The Margin of Safety in Credit: How We Build Portfolios That Survive Bad Years

In 1949, Benjamin Graham introduced the concept of the margin of safety: the principle that an investor should only purchase a security when its price is sufficiently below its intrinsic value to provide a buffer against error, misfortune or adverse change. The idea is deceptively simple. Its application is anything but.

Graham wrote primarily about equities, but we believe his concept is most powerful when applied to credit. The reason is structural. In equity investing, the margin of safety provides protection while preserving unlimited upside. In credit investing, the upside is contractually capped — you receive par plus coupon, nothing more. The entire investment thesis therefore rests on one question: will we get our money back?

That asymmetry changes everything about how a portfolio should be constructed.

Why Credit Is Different

An equity investor who buys a stock at a 30 per cent discount to intrinsic value has both downside protection and the potential for significant appreciation. If the thesis works, the return could be multiples of the purchase price. A single successful position can compensate for several failures.

A credit investor does not have that luxury. If we lend at 90 cents on the dollar and the borrower repays in full, we earn the discount plus coupon — a good return, but a finite one. If the borrower defaults and recoveries are poor, we can lose most of our principal. The mathematics are unforgiving: the best outcome is modest profit, and the worst outcome is near-total loss.

This asymmetry means that in credit, avoiding losers matters far more than finding winners. A portfolio of twenty credit positions where nineteen perform and one defaults catastrophically will underperform a portfolio of twenty positions where all twenty return par plus coupon — even if the first portfolio's winners earned slightly higher yields. The maths of loss avoidance dominates.

Position Sizing as the First Line of Defence

The margin of safety begins before we buy a single position. It begins with how much capital we are willing to commit to any single idea.

We would rather miss a good opportunity than make a bad investment. That is not a platitude — it is a sizing discipline. No individual position should be large enough to impair the portfolio if our analysis proves wrong. We set maximum position sizes not based on conviction, but based on the consequences of being incorrect.

This creates a natural tension. High-conviction ideas deserve meaningful allocations, but meaningful allocations create concentration risk. We resolve this by calibrating position size to the quality and security of the underlying collateral. A senior secured loan backed by tangible assets with an independent valuation can justify a larger position than an unsecured note from a borrower with equivalent creditworthiness. The collateral provides a secondary margin of safety that supplements our credit analysis.

Security Selection: Seniority and Collateral

We have a strong preference for senior secured credit. This is not conservative for the sake of conservatism — it is a direct application of the margin of safety principle.

In a default scenario, claims on a borrower's assets are satisfied in order of priority. Senior secured creditors are paid first, from the proceeds of specific pledged collateral. Subordinated creditors are paid next, from remaining assets. Unsecured creditors take what is left, which is often very little.

Historical recovery data bears this out consistently. Senior secured loans typically recover 60 to 80 cents on the dollar in default. Senior unsecured bonds recover 40 to 60 cents. Subordinated debt recovers 20 to 40 cents. The difference between lending at the top of the capital structure and the bottom is not a marginal improvement in safety — it is the difference between a recoverable setback and a permanent loss.

We focus on assets we can value independently: property, equipment, receivables, inventory with observable market prices. When we lend against real assets, our margin of safety has a tangible floor. We know what we can recover if everything else goes wrong.

Diversification: Enough, but Not Too Much

Diversification is the most misunderstood concept in portfolio construction. Insufficient diversification creates idiosyncratic risk — the danger that a single position's failure disproportionately damages the portfolio. Excessive diversification dilutes conviction and, paradoxically, can increase risk by forcing the manager to invest in opportunities they do not fully understand.

The right level of diversification depends on how well we know each position. A portfolio of thirty credits where each has been thoroughly analysed — borrower visited, collateral inspected, management interviewed, downside modelled — is far safer than a portfolio of two hundred credits selected from a screen. The first portfolio has genuine diversification: independent risk factors, understood correlations, intentional construction. The second has the illusion of diversification: quantity without quality.

We aim for meaningful diversification across borrowers, sectors and geographies, while maintaining a portfolio concentrated enough that every position receives ongoing attention. If we cannot monitor a credit properly, we should not own it.

Conservative Portfolio Construction in Practice

We often say that conservative and deliberate portfolio construction is always the best hedge. That phrase deserves unpacking, because "conservative" can mean many things.

For us, it means a specific set of constraints applied to every portfolio we manage.

