Man FRM Early View - January 2020

What to make of the mixed performance from Credit hedge funds in 2019?

  • January was a positive month for the hedge fund industry.
  • Equity Long-Short managers, Credit Managers and Event Driven managers were all positive, while Quantitative strategies were more mixed.

Markets

Should we be excited about Credit? It’s hardly a new topic given its stellar returns over recent years, but it is a topic of controversy amongst hedge funds and institutional investors. Of course, when we look at Credit from a hedge fund perspective, it is more often than not a search for alpha from fundamental mispricings and/or process-oriented outcomes rather than a hunt for yield. This didn’t always work last year: the degree of dispersion between Credit hedge fund managers was surprising given strong returns for the corporate Credit markets. And there were some relatively high profile underperformers. Is there something looming in Credit markets that serves as a barometer for the health of the economy and vulnerability of markets?

On the surface, the story is well worn, and not particularly interesting. The Central Bank liquidity taps are back on following the aborted attempt to tighten monetary conditions in 2017 and 2018. Excess liquidity finds its way into corporate debt and spreads tighten. At some level of Credit spreads the free lunch of long term excess returns over cash becomes indigestible under any sensible model of default risk, but it seems we are still some way from that yet.

As ever, the most interesting dynamics are hidden away beneath the surface. And there are several today that suggest a different response to previous liquidity injections. Firstly, leveraged loans have lagged the duration-sensitive parts of the Credit complex, explained by their floating-rate nature and resetting of Fed rate hike expectations, but still somewhat unusual behavior for late-cycle risk-on moves. Secondly, the significant growth in the lower quality Investment Grade BBB rated debt, which now accounts for roughly 50% of the investment grade universe. Finally, the US high yield Credit quality curve has steepened over the course of the last year, with higher-rated BBs outperforming CCC-rated debt despite no material increase in overall defaults, again somewhat unusual in a strong risk-on year across asset classes.

While we haven’t changed our long held belief that calling the end of the cycle is a mug’s game, we will venture some thoughts on how these anomalies might develop. The loan market looks difficult to support if rates continue to be low, with no rate hike expectations in the near- to medium-term, especially as defaults have been picking up in the sector (albeit from low levels) and CLO demand for lower quality loans remains constrained.

The abundance of BBB rated debt has been cited as a possible epicenter of a crisis. Demand for these bonds is high given it’s the highest yielding option in the investment grade universe. However any increase in downgrades, so called ‘fallen angels’, leads to technical selling from investors who cannot hold high yield debt for a plethora of reasons. And after all, if they could hold lower quality debt, wouldn’t the hunt for yield have already led them there? The theory goes that this could lead to a domino effect through the Credit universe with no obvious marginal buyer to absorb the potentially enormous volume of downgraded bonds. It’s startling how often risks (and opportunities) are caused by artificial constraints – three B’s good, two B’s bad.

The steepness of the US high yield Credit curve has been blamed on the poor performance of energy-related stressed/distressed securities. And longer term, quite what the impact will be of the growing focus on at least the ‘E’ of ESG amongst some of the investor community remains to be seen. However, we believe that it’s at least partially driven by investors who move out on the liquidity spectrum rather than on the quality spectrum in the hunt for returns.

This push out on the liquidity spectrum has become more common over the last few years, particularly amongst pension assets. Their thread of logic seems to go something like this – rather than hold equities/lower-rated high yield debt with their attendant volatility and ‘uncertainty’ of return, they would rather hold some form of illiquid debt (issued, sometimes, by the same types of companies as that unpalatable equity). Whatever the cause, this demand seems to have spawned an almost entirely new area of the investment landscape – private Credit funds. These arrangements are manifestly less liquid than equities in the period until repayment or maturity, but then offer the illusion of ‘certainty’ of cash flow at some predetermined date in the future. In theory very helpful from both a yield, and a liability matching perspective. However, it is as if switching from a liquid lognormal distribution with a volatility (standard deviation) to an illiquid binary distribution without a volatility measure, somehow magically reduces the risk? Quite what the impact of a negative binary event would be (in this case likely a spike in defaults caused by a recession) isn’t clear to us.

Of course, there are some interesting debates around parts of the less-liquid universe that may be somewhat insulated from any forthcoming economic downturn. One area is consumer Credit-backed structured Credit, such as RMBS – that leading culprit of all our woes in 2008. Markets have seen a continued trend of Credit curing and improving delinquencies across this sector as the consumer balance sheets have been supported by home price appreciation, continued low unemployment and low interest rates. From many angles, the US consumer is in much better economic health than most US corporates, and given the relatively limited supply of new securitized mortgage products, it is tempting to conclude there is possibly more upside for the asset class than in other areas of the Credit complex. However, given the scars remain from the global financial crisis, it is likely that Structured Credit gets caught up in a risk-off move as well, similar to 2015/early-2016 even if the fundamentals remain strong.

