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We recently published a paper about credit opportunities stemming from the economic and market fallout of the pandemic. In particular, we focused on several drivers of opportunity that we believe flexible alternative credit strategies can tap into, including market dispersion and dysfunction. Fast forward just four months and there are signs of a financial system that, on the surface, has healed from the wounds of the March sell-off. But we still see an attractive backdrop for investing in credit, including market vulnerabilities that began to emerge long before any of us had heard of COVID-19.
Despite all of the commentary about credit spreads moving back toward pre-March tights, certain measures of credit market dispersion are still at very elevated levels (Figure 1). Why is this occurring despite tighter spreads? We think it’s a combination of factors. First, different areas of the economy are healing at different speeds and will continue to for some time to come. Second, prior to the crisis, some late-cycle excesses (e.g., leveraged acquisitions) had built up, causing the market to attach a higher risk premium to more vulnerable credits.
Consider the energy sector, for example. Despite the broad market “recovery,” many tradable assets of energy companies are still at their March lows. In some cases, this is justified and may be a warning sign of further impairment to come. In other cases, there is potential value to extract from these assets as commodity prices recover and competent management teams work to put their core business and financial health on a more sustainable path. Another area of dispersion we see is intra-issuer, where opportunities to take advantage of capital structure mispricings (e.g., going long secured debt and short unsecured debt of a specific company) can be a way to extract value as risk premiums in companies remain too elevated or too depressed.
With dispersion comes the opportunity for skilled alternative credit managers to isolate the winners and losers in a given segment of the market and to potentially profit on both sides — long and short. In fact, 2020 has been a much more fruitful year for shorting opportunities than recent years, something we expect will persist. We believe that investors seeking to capitalize on this environment should seek out managers supported by a deep and experienced credit research team and other resources (e.g., trading) needed to quickly take advantage of situations that arise.
The recent rally in credit beta aside, we see longer-term imbalances and sources of potential dysfunction in the market. In particular, corporate debt, which has grown significantly in recent years, is vulnerable to the lack of intermediation, or dedicated market-making activities, from the dealer community. Two quick stats that drive home the scale of this imbalance: Since 2008, fixed income assets under management have increased by US$7.7 trillion globally (a seven-fold increase) but primary dealer balance-sheet holdings of corporate bonds have decreased by US$183 billion (approximately -84%).1
What does this mean? More than ever, credit investors need liquidity, in both stable and unstable times. But the lack of intermediation creates a supply/demand imbalance that can cause prices to move in ways that aren’t explained by issuers’ fundamental properties, as investors are forced to pay a significant premium to access liquidity. For example, in the heat of the crisis earlier in the year, we saw bonds hit bids with up to a 40% concession in spread terms, in many cases driven by forced selling of credit ETFs. Figure 2 shows an even more profound example: Credit index derivatives (also referred to as synthetic credit), the deepest, most liquid segment of the credit market, traded at never-before-seen bid/ask spreads — up 10x in a matter of days! To put this in context, at the wides in March, it would have implicitly cost a buyer of high-yield credit index protection approximately US$500,000 to put on US$50 million of exposure.2
Alternatives strategies can potentially capitalize on this dysfunction. Some relative-value (RV) credit strategies, for example, are designed to serve as a liquidity provider, for a price. These managers are typically less concerned about the underlying fundamentals of an issuer and more focused on identifying a disconnect between bids/offers in the market and what they consider a sensible clearing price for a security. When these disconnects are identified, the undervalued securities are bought as longs and the overvalued securities are sold as shorts. Many RV credit strategies seek to diversify their positions to limit the degree of credit risk that could creep into a more concentrated portfolio.
Importantly, opportunities tied to the dysfunction described here may be available regardless of the prevailing environment. There is always a need for liquidity given the size of the fixed income market and flows that, in many cases, occur for non-economic reasons. For example, the market has struggled to digest the large wave of “fallen angels” (BBB bonds falling to high yield), causing a noticeable uptick in volatility in the impacted issues as, in many cases, credit investors have been forced sellers given guideline and benchmark constraints. As is usually the case, these downgrades occurred well after the fundamental change in the credit quality of the issuer — and thus the price volatility is attributable to selling pressure as investment-grade credit managers offload their impacted holdings. RV credit strategies can potentially step in and provide a clearing price for these impacted securities, and in the process potentially take advantage of some fairly attractive market concessions.
We think investors evaluating RV credit managers should look for a robust process for identifying and applying capital to mispricings. Such a process typically requires a significant technology buildout (e.g., a procured database of CUSIP-level prices) and strong counterparty relationships to access the flow in markets and source the bonds that may be needed in these more time-dependent situations.
In summary, despite the pronounced recovery and relative calm in credit markets, we think there should continue to be plenty of opportunities for the taking. The key, as always in alternative investing, is to find managers who have the skill and ability to search in specific pockets of the markets where there are interesting dislocations to exploit. We believe the themes of ongoing credit market dispersion and dysfunction will persist and provide a strong case to look at alternative credit managers with a specialty in fundamental and/or RV investing.
1Source: EPFR, Figures calculated from 31 December 2007 to 31 December 2019. | 2Sources: Wellington Management, Bloomberg. Protection costs are based on the observed bid/ask spread and the calculated spread DV01 as of 16 March 2020. These calculations are estimates for illustrative purposes only and are not based on actual market transactions.
- Below investment grade risks
- Capital risk
- Credit risk
- Risks of derivative instruments
- Manager risk
- Short selling