• Position sizing limits. No single exposure exceeds a defined percentage of the portfolio, regardless of conviction. The limit varies by strategy but is always binding.
• Sector concentration limits. We cap exposure to any single industry to prevent correlated losses. A portfolio overweight to one sector is not diversified — it is a sector bet dressed in different names.
• Liquidity requirements. We maintain sufficient liquidity to meet redemptions and to act opportunistically when markets dislocate. A fully invested portfolio has no margin of safety against unexpected outflows or unexpected opportunities.
• Stress testing. We model portfolio performance under adverse scenarios — rising defaults, falling recoveries, correlated sector downturns, liquidity withdrawals. The portfolio must survive these scenarios without breaching risk parameters. If it cannot, we reduce exposure until it can.

None of these constraints maximise returns in good years. All of them increase the probability of surviving bad years. That is the trade-off we make deliberately and without apology.

Our View on Leverage

Generally, we do not use it.

Leverage amplifies both returns and losses. In a strategy focused on capital preservation, that amplification is asymmetrically dangerous. A 10 per cent loss on an unlevered portfolio requires an 11 per cent gain to recover. The same loss at two times leverage requires a 25 per cent gain on the underlying assets. At three times leverage, the maths become punitive.

More importantly, leverage introduces a risk that does not exist in unlevered portfolios: the risk of forced liquidation. A leveraged portfolio that suffers mark-to-market losses may face margin calls, requiring positions to be sold at precisely the moment when prices are most depressed. This converts temporary mark-to-market losses into permanent capital impairment — the exact outcome our entire approach is designed to prevent.

There are limited situations where modest, matched-term leverage is appropriate — for example, borrowing against a highly liquid, short-duration portfolio of investment-grade securities. But as a general principle, we view leverage as incompatible with a margin of safety framework.

Portfolio Monitoring: Discipline After the Buy

The margin of safety is not a calculation performed at the point of purchase and then forgotten. It is an ongoing discipline. Credit quality changes. Borrower circumstances evolve. Markets shift. The margin of safety that existed when we entered a position may erode over time, and we must be willing to act when it does.

We monitor every position for early warning signals of deterioration: declining revenue, thinning margins, rising leverage, management turnover, sector headwinds, covenant pressure. The goal is to identify problems while they are still manageable — while we still have the option to exit at a reasonable price rather than being forced to sell into distress.

This requires a willingness to cut losers early, even at a loss. The natural human instinct is to hold a deteriorating position and hope for recovery. In credit, that instinct is dangerous. A credit that is deteriorating slowly is often a credit that will default suddenly. The time to sell is when you first identify a problem, not after the problem has become obvious to the market.

How AI-Enhanced Analytics Help

The monitoring discipline we describe above is labour-intensive. For a portfolio of thirty to fifty credits, each requiring regular review of financial statements, market data, news flow and covenant compliance, the analytical burden is substantial.

This is where AI-enhanced analytics provide genuine value. Machine learning models can process large datasets continuously — scanning financial filings for deterioration signals, monitoring news and market data for early warning indicators, flagging covenant breaches or near-breaches across the portfolio in real time. These tools do not replace human judgment, but they dramatically expand the scope of what a small team can monitor effectively.

Credit deterioration signals that might take an analyst days to identify across a full portfolio — subtle shifts in payment patterns, changes in supplier terms, inventory build-ups — can be surfaced automatically and prioritised for review. The result is earlier detection, faster response and fewer surprises.

We view this technology as an extension of the margin of safety itself: the ability to see problems sooner creates time, and time creates options.

Building for Bad Years

Every portfolio construction decision we make is oriented around a single question: will this portfolio survive a bad year?

We do not optimise for the best possible outcome. We do not construct portfolios that will top league tables when credit spreads are tight and defaults are low. We construct portfolios that will still be standing when spreads blow out, defaults spike and liquidity evaporates — because those are the environments where permanent capital loss occurs, and permanent capital loss is the one thing we cannot recover from.

This approach will underperform more aggressive strategies in benign markets. We accept that. Over a full cycle — encompassing both the good years and the bad — the mathematics of loss avoidance compound in our favour. A portfolio that returns 8 per cent annually with no losses will outperform a portfolio that returns 12 per cent in good years but suffers a 20 per cent drawdown every five years. The first portfolio compounds. The second portfolio recovers.

The goal is not to build the portfolio that performs best in good years. It is to build the portfolio that survives bad years — because survival is the prerequisite for compounding.

Our approach to portfolio construction is grounded in the belief that capital preservation and disciplined risk management are the foundations of long-term wealth creation. To learn more about how we apply these principles, visit our investment philosophy and credit strategies pages, or contact us directly.