The shifting views of the economic cycle and sector prospects have provided a rich set of investment opportunities for Credit Long/Short, one of the key alternative trading strategies within the credit area. We favour specialised managers exploiting mispricing through detailed fundamental company research, while limiting directional exposure to fixed income and credit risk and keeping a liquid profile.
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Traditional fixed income portfolios have been overweight interest rate sensitive bonds that have benefited as rates have continued down a falling path. The flight to safety and obsession with income has left many portfolios vulnerable to the risk of rising rates. We believe it is crucial to find fixed income alternatives that improve overall portfolio diversification and can generate returns, regardless of whether rates rise, fall or stay range-bound. An unconstrained strategy that can benefit from dynamic duration exposure coupled with credit selection is worthy of consideration.
One of the key credit alternatives
Credit Long/Short (Credit L/S) is one of many credit strategies that together make up about one-third1 of the global USD$2.86 trillion hedge fund industry2. These strategies generally seek to isolate one or all of the specific risks related to credit instruments, including default risk, credit spread risk and illiquidity risk. Credit Long/Short can be further divided into four main types of sub-strategies, these being: Relative Value Credit, Macro Credit, Fundamental Credit and Multi-Strategy Credit3. All of the strategies have an extensive liquid universe of trading instruments to utilise across the sovereign, financial and corporate sector. The key instruments widely used are bonds, loans, convertibles and a range of credit derivatives, in particular credit default swaps (CDS) – the most widely used instrument to implement short credit trades within the alternatives community.
The flight to safety and obsession with income has left many portfolios vulnerable to the risk of rising rates
Long/Short Credit: the purest form of credit selection with a focus on profiting from mispricing due to company specific fundamental reasons where the specialist generally takes either outright long or short positions.
Relative Value Credit: seeks to exploit price differentials between bonds and a related security, often driven by supply/demand imbalances or market dislocations. Specialists look to simultaneously buy the security believed to be undervalued and short sell4 the security believed to be overvalued. This strategy usually employs the highest levels of leverage due to optimising returns from a narrow pricing dislocation.
Macro Credit: focuses on implementing positions as a result of ‘top-down’ economic views. Investments are generally thematic in nature, implementing a negative or positive view on a broad industry or a given economy rather than adopting a company-specific position.
Fundamental Credit: incorporates profiting from corporate ‘events’. These strategies tend to have a long-bias, where the portfolio’s long-book exposure outweighs the short-book exposure when looked at in aggregate. Typical event catalysts are: balance sheet restructuring, a divestment, a spin-out or a merger/acquisition.
Multi-Strategy Credit: simply a combination of the above strategies whereby the positioning to each sub-strategy tends to be dynamic and is controlled by a specialist manager.
Attractive return profile
Credit L/S strategies come to the fore when credit markets suffer sudden and harsh corrections. Previous downturns, such as the 2008 Global Financial Crisis, demonstrate this feature. Figures 1 and 2 show the attractive return profile of alternative credit managers in general (HFRI Credit Index)5 since the crisis, with a dynamic correlation between the index and the overall credit market (Barclays Global Aggregate Total Index), coupled with its longer-term outperformance to traditional global equity markets.
Recent market conditions have been quite challenging resulting in mixed performance for alternative credit strategies, including Credit Long/Short. The first quarter was primarily driven by the market agreeing on expecting less tightening from the US Fed, worries about a weaker Chinese currency and commodity price volatility. Given significant swings in volatility, specialists have been actively adjusting portfolio duration and tactically trimming overall portfolio risk while maintaining high conviction credit exposures. Select long holdings in energy and basic materials, and credit shorts in European retail and high cost energy producers have been key contributors. Niche emerging markets sovereign credit positions (e.g. Argentina) have also been accretive to performance. Recent price declines, which have outstripped fundamentals, have generated opportunities for specialists to add back to portfolios.
Opportunities for Credit Long/Short
We expect the overall backdrop to be slightly supportive for credit in general, with global growth continuing and with a slight pick-up in inflation. With credit spreads indicating that the credit cycle is not yet approaching the end and a continued hunt for yield, we see the prospect of further spread tightening.
Even though we see significant opportunities for Credit L/S strategies, managers have to navigate through an environment with liquidity concerns and challenging technical price action. The ongoing volatility, primarily driven by macroeconomic headlines and highly sensitive investor sentiment, has created a rich opportunity set for active trading particularly in sectors prone to overreaction, such as energy, emerging markets or China, and segments closely tied to retail flows. However, limited liquidity continues to be a concern, especially as the growing influence of flows driven by mutual funds and ETFs, and reduced participation by traditional market-makers, is creating one-way markets that are driving up both liquidity premiums and volatility.
Specialists are cautiously constructive, opting for a tactical approach and focusing on lower directional credit portfolio exposures and well-researched credits where fundamental analysis reinforces a position or an upcoming catalyst event is identified. Specialists are also uncovering opportunities where current spreads are implying higher default risk than the fundamentals indicate. European corporate bonds look attractive following the ECB’s announcement to include them in its quantitative easing programme. However, specialists remain prepared for short-term volatility. Warning signals are usually scarce before a major disruption and a prudent stance is therefore warranted which is why we believe this strategy should be a core element of any dedicated fixed income allocation.
1 HFR Global Hedge Fund Industry Report, First Quarter 2016. Estimate of the credit hedge fund universe derived from the following sub-strategies: Event Driven (Special Situations, Distressed/Restructuring, Merger Arbitrage, Activist, Credit Arbitrage) and Relative Value Fixed Income (Fixed Income Asset Backed, Convertible Arbitrage, Fixed Income Corporate and Fixed Income Sovereign).
2 HFR Global Hedge Fund Industry Report, First Quarter 2016
3 AIMA, Alternative Investment Management Association
4 Also known as ’shorting’ or going ’short’ is the practice of selling securities or other financial instruments that are not currently owned, and subsequently repurchasing them in the future, known as ‘covering’.
5 HFRI Credit Index is a composite index of strategies trading primarily in credit markets. It is an aggregation of following 7 HFRI sub-strategy indices. HFRI ED: Credit Arbitrage Index, HFRI ED: Distressed/Restructuring Index, HFRI ED: Multi-Strategy Index, HFRI RV: Fixed Income-Asset Backed Index, HFRI RV: Fixed Income-Convertible Arbitrage Index, HFRI RV: Fixed Income-Corporate Index, and HFRI RV: Multi-Strategy Index.