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So far, most of the rout in the debt markets has been linked to the US subprime mortgage debacle. Increasingly, however, many hedge funds are betting there is far worse to come for the corporate debt market as well as indicated by the distressed fund assets awaiting investment. Richard Branson in his last set of interviews when he was following Gordon Brown around China must have used the word distressed over 5 times in a 2 minute conversation with a journalist. Admittedly they were discussing the very specific matter of the future bailout of Northern Rock, but the “D” word is clearly out there.
Hedge fund managers and the trading desks of some of the savviest firms on Wall Street are expecting the downturn in the corporate debt market as well as most other credit markets to continue. A big part of their bet is that bonds will perform far worse than in previous meltdowns, because financial engineering has created so many layers of debt on top of unsecured bonds, which are the last debt to get paid in the event of a default. Take the credit derivatives market for instance: CDO and CLO spreads have widened as banks and insurance companies, the traditional buyers of the asset class, have disappeared from the market. Active participants in the sector such as the monolines, which write protection on AAA tranches of CLOs, have been hard hit by their sub-prime exposure. "You take the funded/wrapper trade out of the equation and there are far fewer buyers of AAA CLO tranches," says one analyst I spoke with recently.
Yet there are also signs that investors are starting to differentiate the various instruments which exist and their overall quality. As credit markets fall in a synchronous fashion, there will come a time when the most original managers will be able to find value by pairing assets of very different qualities. In a recent report to clients, JP Morgan's Global Structured Finance Research team notes that the CDO market has seen little issuance in recent weeks. Secondary activity, however, has picked up recently as bid lists are beginning to clear.
“From what I’ve gathered from a recent trip visiting US credit managers, a tightly constructed credit relative value portfolio is interesting at this juncture. We’re not looking for fundamental credit as such but principally for funds that can benefit from dislocations as well as arbitrage opportunities” opines Patrick Wills from Montier Partners, a London based hedge fund of funds. He then goes on to add “We’re also closely monitoring a handful of competent L/S high yield managers who shine in these markets.”
“The unwind of AAA CDO’s will create tremendous opportunities and we are looking for managers who can capitalize on the fixed income flows thath will result, for example ABS relative value” states Wills. It’s worth noting that 70% of the high yield market is owned by AAA investors for whom the only thing that mattered was the rating. They barely paid attention to the underlying as long as they could by insurance through monolines. Demand for lower rated tranches was easy for the banks to find in a market where spreads had become very low. When eventually monoline insurers (Ambac, MBIA) were saturated with risk, banks then kept triple these AAA tranches on their own books and in order to keep the merry-go-round going.
“This trade is not unwound completely” continues Wills and goes on to add “Investors who bought them unwrapped (e.g. Banks) will keep on suffering losses. Furthermore, the insurers themselves have a good chance of triggering a rout of distressed selling. We feel at Montier there is still a high degree of impairment risk in the AAA segment of the CDO market.
Hedge funds involved in capital structure arbitrage trades within CDO space appear well positioned. The AAA and equity tranches potentially offer more interesting returns than the mezzanine tranches where the workout periods could be prolonged.
Montier have not been comfortable with strategies that are broadly long the senior secured leveraged loan whilst buying protection through a CDS, what is a combination of a basis trade and capital structure arbitrage. The higher volatility of CDS has allowed for positive carry if the position is structured as beta-neutral i.e. less CDS hedge is required than notional of the loans. A problem arises, however, when default risks increase because not only does the hedge ratio drop but there is potential for the CDS to settle at a recovery rate which doesn't fully compensate for the loan. CDX and LCDX indices have both lost about 7 points since last October with similar volatility.
In the case of default, there is the potential for serious hedging inefficiencies when investors settle. There has been no gatekeeper in the industry looking to limit the ratio of OTC contracts to underlying. It is still unclear as to how orderly the market will be once default rates rise and everyone is scrambling for the exits at once.
“As for distressed debt funds we feel it may be a little early and the opportunities may not be as high as some investors think.” Claims Wills. “Firstly, there has been close to $30Bln already earmarked for this market from dedicated dislocation funds waiting on the sidelines. Add to that the sheer size of Sovereign Wealth Funds and their desire to invest in good franchises at bargain basement prices and you may find the returns are competed away. Secondly, default rates may be different in this in this cycle. Not only are corporate balance sheets healthier but much of the borrowing has been under light covenants making it easier for borrowers to meet their obligations.”
“In any event, it is our view at Montier that good distressed investors will want to focus on sector and idiosyncratic risk rather than simply looking at the macro risks. Good distressed managers will have a thorough sector by sector understanding and thus how companies will be affected. In any case, debt trades at recovery levels way ahead of the occurrence of the actual default, so timing of the entry point cannot be based on a peak in default rates”
Montier’s other interests in credit include:
- Event driven credit funds. Although investors should expect some volatility, Montier see better returns in event for credit than in equity space. Financial buyout activity is obviously curtailed by the CLO market, while strategic acquisitions are harder to complete due to the greater loss of jobs at senior level.
- US high grade mortgage spreads are very high and there could be some good opportunities on the long side for managers that understand the flows in the market.
“Central banks are more pro active and interventionist than in past cycles which means we generally favour managers that have a more active trading style” concludes Wills.
Montier Partners is a London based hedge fund of funds founded by Dominique Montier in 1996. Client portfolios are composed of hedge funds allocated across a range of investment strategies with the aim of generating competitive absolute returns with low volatility. Patrick Wills is a partner at the firm and a member of the Investment Advisory Committee.
Variance Capital Management does not recommend or distribute Montier Partners’ funds.
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