Euro Corporate Bond Q&A with David Stanley

David Stanley has managed the T. Rowe Price Euro Corporate Bond Strategy for over 22 years, making him the longest tenured portfolio manager within his Morningstar peer group1. During this time, Stanley has delivered consistent outperformance both in positive and negative return markets. In this Q&A, Stanley reflects on a highly eventful two decades in markets, and on the key elements in building and sustaining his successful track record.

How do you reflect on the past 20 years and how the strategy has evolved over this time?

The past two decades have seen remarkable change and unprecedented occurrences in the market landscape. We went through the 2008 financial crisis, the near collapse of the global banking system and extraordinary policy stimulus response.

The ensuing years saw multiple sovereign debt crises raise doubts about the future of the eurozone with European Central Bank (ECB) President Mario Draghi famously promising “whatever it takes” to ensure its survival. The ECB introduced negative interest rates and direct purchases of sovereign and corporate bonds, ushering in years of ultra-low and even below zero bond yields in Europe.

Then, the early stages of the 2020s have seen the coronavirus pandemic, lockdowns, further huge policy stimulus, intense inflationary pressure, and aggressive monetary tightening.

In broader trends, we have seen reduced and more erratic liquidity exacerbating directional market moves, partly because regulation has diminished banks’ market-making role, while the rise of environmental, social and governance (ESG) investing has become a forceful technical factor. We have always considered governance in our analysis and fully integrate ESG factors, but the wider systemic impact of ESG is relatively new.

How have you managed to navigate such an eventful environment?

Change and innovation are among the most interesting aspects of investing, but equally can make life challenging. Ultimately, although we must be able to adapt to new environments, as the significance of various fundamental and technical drivers can change over time, our process remains consistent. We focus on our core expertise of fundamental research underpinned by a well-resourced, high- quality platform of analysts. This has been all-important.

Some of the aforementioned events could be classed as exceptional, but shocks seem to be occurring with a greater degree of regularity now. Downside risk management is key for us, and we have used hedges more frequently in the recent past, helped by the growth in derivatives markets, notably credit index options, which have become easier and more cost effective to use.

How do you go about selecting the names in the portfolio?

Rigorous, high quality, fundamental research is the bedrock of our process. Our analysts undertake a 360-degree analysis of a company’s balance sheet, financials, management quality, competitive position, and ESG attributes, before assigning internal ratings and conviction scores to issuers under their coverage. Ratings and conviction scores are not used in a quantitative manner and are instead the start of communication between me and the analysts. Strong sell recommendations will lead to elimination from the portfolio, but buy recommendations are in competition with other ideas – some may have greater downside than others, and are therefore less attractive, or may result in unwanted concentrations.

With regards to ESG, there are several elements to integrating ESG factors. We look at a company’s ESG performance, on measures like number of accidents, carbon emissions, strength of whistleblower programs; its targets, for instance to reduce carbon emissions or increase diversity; and whether there are any risks from ESG-related controversies.

On top of this, we draw on our broad research platform which covers the full range of global bond markets, including high yield, emerging markets, and rates, as well as comprising a small team of economists, as well as from our quantitative specialists.

What are your key considerations in then constructing the portfolio?

From the pool of ideas generated, we construct a portfolio comprising diversified sources of alpha, emphasizing our high conviction ideas and as far as possible idiosyncratic stories that can perform over the long-term, also aiming to out-yield the benchmark. We analyze the correlations between our positions and how they are changing with the market environment, maintaining diversity across sectors, regions, ratings, and issuers, which can help keep the volatility of performance low.

We are particularly conscious of the asymmetric nature of the asset class. The potential downside in investment grade is greater than the upside. It is therefore important that we understand and assess the risks that we are taking when buying a corporate bond. We believe that long-term success in investment grade comes more through avoiding and underweighting underperforming credits than picking the highest performing names.

What are the secret ingredients of your success over the past 20 years?

