Credit-focused strategies are emerging as a key area of focus for investors, as managers rush to seize on the “incredible” opportunities being thrown up by the recent widespread market turmoil.
Sussex Partners, the independent global hedge fund investment advisor, says hedge funds focused on this market are zeroing in on a raft of trades spanning corporate credit, structured credit and risk arbitrage, while Man GLG, the discretionary hedge fund unit of Man Group, is now “materially bullish” on long-term trades in high yield assets.
“Every time you have a dislocation like this it creates opportunities,” says Patrick Ghali, managing partner and co-founder at Sussex Partners. “During the last week, we have had at least half a dozen presentations from credit managers looking to set up special situations vehicles to take advantage of this dislocation.”
Credit markets followed equities in taking a hefty beating as a result of the spread of the Covid-19 pandemic last month, with both investment grade and high yield indices seeing slides in the double-digit territory.
But following the distress, managers have moved quickly to capitalise on buying opportunities as assets begin to rise as the result of central banks injecting liquidity support into markets.
“You have had a huge shakeout in credit; a lot of liquidity-driven things that have happened – you’ve had convertibles trading through the bond floor which shouldn’t happen, while long-only managers have had to reallocate,” says Ghali, whose firm advises institutional investors globally on their allocation to hedge funds.
“We’ve been arguing for 18 months that markets were toppy. We put together some portfolios for clients, as we were pretty sure something was going to happen at some point – though not to this extent – and those portfolios are now currently up around 3 per cent.”
Observing the current landscape, he continues: “What we are trying to do now is to understand where the dislocations might be the most severe and where this might create opportunity.
“It’s moving quite quickly; there have been moves specifically in investment grade in recent days, and from what we gather some of those opportunities have already gone. Now is the time to get your ducks in a row, and to have some dry powder.”
Meanwhile, Man GLG is flagging up “rare value opportunities” within the high yield space following sustained indiscriminate selling in credit across a range of sectors.
“We are now materially bullish on a longer-term horizon following the aggressive repricing of market spreads,” Yves Blechner, senior analyst at Man GLG, said this week.
Despite a prevailing backdrop of continuing near-term volatility, the downside risks are limited, with the entry point offered by current spread levels and valuations offering “real long-term value”, and potentially “compensating investors for a much worse default rate outcome than we think might be possible,” Man Group’s discretionary investment unit explained.
In a market commentary on Wednesday, Blechner said: “Historic median data shows that in the right circumstances, equity-like returns are possible when investing at levels the market is currently trading at.”
Elsewhere, the size of the shock to credit markets has been compared with the 2008 global financial crisis – and now structured credit assets may also prove particularly appealing to those investors that can stomach the potentially severe volatility up ahead.
“People are bringing up CLO equities and other spaces in structured credit – we’re already hearing of managers here being down 50 per cent in a month,” says Ghali. “We saw that in 2008-09, when a few managers were down 90 per cent when the dust settled. A year later they’d fully recovered, plus some, and there were no defaults in the portfolio. Back then, those who bought the bottom ended up making ten times their money in 12 to 18 months.
“I’m not saying that’s going to happen again, but these are the potential situations we’re trying to identify right now.”
He continues: “I think you’re going to see some rotation and some reallocation now. Managers will have positions which have held up well so far throughout the correction, but whose longer-term outlook is less positive. Then there might be other parts of the market which have not performed so well recently, but where there’s huge potential there going forward.”
Timing also remains key, with industry observers predicting further sharp spikes of volatility in the next few weeks as Covid-19 cases surge in the US and UK, causing further anxiety in markets.
“While managers see a strong pipeline of opportunities, the majority expect that the bottoming process will not be over in a night,” Philippe Ferreira, senior cross asset strategist at Lyxor Asset Management said in a credit commentary last month. “Managers are spotting deep dislocations and oversold issues, with high alpha potential amid extreme credit dispersion.”
Reflecting more broadly on the sizable upheaval, Ghali suggests that investors who have been “discerning” in their alternative portfolios should have weathered the recent turmoil reasonably well.
“The purpose of a hedge fund portfolio really should be to generate long-term attractive risk-adjusted returns,” he says. “Most investors have a return target in mind, whatever that may be, and there are different ways in which they can achieve that.”
He adds: “You can either have your standard 60/40 portfolio and you take the volatility that comes with that. Or you can put something together which you feel has lower volatility and better risk-adjusted returns, but gets you to the same point. It’s just a question of what you feel more comfortable with.”