What's Trending - Allocator Perspectives on Investment Strategies - Q1:2017 - Pershing Prime Services - BNY Mellon

In anticipation of rising interest rates, many investors have avoided liquid credit strategies. However, not all investors are so bearish. What opportunities are these investors seeing with liquid credit hedge funds? What considerations do they have around credit spreads, volatility and other market forces?

LIQUID CREDIT: A GAME OF PATIENCE

In the opinion of many investors, rising interest rates will lead to the return of volatility in the credit markets, which should increase price dispersion and provide future opportunities for hedge funds. Since volatility remains close to all-time lows, many investors are sitting back and waiting for volatility-increasing scenarios to play out, including: (i) an increase in corporate defaults, (ii) the White House's ability to implement economic stimulus initiatives including healthcare reform, corporate tax cuts, and infrastructure spending, and (iii) a large market correction occurrence caused by a thematic or sentiment-driven catalyst.

INVESTOR AREAS OF INTEREST

Liquid credit strategies available to investors include relative value corporate credit, distressed corporate credit, structured credit, government securities arbitrage, and convertible arbitrage. The views expressed herein were shared by different investment consultants, fund of funds, and wealth management firms.

Relative Value Corporate Credit: There are a number of strategies within relative value (RV) corporate credit, including:
- Cash Structure Arbitrage: Managers take long and short positions across the capital structure of a single name issuer.
- Cash versus Synthetics: Managers are long cash bonds and short credit default swaps (CDS).
- Synthetics Only: Managers are long and short CDS.
In the post-credit crisis era, default rates remain low, and credit spreads are tight. In the opinion of some investors, investing in RV corporate credit strategies today (before the next distressed cycle begins) may expose them to unnecessary tail risk. However, other investors are comfortable investing in these strategies as long as managers are short duration and can change their net exposures dynamically.
Distressed Corporate Credit: In this space, managers buy stressed and distressed corporate credits, become active on bankruptcy creditor committees, and work on company restructurings/turnarounds. Strategy returns come from selling post-reorganized equities at a profit to interested investors, including private equity firms.
As per investors, there has not been a new bankruptcy cycle since the credit crisis, and default rates remain very low. As a result, distressed managers are still invested in many of the same situations they have been invested in for years, including Lehman Brothers and MGM. This has left many managers eager for new opportunities.

In certain instances, managers have entered the credit markets too early in search of distressed opportunities, most notably in the high yield energy space. The managers who were early to energy credit (during 2014 and 2015) experienced large double-digit losses. However, these strategies recovered during 2016 and 2017 and many are now flat-to-slightly positive. Those managers who were more patient (entering the space in 2016) avoided heavy losses and have experienced positive performance.
Structured Credit: Within structured credit, there are a number of different areas, including CMBS, RMBS, ABS, and CLOs. Since the credit crisis, the securitization market has been shrinking, and there are fewer market makers in the space. As a result, the structured credit space has become a buyer's market. As per investors, this space has been and will continue to provide attractive opportunities for hedge funds.
In most cases, structured credit hedge funds focus on yield generation. To achieve this, many managers are long select credit tranches and hedge their exposure with CDS on tranche indices. Other approaches include RV structured credit, when managers arbitrage price differences between tranches in different geographical areas, most notably Europe versus the U.S.

As per investors, these strategies can provide attractive upside returns if allocations are made at the right time. For example, during 2016 and 2017, many investors allocated to CLOs to take advantage of the energy credit rally. These opportunistic and carefully timed allocations have returned made large double-digit returns.
Government Securities Arbitrage: This category is specific to strategies that trade U.S., Sovereign, and municipal government credit markets. As per investors, strategies available include treasuries versus treasuries, municipal securities versus treasuries, and structured credit versus treasuries.
As a result of a prolonged period of low interest rates, many government securities markets have flat yield curves and low volatility. In the opinion of some investors, the increasing interest rates in the U.S. coinciding with pursuit of monetary easing in other countries creates divergent monetary policy, and this should provide more opportunities for hedge funds.