The combination of Central Bank taps, huge demand, a hunt for yield, and in some cases somewhat artificial constraints have contributed to some of these dynamics. How these play out through either a proper tightening of liquidity by Central Banks, or a material spike in defaults caused by a recession isn’t clear. It is at this point the tolerance for illiquidity and willingness to ignore mark-to-market losses would be sorely tested. Calling the end of a cycle may well be a mug’s game, but trying to be well prepared for it certainly isn’t.

 

Hedge Funds

Hedge Funds generated positive returns in January. Equity markets remained buoyant in the first half of January but were derailed by the emergence of the coronavirus in China which weighed on global markets, especially transports and pro-cyclical sectors, alongside the likes of crude while safe havens tended to rally.

Where else to start this month’s rollick through hedge funds than Credit Managers? Amidst the volatility in the equity markets and a rally in government bonds, US investment grade Credit outperformed high yield and leveraged loans. January saw strong US high yield and leveraged loan issuance led by refinancing and re-pricing activity. The meaningful sell-off in crude oil on global growth concerns drove the underperformance of the Energy sector in the month.

Corporate Credit managers were mostly positive in the month; bright spots included US financial preferreds on good bank earnings and opportunities in the primary market as well as convertible arbitrage, which benefited from elevated equity market volatility. Reorg and value gaming equities and commodity-related Credits/reorg equities were detractors – driven by the potential impacts from the spread of the coronavirus. Incremental progress in a potential deal between the Creditors and Puerto Rico drove positive P&L for some.

Spreads were largely stable to tighter across most securitized products sectors, with the lower-rated CLO tranches continuing to outperform. Most Structured Credit managers were also up in January.

Fundamental Equity Long-Short funds broadly tended to perform positively with outperformance from the US vs. Europe and Asia. Gross and net leverage levels remained elevated in January before falling slightly in the latter part of the month over fears about the spreading Coronavirus.

As of writing this, some of the better performing sectors YTD in the US have been Info Tech and Commercial Services but they have seen the most net selling this month as investors look to take profits (according to GS Prime data). Over half of the Information Technology sub-sectors have been net sold on a YTD basis led by Software and Interactive Media Services while Semiconductors and Semiconductor Equipment is one of the more net bought on continued momentum from US/China phase 1 trade deal. These are a reversal from what we witnessed last year.

Event Arbitrage has had a positive start to the year with most funds up about 1%. The environment continues to be benign for hard catalyst trades, although the 2020 pipeline for new deals has gotten off to a slow start in comparison to the very active fourth quarter of 2019. That said, significant amounts of private equity capital remain available for deployment. An additional small but growing pool of capital stems from public listings of so-called Special Purpose Acquisition Vehicles (‘SPACs’) that raise cash from investors with the express purpose of looking for companies to buy. 2019 was a record year for SPACs in the US.

In some interesting deal news, one day before the merger of Just Eat and Takeaway.com was due to be completed, the UK’s Competition and Markets Authority (CMA) decided to launch an investigation into the all-share deal of the food deliverers. The surprising announcement by the regulator was criticized by the market as intrusive, but is generally expected to only delay the integration by a few weeks and not change the outcome.

Managed Futures managers were generally positive in January (the SG CTA index was up around 1% at the time of writing). Gains were primarily driven by Fixed Income positions. Long exposure helping amid heightened Coronavirus outbreak. Equity was also generally a positive driver, though this was more mixed than the Fixed Income attribution. Commodities and FX were close to flat across most managers.

The equity exposure has actually come down marginally across the systematic space, having been at close to highs at the start of the month – both due to volatility and the signals. The reverse of this is also true, with managers starting to build a long exposure in Fixed Income, having been flat in the asset class for some time. In FX, managers have started to build into a long USD position.

Performance in Statistical Arbitrage was mixed. The factor space was actually modestly positive over the month (albeit was dispersion in returns), while technical strategies seem to have suffered. Despite early setbacks, returns generally picked up during the second week of January and continued to improve throughout the latter stages of the month. Value themes struggled whilst Momentum, Growth and Quality themes drove performance. Low Beta and Low Vol were notable factors on the positive side, whilst forward-looking PE and operating cash flow metrics hurt Value. Mean reversion technical strategies struggled through the month.