Neil Mason Senior Managing Director
The markets have witnessed a volatile and retrograde start to the year, with equity indices in flying retreat: the major Western markets have recorded significant falls, while in the emerging market space it has been even more of a rollercoaster ride.
Global equity market declines
January 4, 2016 to February 11, 2016
Morgan Stanley reports that it has seen USD 1 bn of trading flows on its European equity desk every day this year so far (this only occurred 50 times in 2015 and 15 times in 2014): volumes are very high and many large institutions are selling. Oil prices have continued to plummet, driven by concerns over global growth and not helped by Iran’s reintegration into the fold. Commodity prices have largely followed suit. Credit spreads are heading towards 5-year wides, with banks and financials coming under particular pressure.
Not everyone expects the UK and US economies to move into recession in the coming year, but it’s clear that there are significant headwinds to contend with, and that Janet Yellen may be forced to abandon her interest rate rises almost before they’ve begun (with some even predicting a rate cut before the year is out). If we were feeling pessimistic, it would be easy to construct a scenario where a continued Chinese slowdown coupled with banks reining in lending after taking losses on loans to energy companies leads to a sustained period of low to no growth. Even in an optimistic vein, it’s clear that we are going through a clearing moment in the markets and that volatility is likely to persist for some time.
It is likely that we are entering a new downward phase of the cycle, although how prolonged and contained it will be is debatable. The previous two significant corrections – the Dot Com Bust of 2000 and the Credit Crisis of 2008 – both followed similar patterns. They began with the sector at the heart of the crisis (internet stocks in ’00 and subprime lenders in ’08), before spreading to second-derivative industries (telcos in ’00 and broader financials in ’08). Both took more than a year to resolve themselves and were accompanied by stories of fraud and corporate malfeasance that led to volatile and disjointed recoveries. While another 2008-style scenario currently appears unlikely, the significant amount of volatility and dispersion generated by recent events has created meaningful opportunities.
This time around, distress centers upon the energy sector, which had dangerously over-extended itself in an era of USD 80-100 per barrel oil. Oil and commodity price inflation was largely driven by a Panglossian belief in China as a kind of risk-free perpetual bond churning out 7% GDP growth ad infinitum, leading to widespread over-investment in commodity-related capacity. We have already seen second-derivative sectors drawn into the firing line, with utilities, industrials, and shipyards all suffering in the current rout. The latest industry to come under the spotlight is financials, with rumors circling about loan exposure to commodities firms and the knock-on effect for capital ratios.
Warren Buffet has been right so many times that his market pronouncements have become platitudes, but the fear on the financial streets is palpable and it is at this point that opportunities begin to show themselves. We asked our managers to outline their thoughts about the current volatility, and to highlight their highest-conviction trades.
Simon Freeman Portfolio Manager
We are currently witnessing an unprecedented opportunity in the world of M&A arbitrage, with deal spreads at historical wides and a wave of merger activity ahead. This perfect storm of wide deal spreads and frantic deal volume could have the potential to offer real opportunities for M&A arbitrage.
2007 was the last bumper year for M&A (although spreads then were nowhere near as wide as they are now). Post-Credit Crisis, CEO confidence was crushed, which meant that despite a backdrop of cheap financing and low global growth (which should drive deals), management teams were focused on cost-cutting and getting their houses in order. The situation has now changed dramatically.
2015 proved to be the best year for merger and acquisition volumes since the financial crisis. Now, with macro risks escalating, CEOs appear to be increasingly looking to put their corporate ‘war chests’ to work in order to diversify operations and access new markets. Management teams who were previously comfortable keeping their cards close to their chests are being forced to play their hands by the extreme volatility of the early months of this year. Accordingly, we suddenly have a full slate of often very large deals, some of which are extraordinarily complex.
The graph below shows the distinct widening of M&A spreads over the past 18 months – from 1% to 6% on average, but with some deals at unprecedented levels – the Baker Hughes / Haliburton tie-up is trading at a 28% gross, 65% annualized spread, with even less complex deals such as Dell / EMC trading close to 40% annualized spread1. This extreme dislocation has been driven by a combination of factors: an increased number of multi-billion dollar ‘mega-deals’, which mean merger arbitrage funds (which might typically own 20-40% of a target company) are unable to assert significant pricing influence; a deal mix that is more skewed towards complex transactions – larger deals with more regulatory hurdles to get over; a difficult backdrop throughout the second half of 2015 with choppy economic waters and several high profile deal breaks; and, because of this turbulence, a general aversion among event-driven funds for longer duration (>6 months) deals.
