The Worst of All Debt

Markets in May: A Focus on the US Debt Ceiling

‘Junk bond king’ Michael Milken recently summarised the lessons he learned in investing in credit markets during the last five decades. One of those was that sovereign bonds are the “worst of all debt”. That summarises our emotions during the second half of May well, when we watched how the political class in the US dealt with the debt ceiling. A sovereign default of the US became a real possibility. US Treasuries are considered the safest debt, issued by the most powerful nation with a mighty economic engine and near unlimited ability to ‘print’ its currency to repay creditors.

Anything can happen when the political system of a nation is borderline dysfunctional. We believe that it has been wrong to discount this saga as show for commercial news channels and to rally up the fringes of the political spectrum. Frustratingly, we saw a fair amount of complacency amongst investment managers taking the view that it’s a fabricated crisis which can, and will, be ‘solved’ once the market pressure is high enough. But where is that pressure point and what can break in the meantime? The willingness to ‘blow up the system’ is high amongst many representatives that the people have asked to govern us. To ignore (extremely?) low-probability, high-impact events isn’t a risk-management strategy.

With a tentative deal agreed, the worst has for now been prevented for the safest of the “worst of all debt”. Some damage has been done though (as the rating outlook changes of two agencies have shown). And the long-term issue of an unsustainable stack of debt remains unsolved. But that’s a story for another day (when the market forces the issue as neither of the two parties is willing and able to tackle it when in power).

Another headache for hedge funds in May was that regulators once again put their hand on a corporate transaction. The same country that was musing whether or not to pay its debt felt it needed to interfere in the merger between two private corporations, Horizon Pharma and Amgen. The Federal Trade Commission (‘FTC’) has an important role in securing the functioning of capitalism and the heavy hand by anti-trust bureaucrats isn’t a phenomenon we only observe in the US (the UK CMA’s Activision Blizzard/ Microsoft intervention last month comes to mind). Merger arbitrageurs were caught off-guard by this, and the market noise was that the FTC doesn’t have a strong case. We shall see. Today, we only state that the case for the M&A strategy hasn’t been strong – May’s return will pull them into the negative (again).

Judging by equity market volatility, equity markets ignored most of this, with the VIX staying in somewhat narrow range. But that’s like claiming there are no currents just because the surface of the ocean is calm. The market didn’t like Value and low Beta stocks; but it liked speculative companies with the AI frenzy doing its part.

Who's to ‘blame’ for the low equity volatility? When no other narrative is available, ‘the quants’, of course! As if this class of systematic investors is a monolithic, homogenous group that trades in concert!

Another lesson that Mr. Milken shared was that ratings aren’t research. Whether it’s sovereign bonds, money market exposures or merger agreements – in-depth research is often not glamorous; but it can make a difference. We are betting on it.

Key Drivers of Hedge Funds’ Performance: An Early May Snapshot

Equity Long-Short:

• Performance for equity long-short managers was muted in May as the market awaits the outcome of the US debt ceiling negotiations;
• Sector TMT funds – especially those with exposure to the AI ‘theme’ – outperformed in May alongside a somewhat narrow rally in the Nasdaq composite;
• Asia-based long-short managers tended to underperform but results were mixed: China-focused funds struggled while Japan-focused funds advanced in May, with Beta a driving factor of returns.

Credit:

• Corporate credit managers generally enjoyed another month of modest positive returns against a backdrop of mostly negative total and muted excess returns for credit markets;
• Managers saw small gains across cap structure arb, convertible bonds arb and credit long-short strategies, with few meaningful single-name P&L drivers, similar to last month; rates hedges contributed positively while other portfolio hedges were modest detractors;.
• Managers with exposure to US financial preferreds had a challenging month after the failure of another regional bank and speculation about others;
• Structured credit managers were up small driven by carry and modest spread tightening.

Event-Driven:

• A very challenging month for event-driven, particularly in merger arbitrage where losses were led by the First Horizon/Toronto Dominion deal break early in the month and the FTC decision to sue to block the Horizon Pharma/Amgen merger, as well as several other smaller deal set-backs;
• Merger spreads widened across the board, potentially overshooting in some cases, which saw some managers entering or adding to positions opportunistically. Deal activity was decent, with several new transactions announced in the $5-15 billion range;
• Special situations generally detracted as equity markets struggled and mid-cap index multiples traded down;
• Asian-focused strategies also struggled in volatile markets amidst selling pressure. China offshore positions saw risk reductions post-earnings, and relative value spreads widened. Japan has been a positive offset, benefiting from multiple tailwinds.

Macro:

• It was another month of muted returns in discretionary macro. While managers are generally not trading around their views on the debt ceiling negotiations, the uncertainty it brings has encouraged them to maintain lower risk levels and continue with a more cautious trading approach. However, we saw positive returns from emerging-market themes, including Turkey and Tunisia, while long euro positions caused losses.

Quantitative:

• Trend-following strategies were positive in May. Short fixed-income positions worked well in developed markets as investors priced in a sustained period of higher policy rates, while Japanese yen shorts also added. Alternative trend strategies were also up, helped by a continuation of trends in credit and alternative energies;
• Quant macro performance was more mixed. Fixed income trading has generally produced gains from net short positioning. However, currencies have proved difficult, with macro models struggling due to reversals in the euro and Australian dollar. Energy trading continues to frustrate with crude oil longs detracting;
• In quant equity, some managers complained about de-leveraging in the first weeks of May. Value was a detractor, with only modest support from Momentum. Quant credit strategies gave back some of their year-to-date gains.

On the Radar:

• Now that a debt deal has been passed, we are watching the impact of the Treasury replenishing its accounts. There are concerns that the flood of issuance may lead to rates volatility; however, the issue has been widely discussed and our view is that its impact may be more muted than some feared.
• The loan market experienced a number of defaults in recent weeks. None of them came as a surprise, judging by how issuers’ debt was priced. We are keeping an eye on signs of more distressed in corporate credit.
• If ‘AI’ is unleashing a lot of imagination (of which little will play out as the hype suggests today, of course), commercial real estate (‘CRE’) is feeding the doomsday scenarios. Many players are talking about the risks for offices and downtown retail ; and some are betting against it. What is going to be critical in defining how the downturn is going to play out depends on the time frame. Ideally, it will be spread out and a few more regional banks – who hold concentrated exposures in CRE – may have the chance to earn enough to offset write-downs.