“Markets are shifting”: How US hedge fund Mill Hill Capital is carving opportunities from structured credit dislocation

Dave Meneret & Nick Pepe, Mill Hill Capital

Founded in 2015 by David Meneret (above left), a former Macquarie senior portfolio manager and structured credit specialist of almost 20 years, New York-based credit hedge fund Mill Hill Capital believes the current market landscape offers fertile ground for its market neutral, relative value investment style.

“All in all, markets are shifting right now,” Meneret, the firm’s chief investment officer, says of the current investment landscape in credit. “They are a good place to find dislocations, to move around the portfolio, and to look across opportunities not only in CLOs, but also in shipping bonds, aircraft, CMBS, RMBS and in financials.”

The firm launched its first fund, Mill Hill Credit Opportunities, in 2016 focusing on four main asset classes in the US credit markets: collateralised loan obligations, corporate financials, corporate transportation and asset-backed securities, the latter spanning a broad range of sub-classes including residential and commercial mortgage-backed securities and esoteric ABS.

‘Apples and oranges’

“The models in our investment process allow us to compare apples and oranges on a constant basis,” Meneret tells Hedgeweek. “They help us determine whether it’s more interesting to allocate to CLOs, or to transportation, or mortgages or financials.”

Describing Mill Hill’s investment approach, Nick Pepe (above right), chief operating officer, managing partner and head of business development, says the firm sits at the intersection of the structured credit, securitisation and corporate bond Venn diagram.

“While those markets are large and quite efficient in and of themselves, what we find when we look across those markets is that sometimes there are glaring inefficiencies,” Pepe explains. “Due to the different buyer bases, different metrics, and different ways of evaluating value, sometimes the corporate credit market and the securitised market don’t line up - and that’s where we look to capitalise.”

Before launching Mill Hill, Meneret spent almost seven years at Macquarie between 2008 and 2015, latterly as a senior managing director and senior portfolio manager focusing on securitised debt in the firm’s Credit Nexus Fund, having earlier headed securitised debt trading within its Credit Principal Trading unit.

Before that, he managed ABS CDO, CLO and aircraft ABS trading on UBS’s structured products proprietary trading desk in New York between 2006 and 2008, having earlier structured aircraft and esoteric ABS for Credit Lyonnais Americas and Credit Agricole Calyon Americas.

Today, Mill Hill manages two private funds: their flagship Credit Opportunities Relative Value Fund, and the Mill Hill Convex Credit Fund, which launched in July 2020 to capitalise on growing investor appetite for alpha-generating short trades.

Volatility

While many investment managers operating in the securitised credit space are often long-biased, Mill Hill’s strategies are built around a resolutely market neutral trading style, an approach the team says has served the firm well in light of last year’s Covid disruption, when it experienced a far less severe drawdown than many of its competitors.

Last year, the Mill Hill Credit Opportunities strategy generated a 2 per cent annual return, and the flagship fund has continued its positive momentum into 2021, rising 6 per cent since the start of January.

Looking back on a tumultuous 12-month period, Meneret points to the “welcome return” of volatility last year, following a prolonged period throughout 2018 and 2019 when there had been a distinct lack of market dislocation. 

“Those markets were behaving with very little volatility and very few defaults. But since last year it has been very different – markets have generated many opportunities for us,” he continues.

For the first time since 2009, the US has seen a high number of corporate defaults among companies who had previously been able to refinance year after year, despite poor earnings, he adds. As a result, this rise in US bankruptcy filings is throwing up what Meneret sees as “very attractive” trades from a relative value perspective.

“Even though we saw a pretty fast recovery last year after March and April, we've since seen periods of high stress concentrated in certain areas,” adds Pepe, who before joining Mill Hill was a senior member of Citigroup’s Global Securitised Markets business between 2005 to 2018, focusing on an assortment of transaction spanning RMBS, CMBS, ABS, and CLOs for institutional investors including hedge funds, money managers and private equity funds.

“We still have had those mini-spikes of illiquidity that present attractive opportunities to enter into new relative value positions - in CLOs during the summer; at the end of October for the aircraft market; in December for some parts of the mortgage market.”

Alpha focus

Observing the current market landscape, the pair point to particularly enticing trades surfacing in the shipping, aviation, specialty finance and CLO segments of the firm’s investment universe.

