The Credit Cycle Has Turned

The Credit Cycle Has Turned
6 min 35 sec

Our Alternatives Consulting group has been assessing a wide variety of credit-related hedge fund managers to determine how they are navigating the recent market volatility. We confirmed that each manager we contacted had implemented its business continuity procedures, and virtually all staff is working remotely. In most cases the managers have specifically documented back-up coverage should key senior professionals become incapacitated; other managers have more of a “zone defense” approach in which individuals on the management committee will take over senior coverage on a case-by-case basis as needed.

Month-to-date performance through mid-March has been volatile and widely dispersed, with the better-performing managers down 4% to 5%, many off by 6% to 8%, and underperformers down by the mid- to high teens. We expect performance across this universe to be volatile over the next several weeks.

Callan breaks down the credit-oriented hedge fund universe into three categories: liquid corporate credit strategies, liquid structured credit strategies, and more opportunistic strategies that invest across liquid corporate and structured credit. Opportunistic credit portfolios may also have modest equity exposure as well as some exposure to private credit, often in the form of directly originated or pools of private loans. Each of these strategies may participate in more distressed opportunities, but generally reserve more restructuring and operational-style distressed investing for drawdown funds, many of which have recently been structured with a provision that triggers the drawdown of committed capital.

Performing Corporate Credit: Proceeding with Caution

With high yield spreads rapidly widening to 900+ bps over Treasuries, edging up on Global Financial Crisis (GFC) spread levels of 1000+, those hedge funds with significant high yield and broadly syndicated loan exposure have been relative underperformers given beta-driven drawdowns. Conversely, outperformers have been those managers with significant portfolio hedges in place going into the recent market sell-off or that have seen a dampening of portfolio volatility through material (20% to 50%+) private credit exposure in the form of private corporate loans, which do not reflect current marks. Execution in the credit markets has been difficult as liquidity has dried up while trading desks adapt to new work-at-home protocols and investment banks are no longer positioned to hold this type of risk on proprietary trading desks.

The common theme when discussing current portfolio positioning has been a flight to quality. In particular, managers have been trying to find attractive investment-grade paper that was trading at 4% to 5% a month ago and now can be purchased with yields in the 8% to 9% range, potentially offering returns well above 10% when an attractive return a few weeks ago would have been in the 5% range. Favored sectors include U.S. and European financials as well as telecom and consumer non-discretionary. For the most part, managers have been wary of jumping into investment-grade names with large exposure to industries most directly impacted by COVID-19, such as aviation, leisure (resorts and gaming), retail, and lodging. A significant energy sell-off in tandem with the virus effect has created some seemingly interesting relative value opportunities, but many managers are not quite comfortable taking the underlying commodity risk. While many medium- to lower-quality high yield bonds have taken a price hit of over 50%, many managers prefer to wait on the sidelines for now.

Distressed Credit: It Has Been Triggered!

We have spoken to a number of alternative credit managers that have structured and closed on “contingent capital” or “trigger funds” in which capital is committed but not drawn until certain triggers are tripped (e.g., if the high yield spread reaches 800 bps or the percentage of high yield bonds trading below 80 exceeds a certain threshold). These structures were devised by many managers with distressed capabilities that wanted to create dry powder vehicles that could be quickly drawn should the distressed cycle turn. Most credit managers believe the distressed cycle has arrived, with many trigger structures activated when high yield spreads exceeded 750 to 900 bps over Treasuries.

Distressed capital is also starting to be deployed out of opportunistic credit vehicles as well as bespoke separately managed accounts. Many managers have indicated they are currently seeing a fair amount of interest in deploying additional capital in distressed. While capital is available, the general theme communicated by managers is that while higher-quality names provide relatively attractive entry points in this environment, the lower-quality segment of the universe (i.e., single Bs and triple Cs) may see more attractive entry points over the next few weeks.

Opportunistic Credit: Be Nimble but Don’t Forget the Hedge

Callan believes that managers with experience in opportunistically rotating across multiple credit sectors are well positioned to outperform in the current market. The key, however, is to be able to move in and out of investment themes in an efficient and timely manner. This ability has been greatly hindered in the current environment of constrained market liquidity. We are watching the opportunistic managers closely as we have found that some have exposures, such as creeping equity exposure, that have led to underperformance relative to peers with a more senior and liquid credit focus. We also have seen underperformance by those that have not been nimble in putting on portfolio hedges moving into the current environment. Finally, many of the opportunistic players have seen an increasing portion of their portfolios invested in private loans and other longer-dated assets, which might create an asset-liability mismatch as well as underlying portfolio volatility because these assets have not yet been marked during the recent market decline.

Structured Credit: Watch for Private Exposures

A survey of structured credit hedge fund managers shows that the liquid market opportunity in traditional residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) has broadly played out over the past few years post-GFC. Many structured credit strategies have evolved to focus on niche areas of the market, including idiosyncratic collateralized loan obligation (CLO) paper and consumer asset-backed securities in areas such as student loans, auto finance, and other hard asset financing. Further, many managers have pivoted a portion of their portfolios into specialty finance such as asset-backed lending in which they purchase or originate pools of loans that are then securitized in the broader market. The attractiveness of this asset class is that value accretion is quickly achieved through a securitization, which increases liquidity and, correspondingly, value.

In adapting to the current market environment, managers are taking another look at higher-quality opportunities in the liquid markets. For example, some managers are looking at AAA CLO paper, which previously offered yields too low to be attractive. New CLO issuance has shut down, which is expected to cascade into reduced loan issuance, since CLOs now drive 60% of the demand for loan assets. Rapidly amortizing CMBS and RMBS that have sold off may be added to portfolios in the absence of CLOs. As with corporate credit, managers are still wary of materially adding to sectors that may see longer-term stress as a result of the coronavirus effect. Caution is also being exercised around existing pools of loans that rely on an active securitization market as a driver of total return.

Looking Ahead: An Attractive Longer-Term Opportunity Set Grows

In the near term, many alternative credit managers are in risk-mitigation mode, working to fine-tune hedges and move portfolios into higher-quality assets. Smooth execution in this environment has been somewhat challenged by limited market liquidity and a general adjustment to the new work regimen as investment teams are physically separated by work-from-home protocols. In the meantime, research teams are digging in to determine where longer-term value can be found, sifting through securities that have traded off 20% to 50% or more over the past week. Distressed teams are gearing up for a robust distressed cycle benefiting from significant dry powder that has been raised over the last few years through trigger fund structures as well as through more opportunistic credit strategies.

We will continue to closely monitor the alternative credit landscape in real time as the market backdrop is dynamic, with the possible emergence of some clear winners and losers.

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