MAY 2010

 

 

The broad rally in credit markets following the credit crisis of 2008 narrowed yield spreads for risk assets back toward historical averages almost as quickly as they had widened.  We believe today’s credit markets, specifically high yield bonds and bank loans, offer a more limited “margin of safety” for accepting long-only credit risk amid a backdrop of a slow economic recovery.  The chart below shows the narrowing yield spreads for high yield bonds versus Treasuries after peaking in 2009, while the bottom chart shows the average bid for the most liquid bank loans.  These charts suggest that investors should not anticipate meaningful upside price appreciation or narrowing of spreads in the near term to the degree that was felt with the rapid rebound from distressed levels.  Following the credit crisis, credit was systematically “cheap,” which lent itself more to a long-only “beta” approach.  Today, as credit is trading closer to historical spreads a more balanced and flexible mandate seems appropriate.

 

 

 

 

We advocate the use of credit hedge funds due to their ability to play both the long and short sides of the market, provide better diversification than a long-only credit mandate, and their ability to adjust tactically the capital structure positioning.  Nevertheless, this approach came under pressure during the credit crisis.  Like all investment strategies purchasing risk assets, credit hedge funds were not spared by the massive de-leveraging and technical instability (prime brokerage failure, short bans, etc.) that took place in 2008 and early 2009.

 

During the subsequent market recovery, credit hedge funds have been able to tactically adjust their portfolios and alter their liquidity structures to handle future client redemptions (should they occur).  Credit hedge funds adjusted their structures in part to better match the liquidity needs of its client base, which should help protect investors should there be a future credit crisis or bout of illiquidity in the credit markets.  With structural improvements in place and yield spreads for risk assets back near historical averages, investors should consider reducing long-only credit risk in favor of credit hedge funds.

 

 

Embrace Credit Risk if there is a Reasonable Margin of Safety, if not, Hedge

 

When discussing credit risk, we are specifically interested in discussing non-investment grade bank loans and high yield bonds, as investment grade corporate bonds tend to have more interest rate sensitivity than they do credit sensitivity.  An investor who truly embraces the concept of investing in credit within a diversified portfolio understands that to allocate assets to a long-only bank loan or high yield bond strategy, the investor is in effect purchasing a beta-driven portfolio, where market risk has the greatest impact on returns.  This approach can be an acceptable solution for investors whenever there is an attractive “margin of safety” available in the form of meaningful risk premiums over Treasuries.  As the individual issuers backing these credits recover from the financial crisis to various degrees, the “margin of safety” in these mandates is more limited than it once was, and one could argue that every cent of return is earned with definitive risk.

 

 

Why Rotate Out of Long-Only Credit Exposures Now?

 

Following the broad recovery in risk assets, credit investors should begin focusing on what could potentially derail the high yield bond and bank loan markets over the next three to five years.  The following charts help investors put the recent rally in credit in a more forward looking context.  The first chart is the debt maturity schedule for bank loans and high yield bonds.  As the chart depicts, bank loans (which typically have maturities of three to five years) are a meaningful part of the refinancing needs of 2012 to 2014.  High yield bonds, on the other hand, comprise a meaningful part of the maturity schedule over the next eight years, with a significant amount of issuance coming due between 2014 and 2018.  There is a deep investor base for high yield bonds, but less so for bank loans.

 

 

 

The following chart shows a key concern that makes us particularly wary of the 2012-2014 credit markets, with greater emphasis on what could become a challenging 2013-2014 for credit investors.  This chart highlights U.S. collateralized loan obligation (CLO) issuance (or lack thereof it over the past three years) which is of particular concern to the overall health of the credit markets.  CLOs historically comprised more than 70% of the demand for bank loans, and the lack of new CLOs and weak appetite from existing CLOs for new bank loan issuance has been a critical driver of corporations in their decisions to term out their maturing or existing floating rate debt into fixed rate, high yield bonds maturing at a later date.  While everything appears to be rosy today, credit-minded investors need to start thinking about the next turn in the markets, and what could ultimately become another bite at the apple for distressed investors.  One proactive solution to a more challenging credit environment is a rotation out of long-only credit into credit hedge funds.