Meneret notes that for the first time since 2007, certain secured bonds in the shipping space are now trading at a discount to the underlying metal commodities – typically steel – that are used to build large vessels, a development he sees as a “pretty unique opportunity”.

“We selected the credits with the most attractive loan-to-values and the ones with the most amount of upside, and paired those bonds with out-of-money puts on miners and metal producers,” he explains. “While we lost money on the put options, we’ve made a lot of money on the shipping bonds.”

Meanwhile, the team are also zeroing in on a number of mezzanine CLO tranches with strong underlying leverage loan portfolios which have withstood last year’s spike in default rates. As the market rebounded, that default rate spike has rapidly given way to prepayment spike - a shift yet to be reflected in those bonds’ ratings.

“Essentially, you can buy A- or AA-type CLO risk at BBB-type yield for a very short duration, because the rating agencies are slow to upgrade many of those improving tranches. It’s a tremendous opportunity to buy some static CLO tranches that are benefitting from high prepayments,” Meneret explains.  

“On one side, we’re buying a bond that’s BBB-rated, but yields more on an unlevered basis than single Bs in the corporate bond market. On a levered basis, these tranches yield in the mid-teens,” Pepe adds. “We use that income to fund really convex shorts on select high-yield indices which are very exposed to macro moves and uptick in defaults or downgrades.”

In order to further capitalise on emerging investment opportunities, especially shorts on over-levered corporate debt, the firm launched the Mill Hill Convex Credit fund last July, following growing investor interest in its short book during the Covid correction.

“Alpha-generating shorts are a real focus for us. We don’t treat shorts as just a hedge; sometimes our shorts are the thesis behind a pair trade,” Pepe explains of the second fund, which is positioned as a carry-neutral, long-volatility, directionally-short tail strategy. “This short fund is also quite unique in that investors looking to hedge their credit risk can allocate to this fund.”

He continues: “It's long volatility, but doesn't cost any carry – the portfolio carry is about zero per cent. We’ve allocated right now about 1300 per cent of our AUM in notional shorts, and about 150 per cent of our AUM in notional longs. That means that in the event of a correction or a steep sell-off, the portfolio should do quite well.”

Part of the appeal of the convex portfolio, says Meneret, is that it’s well-designed to generate returns either in a repeat of March 2020, or more benign environments such as 2011 or 2016. So far, the strategy has generated significant alpha, gaining 6 per cent since its July 31st inception, while the high-yield market by comparison is up around 5.1 per cent over the same period.

Adapt and evolve

Investor sentiment has shifted in recent times, says Pepe, with more interest coming from large family offices looking for kind of outsized returns in an era of compressed yields. Meanwhile the endowment and foundation sphere is also demonstrating renewed appetite for the firm’s strategy.

Family offices currently comprise around 49 percent of Mill Hill’s AUM, while endowments and foundations account for about 20 per cent capital. Just over a quarter of AUM is from fund of funds investors, with the remaining money coming from in-house partners.

“We’re speaking with endowments and foundations who are looking for creative hedges for long biased portfolios that suffered losses in the Covid crisis. We think that our Convex Credit Fund is a great solution,” Pepe says. “Our Master Fund is also set up to do quite well in the event that volatility spikes again.”

Reflecting on the unfolding investment environment, Meneret suggests there are “lots of hurdles” still looming in the US economy, and says Federal Reserve policy has created the opportunity for many cheap shorts.

He believes the market is anchored around “extreme support” from the Fed, which is leading some to discount any kind of extreme shock in the next two years.

“We cannot predict the future. We don’t pretend to know what type of shock may take place in the next two years. But, right now, credit markets are not equipped to deal with any kind of shock, given current valuations and extremely high leverage.”

He continues: “The current market implied default rate for 2021, as crazy as it sounds, is less than 1 per cent. We live in a world right now where the capital markets seem pretty convinced that the Fed is going to be very successful in making sure that almost no company defaults in 2021. That might very well be the case, but that basically implies that some other securities – especially CLOs, aircraft ABS, or some specific RMBS - are extremely cheap at current valuations.”

Against that backdrop, both Meneret and Pepe underline the need to adapt and evolve according to the prevailing opportunity set, noting that Mill Hill’s approach offers investors exposure to credit markets without picking a direction in which the credit markets will go.

“For us, one of the things that’s very important right now is being able to keep on generating alpha on the long side, and alpha on the short side,” Meneret adds.