How to find mispriced securities in the credit market

A large-cap publicly listed company might only have one stock, but they’ll have dozens, hundreds, or even thousands of tiers of debt within its overall capital structure. There is effectively a mass of different corporate bond securities lying just under the surface for many companies, while the company’s stock floats above the proverbial waterline. Ilias Lagopoulos works to capitalize on the opportunities he can find under the surface.

Lagopoulos is Principal and Head of Investment Grade Credit at RPIA, an active fixed income manager. He explained that largely because there are so many securities in the corporate bond market, he and his team are able to regularly identify mispriced opportunities. He outlined the process he and his team employ to identify those opportunities and how they turn them into possible alpha generators. He explained why ongoing market volatility can create more of these opportunities and highlighted why advisors may want to consider active credit strategies even as monetary conditions normalize and treasuries resume their pre-zero interest rate policy (ZIRP) utility.

“Over the past 12 to 18 months, we've found some really interesting opportunities in bank capital structures, within the tier two subordinated debt segment of the capital structure, as well as the AT1 (additional tier one) or preferred share part of their capital structures as well,” Lagopoulos says. “We've seen really interesting opportunities within the US banking sector, GSIBs, money center banks, as well as national champions in Europe. You don't really need to go too far down the quality spectrum with regards to banks to find really interesting inefficiencies and opportunities within their capital structure”

The process of identifying these opportunities begins with SANTA’s delivery. SANTA is a proprietary tool that RPIA developed back in 2019; an acronym for Structuring, Analysis and Trading Assistant. SANTA pulls dealer pricing from around the globe and plots individual curves for a company as well as sector curves. It can identify when a bond issuance is mispriced against the company curve or sector curve. Given the sheer number of securities on the market, this quantitative tool is an essential first step.

Once SANTA makes its delivery and points out these mispriced opportunities, managers take over. Sometimes, Lagopoulos notes, a bond might trade cheap or rich on the curve because it’s a highly illiquid issuance. It could only be around $100 million in deal size, when real liquid opportunities come in individual bond deals that are over a billion dollars in size. Human managers can apply criteria like liquidity as well as the work of fundamental analysis to narrow the field of opportunities further and look for areas of value that they’re constructive on or areas they think are overpriced and can be shorted.

While the scale of the market sits at the core of these pricing opportunities, there are also current conditions that create new areas of possible upside. Lagopoulos notes that when volatility in the market picks up overall, mispricing often occurs because corporate credit is an “over the counter marketplace.” The recent rise in overall market volatility driven by US trade policy has created more mispriced opportunities for Lagopoulos and his team to identify.

Moreover, he notes that the overall quantity of corporate debt has grown significantly in recent years. In the US marketplace last year, he notes, roughly $1.4 trillion in new corporate debt was issued. That volume of debt compounds the impact of volatility on pricing, creating new opportunities to take advantage of a price dislocation.

Taking advantage of these opportunities, Lagopoulos argues, requires tools like SANTA and dedicated teams to follow up with the fundamental analysis. It requires the access to markets that institutions and specialized active managers can gain while many retail investors and advisors may lack the volume to execute effectively. It also helps to have a sophisticated and dedicated approach, in his view.

But just as Lagopoulos finds opportunities for alpha generation in these fixed income securities, many advisors and investors are returning to the pre-GFC utility of bonds. Treasuries now pay more attractive yields and appear to offer non-correlated returns against equities once again. Some investors are arguing that the fixed income side of the portfolio doesn’t need to be a source of alpha generation, especially now that yield can meaningfully contribute to total returns.

Lagopoulos acknowledges that point but notes the recent experience of 2022 as evidence of when that non-correlated promise can fail to materialize. He argues that active approaches to fixed income outperformed in that very difficult year for investors. Moreover, while ZIRP saw many fixed income allocations focused on alpha, he believes that the merits of alpha generation in fixed income can extend past the end of ZIRP and into our current monetary regime.

“You can take a two-pronged approach to the market, with long-only as well as more sophisticated strategies where they fit,” Lagopoulos says. “And that can go a long way for investors to meet their goals during challenging and volatile periods.”