 

 

 

 

How Credit Hedge Funds Can Add Value

 

Credit hedge funds seek to add value throughout the credit cycle, primarily by shifting up in the corporate capital structure (i.e., bank loans) deep into the cycle and shifting down in the corporate capital structure (i.e., bonds) during the troughs.  They also attempt to add value by incorporating a more diversified investment approach than a long-only credit strategy.  This is accomplished by taking both long and short positions, as well as incorporating multiple credit-related strategies.  While a long-only credit strategy may make only one kind of investment (such as high yield bonds), a credit hedge fund could approach the same credit idea with different tactics.  For example, a credit hedge fund can add value via their ability to trade in and out of the capital structure using both long and short positions.  Credit hedge funds also can provide a more robust way to invest in the credit markets, focusing on areas less traveled by long-only credit investors, such as stressed/distressed securities, securitized and structured investments, deal origination for private companies, whole loans, trade claims, and other niche areas.

 

 

Risks Involved in Credit Hedge Funds

 

Despite their ability to take short positions, credit hedge funds tend to be long biased, although this is not always the case.  The rationale behind the long bias for most credit strategies is the “negative carry” element involved in taking short positions.  In other words, there is a cost involved to create a short position that must be overcome by either strong security selection and/or the interest and principal paid out in long securities that exhibit “positive carry.”  As a result, most credit hedge funds tend to have a long bias, which makes them susceptible to event risk, leading to “fatter tails” in the distribution of returns than investors might expect.

 

Long-only credit strategies are also subject to event risk and the table following highlights the kurtosis and skew factors, which measure the opportunity for unusual and negative return outcomes, for both long-only credit indices and several prominent credit hedge fund strategies¹.  Long bank loans, distressed/restructuring, and corporate securities strategies each show higher levels of kurtosis (unusual outcomes) and negative skew (frequency of negative outcomes) in their quarterly distributions.  Thus, the measures reflect the occasional period of severe negative returns, the fatter tails in the observed distribution of returns vs. what one would expect assuming a “normal” distribution of returns.

 

Both long high yield and credit arbitrage strategies showed kurtosis levels that were generally considered in-line with normal distributions and modestly positive skew.  While none of these indices are perfect metrics for defining all credit investments, they provide a general understanding that both long-only and credit hedge strategies tend to have modestly higher degrees of fat tail risk and negative skew than a normal distribution of returns.

 

 

Why Invest in Credit Strategies if they Exhibit Fat Tail Risk and Negative Skew?

 

Many investors have already decided to allocate to credit investments in some area of their portfolios.  The question they must ask themselves is how robust is this allocation?  Are they really trying to create alpha in the portfolios by making an allocation with a long-only credit mandate?  As mentioned previously, this may be an acceptable strategy in periods where there is an attractive “margin of safety.”  This approach requires a timing element, however, which plays more to the strengths of a credit hedge fund manager.  Credit hedge funds have within their mandate the ability to adjust the structure of the fund to increase the short exposure or move up in the corporate capital structure when credit markets become unattractively valued or lack a “margin of safety.”  Their ability to create a more diversified credit portfolio through the use of different strategies or investments outside the mandate of a long-only credit strategy enhances their approach relative to the long-only version.  Strong manager selection is also required in order to mitigate the event-risk inherent in these strategies.

 

 

Conclusion

 

Allocations to credit hedge funds provide investors with an enhanced opportunity to add incremental returns to their portfolios relative to long-only credit investments through market cycles.  As in all markets, attempting to time the credit markets is fraught with challenges and the risk of being early or wrong.  Credit hedge funds that were able to stay the course throughout the recent credit crisis are stronger as a result, having already made challenging decisions on portfolios, personnel, and fund structure.

 

We believe long-only credit managers provide investors with “beta” allocations to credit, due to their inability to play both sides of the market and exposure to asymmetrical downside risk.  For investors seeking alpha through their credit allocations, the use of a credit hedge fund provides a more robust investment experience through better diversification, lack of benchmark orientation, and the ability to use both long and short positions to add value.  As always, strong manager selection is critical in making an allocation to the credit-related areas of the market.

 

 

¹ The term “fat tail” risk (a.k.a., kurtosis risk) denotes that observations within a statistical sample are spread in a wider fashion than in an otherwise normal distribution.  In other words, fewer observations cluster near the average and more observations populate the extremes either far above or far below the average compared to the bell curve shape of the normal distribution.  Negative skew reflects unusually severe negative periods on occasion.