Playing defence in a rally
Following a period in which high-yield corporates and equities have rallied roughly 80 per cent off their lows, much of the ‘easy money’ has already been made. Although we are not taking an unqualified bearish view of risk assets, we feel there are reasons to be cautious in the face of an uncertain environment. It is precisely this uncertainty that makes a credit-focused, cross-asset class investment strategy attractive.
We believe that the economic recovery will be more tepid than consensus expectations. The recent rally has been fuelled in part by liquidity and improved perceptions of the macro environment. Chief among our concerns are persistently high unemployment, sizeable budget deficits, withdrawal of stimulus and a lack of organic economic growth. Nevertheless, we’re cognisant of the positive technicals currently present in credit markets, including strong fund flows and record-breaking primary market activity.
This only tells half the story. Given low yields and spreads in line with historical averages, opportunities to generate outsized returns are limited by elementary bond math. Traditional credit funds have little choice but to purchase new issues due to capital allocation requirements from sizeable inflows. The credit profile of the high-yield market has improved temporarily, as issuers termed out maturities and began dealing with the estimated USD1trn-plus wall of maturities due between 2012 and 2014.
That dynamic is coming to an end as issuers take advantage of improved market conditions. CCC issuance is up markedly, and proceeds are being used to return value to equity holders at the expense of creditors. This is a logical reaction to improved market access, low interest rates and a general unwillingness to increase shareholder value via capital expenditure and headcount. This should be familiar to anyone who observed the excesses that led to the credit-fuelled bubble that cracked a mere two years ago.
Cross-asset class managers skilled at picking individual credits have a clear advantage in this environment. Credit differentiation becomes far more important in a market that has rallied indiscriminately and is characterised by modest upside. This is not limited solely to credit, as increasing appetite for other risk assets creates opportunities for managers able to transact across classes. Depressed volatility affords us the opportunity to take advantage of the high correlation between credit and equity markets, providing inexpensive insurance against a decline.
Given the compression between subordinated and senior secured bonds of the same issuer, we see significant opportunities to create defensive positions with a wide band of profitability even if our underlying economic thesis proves incorrect. The rise in high-beta equities has led to opportunities within our relative value debt/equity strategy. As management teams monetise their inflated market capitalisation, these trades have the potential to profit on both sides from a dilutive equity or convertible issuance.
We also see additional opportunities in distressed debt, where profit can be generated throughout an issuer’s reorganisation cycle. Purchasing undervalued, asset-covered secured paper prior to reorganisation will often lead to a subsequent trade in cheap post-reorganisation equity.
The road ahead remains uncertain, and the relative returns of different asset classes will be path-dependent. A sharp move in either direction broadens our opportunity set, as dislocation between securities increases. With the flexibility and expertise to shift quickly between asset classes, our approach allows us to take advantage and profit going forward.
Henry Pizzutello (pictured) is chief investment officer and Brad Lo Gatto is portfolio manager and head of research at Centaur Performance Group
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