One of my personal beliefs is that it is not necessary to always take a strong market view or make a big call. Taking a neutral position on a sector or issuer, or indeed the market, can at times be the more prudent thing to do, being ready to express conviction when we do have a strong fundamental view or see relative value opportunities.

Similarly, it is not necessary to always strive to be top quartile over short-term time periods. Moderate outperformance, sustained over the long-term is more important. Even consistent second quartile short-term rankings will lead to top quartile over time. The team searches exhaustively for opportunities, sometimes niche and opportunistic openings, which can include shorter-term positions. We often find we can add incremental alpha by exploring the issuer’s full capital structure when we believe we are being compensated for taking additional credit risk.

We avoid taking excessive beta, duration, or directional market exposure. Similarly, we do not chase risk, or alternatively shy away from taking it. As active fund managers, we look to see where we are sufficiently rewarded for taking the risk, be that with an issuer, sector, or market in general.

In truth, there are no great secrets and no magic formula. Drawing on the resources and ideas of an excellent research platform, and avoiding deteriorating credits, is essential. Consistency requires diversification, but also flexibility. Drivers of performance can change, and we do not get too attached to positions. At the same time, we look for high-conviction, long-term positions. During the European sovereign crisis, we identified compelling opportunities in the banking sector, which incurred short-term losses but ultimately did well.

Generating excess returns by out-yielding the benchmark over the long term is also a key building block in outperformance. Adding yield means taking on extra risk, be that duration, liquidity or credit quality risk. Therefore, we do not do this indiscriminately, but stringently assess opportunities relative to risk and volatility.

 

Risks - the following risks are materially relevant to the fund:

Contingent Convertible bond risk – Contingent Convertible Bonds may be subject to additional risks linked to: capital structure inversion, trigger levels, coupon cancellations, call extensions, yield/valuation, conversions, write downs, industry concentration and liquidity, among others.

Credit risk – Credit risk arises when an issuer’s financial health deteriorates and/or it fails to fulfill its financial obligations to the fund.

Default risk – The issuers of certain bonds could become unable to make payments on their bonds.

Derivative risk – Derivatives may be used to create leverage which could expose the fund to higher volatility and/ or losses that are significantly greater than the cost of the derivative.

High yield bond risk – High yield debt securities are generally subject to greater risk of issuer debt restructuring or default, higher liquidity risk and greater sensitivity to market conditions.

Interest rate risk – Interest rate risk is the potential for losses in fixed income investments as a result of unexpected changes in interest rates.

Liquidity risk – Liquidity risk may result in securities becoming hard to value or trade within a desired timeframe at a fair price.

Total Return Swap risk – Total return swap contracts may expose the fund to additional risks, including market, counterparty and operational risks as well as risks linked to the use of collateral arrangements.

Sector concentration risk – Sector concentration risk may result in performance being more strongly affected by any business, industry, economic, financial or market conditions affecting a particular sector in which the portfolio’s assets are concentrated.

General Fund Risks

Counterparty risk – Counterparty risk may materialise if an entity with which the fund does business becomes unwilling or unable to meet its obligations to the fund.

ESG and Sustainability risk – ESG and Sustainability risk may result in a material negative impact on the value of an investment and performance of the fund.

Geographic concentration risk – Geographic concentration risk may result in performance being more strongly affected by any social, political, economic, environmental or market conditions affecting those countries or regions in which the fund’s assets are concentrated.

Hedging risk – Hedging measures involve costs and may work imperfectly, may not be feasible at times, or may fail completely Investment portfolio risk – Investing in funds involves certain risks an investor would not face if investing in markets directly.

Management risk – Management risk may result in potential conflicts of interest relating to the obligations of the investment manager.

Market risk – Market risk may subject the fund to experience losses caused by unexpected changes in a wide variety of factors.

Operational risk – Operational risk may cause losses as a result of incidents caused by people, systems, and/or processes.