth Management investment platform, please contact Stephanie Hackett at [email protected].
 

Past performance is not a guide to future performance. The value of investments and the income from them may fall as well as rise and is not guaranteed, and investors may not get back the full amount invested. Where references are made to portfolio guidelines or features, these may be subject to change over time and prevailing market conditions.
 
Any research in this presentation has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and are subject to change without notice. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity; they are for information purposes only.
 
The fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The Summary Prospectus and Statutory Prospectus contains this and other important information about the investment company, and it may be obtained by calling 1-855-Muzinich or visiting http://www.muzinichusfunds.com/. Read it carefully before investing. For U.S. Investors: The Muzinich Mutual Funds are distributed by Quasar Distributors, LLC.
 
Diversification does not assure a profit or protect against a loss in a declining market. The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk. Bond ratings are grades given to bonds that indicate their credit quality as determined by a private independent rating service such as Standard & Poor’s. The firm evaluates a bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Ratings are expressed as letters ranging from “AAA,” which is the highest grade, to “D,” which is the lowest grade. In limited situations when the rating agency has not issued a formal rating, the advisor will classify the security as non-rated.