By Don Steinbrugge (pictured), Agecroft Partners - Hedge fund managers focused on structured credit strategies can be simplistically divided into two categories: beta managers or alpha generators. Many investors believe the beta opportunity born out of the financial crisis has substantially run its course.
As such, they find risk adjusted returns from structured credit beta managers are not particularly attractive. On the other hand, inefficiencies in the structured credit markets persist, providing opportunities to generate strong, alpha-driven risk adjusted returns relative to other hedge fund strategies.
Beta managers are defined as primarily long biased managers with some leverage. Typically their net exposure will range from 75 per cent to 200 per cent, adding value through security selection with low turnover. Many of these beta managers were founded after the 2008 financial crisis to take advantage of depressed securities prices and double digit spreads above treasuries. These managers were rewarded for adding risk as both interest rates and credit spreads declined from 2009 through 2014, and subsequently control the majority of assets in structured credit hedge funds. It was during this time that structured credit morphed from an exotic niche strategy to a long term core component of many investors’ portfolios.
Today, many investors believe the “trade” is almost over due to the housing recovery and the potential bottoming out of interest rates and credit spreads. Demand for beta structured credit managers has significantly declined since 2014 and has resulted in a few of the larger players closing. The carry for high grade unlevered structured credit has declined to the low single digits, and many of these managers are now exposed to the risk of widening credit spreads.
Alpha generating structured credit managers are defined as those focused on gaps in inefficient structured credit markets and seeking to take advantage of mispriced relative values. They generally carry low net exposure, hedge their portfolio’s tail risk and have more frequent turnover. Their returns are not dependent on leverage or a directional bet on the market. One example within the structured credit market that we particularly like is junior tranches of non-agency residential mortgage backed securities (RMBS). Since shorting the RMBS market is not possible, corporate credit index default swaps (CDS) are one example of instruments that can be used to hedge. In addition to providing an offset to the market risk, investors can take advantage of mismatches between the demand from protection buyers and sellers in different maturities or various option strike prices.
How has structured credit evolved since the financial crisis? Why do market inefficiencies exist in structured credit?
The most significant change in structured credit markets since the financial crisis of 2009 is the effect of the Volcker Rule implementation. This has resulted in a severe reduction in dealer capital supporting market-making of these securities in addition to the closure of proprietary trading desks. As a result, the expertise to price these securities has largely moved from prop desks to hedge funds. Dealers are not actively providing two-way markets in many of these securities. For instance, when a non-agency RMBS bond comes up for auction, there is often no reference point for the clearing price. As a result, market participants with sophisticated pricing models and solid trading experience have an advantage in picking up bargains and selling at favorable prices.
Another important change was the introduction of central clearing for credit default swap indices. This has significantly reduced the counterparty risk embedded in these contracts. (Counterparty risk was one of the primary triggers of the federal government needing to step in to support major financial institutions during the financial crisis of 2009.) Clearing has improved liquidity in index products (e.g. CDX). These indices provide a great way to hedge credit spreads and have low exposure to market direction. Credit default swap index markets are very deep and trade with a very tight bid-offer spread. In our view, this is one of the most efficient ways to hedge structured credit portfolios because of its low hedging costs and efficient capital usage.
Potential risks of investing in structured credit
Both beta and alpha managers are exposed to liquidity risk in their securities portfolios. Structured credit funds may face a liquidity mismatch during times of market distress, which has been exacerbated due to the lack of dealer capital to smooth capital flows. It is important that the manager have the appropriate liquidity terms and gates to prevent being a forced seller and to take advantage of sell-offs.
While beta funds carry the risk from outright market exposure, alpha generating structured credit funds are exposed to basis risk. Most structured credit bonds cannot be shorted (eg CLOs, non-agency RMBS), so managers typically short CDS on high yield, investment grade, or commercial real estate (CMBS) indices or buy equity options for hedging. Sometimes, the long asset and the associated hedge may not move in tandem due to lags between different credit markets. We believe this basis risk is small compared to taking on an unhedged long-only exposure. In distressed scenarios, markets tend to become more correlated, so the hedges should be beneficial even if they do not fully offset the drawdown.
Managers should also be acutely aware of tail risk embedded in fixed income securities. The credit default swap markets afford a very efficient way to hedge credit spreads and put on positive convexity positions which can provide good downside tail protection.
We believe there are still great opportunities in structured credit for managers that are generating most of their return from alpha by taking advantage of price inefficiencies. We are wary of beta driven strategies that look to be leveraging up low-carry return streams to reach their return targets, particularly late in the cycle. The low return correlation of alpha oriented structured credit managers can be an important diversifier to equity exposure without taking on the risk of rising rates. The next credit cycle might again offer great distressed long-only beta trades at some point, but until then we recommend investing in hedge funds that carry low market exposure.
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