Spreads on merger arbitrage deals have widened considerably
Source: Bloomberg data; Merrill Lynch (period analysed: June 30, 2013 to December 9, 2015).
There’s also the activity of the long-only funds which are involved in this space to take into account. Some of these funds buy the target in an M&A situation as a cash-proxy, in the knowledge that prices will be supported by the promise of the imminent deal. Now they have become an easy source of liquidity as exceptional opportunities have emerged elsewhere. So, for instance, funds which have invested in Baxalta, a biotech firm being purchased by Shire whose stock price has remained fl at despite the current volatility, have been selling out in order to invest in, for example, BioMarin, another, comparable, biotech firm, whose stock is down 36% YTD.
While we believe this is truly an exceptional market for M&A arbitrage, like nothing we’ve seen in the history of the strategy, there are a number of caveats to make. There are some very complex transactions out there, mergers where there are anti-trust issues, other regulatory problems, certain tax changes that might render a deal unfeasible. The Federal Trade Commission in the US is suing to prevent the Office Depot / Staples tie-up, while there are anti-trust concerns surrounding the merger between Baker Hughes and Halliburton – numbers one and two in their industry. This complexity, and the very different nature of the deals on the slate currently, makes it a time when the last thing you should do is put on a portfolio of event names, hoping to sit back and watch the spreads contract. Instead, an enormous amount of due diligence needs to be carried out – you need to get into the weeds on deals, really try to get to the bottom of the regulatory landscape and potential issues surrounding the completion of a deal. The risk / reward profile for M&A arbitrage has changed radically in recent months. In the past, spreads were thin, but the market priced 90-95% of deals coming to fruition. Now, spreads are wide, and of these complex deals, the market is pricing less than a 50% chance of deal success. It’s a new risk / reward universe and not all of those in the space will benefit from the undoubted opportunities out there.
In short, we think that we’re currently at an extremely exciting point in time for M&A arbitrage – spreads are wide, uncertainty stalks the streets, management are desperate to close deals and the quality of deals suddenly looks much better. It’s a time, though, to back tried and tested managers to do intensive work on the large, complex deals, a time to recognize the risks as well as the potential rewards on offer.
Chris Huggins Portfolio Manager
Financials haven’t been this stressed since the sovereign debt crisis of 2011. At that time, a ‘doom loop’ caused a downward spiral in the banking systems of several peripheral Eurozone countries, and in the sovereign debt markets to which they were heavily exposed. Prior to this, of course, financial credit and equity suffered heavy markdowns everywhere as a function of the GFC (‘Great Financial Crisis’) of 2008 / 9, when banks across the globe were heavily exposed to subprime assets and structured credit.
In both of these periods, banks were quite correctly at the center of the crisis; their balance sheets were bloated with assets of dubious quality and the banks needed significant amounts of restructuring and new capital to restore themselves to financial health.
Market participants and commentators have been eager to identify a similar ‘troubled asset’ to blame for this most recent bout of volatility; there simply isn’t a satisfactory culprit. To comprehend the price action, one has to understand some of the subtleties of credit markets, and the unintended consequence of heightened regulations.
In fact, banks are largely in decent financial health, and the vast majority have little notable exposure to the energy and commodity firms that have suffered from a slowdown in the Chinese economy. Since 2008, banks have raised significant amounts of capital, and this capital is of higher quality than in the past; leverage has been dramatically reduced. Central banks have also established systems so that no solvent bank should fail because of its inability to roll over debt. It was liquidity that brought down the likes of Lehman and Northern Rock, and now banks are able to draw on large, government-backed, lines of credit to avert any short-term liquidity crisis.