Also, within municipal markets, some investors believe that if the White House can implement their infrastructure agenda, more municipal and municipal-like opportunities may come to market. For the time being, this is an area where many investors prefer waiting for more volatility and price dispersion before investing in these hedge fund strategies.
Convertible Arbitrage: With this strategy, managers arbitrage the price differences between an issuer's convertible securities and its equities. As per investors, this space has been much less crowded since the credit crisis.
In the opinion of some investors, the prolonged period of low interest rates has limited the upside returns within the convertible arbitrage space. However, with increased dispersion from rising rates and increased short rebates, convertible strategies may become more attractive.

OTHER INVESTOR THOUGHTS

In addition to the views shared above, there are a number of other factors investors take into consideration when evaluating credit hedge funds. These include:

Liquidity: Some investors have challenged the idea of credit markets being liquid (i.e., liquidity versus perceived liquidity). As per investors, liquidity will change as market environments change. A top concern of investors is that retail investor crowding in the investment grade and high yield credit space (through mutual funds) can cause sharp sentiment-driven market corrections, which can reduce liquidity and depress prices. In the opinion of some investors, the managers with the best performance during sentiment-driven price swings are highly cognizant of retail mutual fund flows and their effects on credit spreads and valuations.
Fund Structures: Less liquid credit strategies offered via private equity fund structures are becoming more popular with large institutional investors. In the opinion of some investors, these structures prevent funds from forced selling caused by investor redemptions. Strategies offered via these structures include stressed and distressed credit, less liquid performing credits, and some off-the-run structured credits. The average fund life is between four and five years.
More liquid investment grade strategies continue to be offered through hedge fund structures. Some notable changes to investor liquidity are increased additions of investor-level gates, which limit individual investor redemptions to 25% of their capital balance at each fund liquidity window.
Duration Risk: The most discussed area of concern among credit hedge fund investors is duration risk. To address this, some investors have been using floating rate/fixed rate arbitrage strategies and private market lending strategies to create positive convexity in their portfolios. Additionally, many credit managers have shifted from longer-term value investing to short-term trading.
Manager Size: In the opinion of some investors, managers that have $2B or less can trade more easily than larger managers. However, larger managers have other advantages that come from being meaningful counterparties to Wall Street. To capture the advantages of both, some investors prefer smaller investment strategies offered by large hedge fund organizations.
Other investors prefer niche, smaller managers (sub-$500M in AUM) that can make small, higher returning opportunities more concentrated in their portfolios.
Lags Among Credit Types: As per investors, it is common for price changes to lag among different credit types. For example, during 2016, oil prices started rebounding. As a result, investment grade credits should have rallied. Instead, high yield credits rallied. In this case, the prices of the safer credits (investment grade credits and structured credit) significantly lagged the prices of the less safe credits. The view of some investors is that safer credits are now cheap relative to less safe credits. As a result, safer credits may experience rallies in the near future.
Industry Concentration: To prevent industry concentration risk, credit managers are now more careful with capping industry exposures. For example, many high yield managers have capped their energy credit exposures to 10%-15% of their portfolios. In other cases, some managers that have previously shorted certain sectors unsuccessfully (retail for example) have decided to exclude those sectors from their portfolios for the time being.
Fees: Some of the largest institutional investors increasingly prefer fee structures that emphasize performance. For example, some investors have proposed 1% management fees with 30% performance allocations. Other investors are now requiring management fees and performance allocations-over-a-hurdle rate with a catch-up.
A catch-up is when an investor does not pay a performance allocation until specified net returns (e.g., 8%) have been achieved. Once that occurs, the manager is entitled to the next specific amount of net returns (2%) to catch up on their performance allocation. Once the manager is caught-up, investors go back to only paying the performance allocation.

CONCLUSION

Many investors who are bearish on liquid credit strategies already have significant long-only credit exposures and will likely remain uneasy about the impact of rising rates across their portfolios. On the other hand, those investors who specialize in credit hedge fund investing will continue to be excited about the opportunities that rising interest rates and increased volatility will bring to the credit markets.

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Market Commentary Investment Solutions Pricing Strategies

What's Trending - Allocator Perspectives on Investment Strategies - Q2:2017

LIQUID CREDIT: A GAME OF PATIENCE

INVESTOR AREAS OF INTEREST

OTHER INVESTOR THOUGHTS

CONCLUSION