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?
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.
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.
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.
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.
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.
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.
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.
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:
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.
Other investors prefer niche, smaller managers (sub-$500M in AUM) that can make small, higher returning opportunities more concentrated in their portfolios.
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.
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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