This is not to say that the banking sector is entirely clear of issues. For example, Italian banks never fully recovered from the twin setbacks of the GFC and the sovereign debt crisis, and certain German banks also look to be light on capital, with one or two of them moving close to their MDA limits, where they are restricted in paying certain coupons, dividends and bonuses. However, these instances are localized, and there appears to be little reason why all banks should be suffering due to the problems of a few outlying entities. Picking out a few examples: it seems bizarre that stable UK mortgage lenders such as Lloyds or Nationwide Building Society should be feeling investors’ wrath. Capital ratios are extremely solid, exposure to energy loans virtually nil, and yet the debt of these institutions has been pulled into the general mire.
CoCos, contingent convertible bonds, have been feeling the specific heat of market moves in early February, particularly the AT1 (Additional Tier 1) securities which sit between equity and subordinated debt in a bank’s capital structure. These instruments, which are coupon-paying, perpetual-dated but callable (usually after 5 to 10 years), have been issued as a source of additional capital in the event that a bank gets into trouble. They have a trigger point, usually either 5.125% or 7% of CET1 (Common Equity Tier 1), where these securities are either written down or are converted into common equity; current average CET1 ratios stand at around 12.5%. Prices for these bonds have fallen into the 80s on a cash price basis, and are now being priced on a yield-to-perpetuity, whereas in stable markets many priced them on a yield-to-call. We believe many of these AT1 bonds offer compelling value.
Part of the opportunity is that much of the current price action is driven by technical pressures. Due to their high coupons, AT1s are popular investments for daily liquidity income funds, who are now selling on a more-or-less indiscriminate basis to raise cash levels and meet redemption requests. In addition, real money managers – pension funds and investment companies – have been underweight energy for more than a year now; and financials were an obvious overweight to balance the books. What we are seeing is the unwinding of a trade that has done well for these investors, and an inability for dealers (due to regulatory constraints) to absorb these flows and recycle the risk. In the majority of cases, it is this market technical rather than any fundamental weakness that is described by the current price action.
In short, we believe there are opportunities with AT1s of banks with strong balance sheets, where conversion or coupon skip triggers are remote. For example, bonds issued by banks where there is the potential that the structures could withstand losses in their lending books that are a multiple of their previous worst loss experiences. We are not saying that this is the bottom of the market – Brexit still casts a shadow over UK names, and a continued market rout could see more technical selling – but we believe that if you pick the right bond and have the right time frame in mind, there is the potential to be protected against all but the most apocalyptic scenarios, while if things improve more swiftly than some are suggesting, the yield-to-call of these bonds looks enticing.
Expected 2015 Risk Weighted Assets
Source: Autonomous Research.
Richard F. Kurth and Steve Kalin both Co-Head Leveraged Credit
After a near-two-year period of low volatility and high pricing in the levered loan market, the early months of 2016 have seen steep plunges in the value of loans. Much of the pain is being felt by companies associated with the energy, mining and utilities sectors. As the graph below shows, these loans are at the lowest prices and have seen the most volatility since the middle of last year.
Credit Suisse leveraged loan index average price vs. price volatility by industry
Source: Credit Suisse.
While commodities and energy were hot, a large number of deals were launched which seemed to show little regard for the credit fundamentals of the underlying businesses. Loans were issued predicated on continued high prices for oil and minerals, and very little room was left for companies to maneuver in the event of a downturn. Prices for a number of the loans issued by these late-to-theparty energy companies are fully justified. Many of them will need to restructure, and such was the over-ebullience of companies, investors and the arranging banks, that there appears to be limited asset coverage in many of the deals: we expect recoveries to be minimal in these cases.
This is not to say, though, that we think the loan market as a whole is in serious trouble, nor even that all companies in the energy space are basket cases. A market like this sends you back to your business school books, back to the fundamentals of credit investing, and in our view this is a good thing: in volatile, uncertain markets, when there are a number of credits which deserve to be trading at depressed levels, but a larger number who are being unfairly tarnished by contagion, you need to look long and closely at the numbers, you need to run stress tests and talk to management, competitors, customers and suppliers coupled with an in depth collateral and documentation review. Only then are you able to make the right decisions about what is value and what is fairly priced.
There is also the question of the best means of taking exposure to an asset class in a market where there are numerous alternatives. We believe that the optimal way of participating in the current dislocation in the loan market is to invest in tranches of CLOs – securities which reference a pool of underlying levered loans. You need to choose a manager with the expertise to look through to the specified underlying loans and distinguish between those that have employed rigorous credit selection in the construction of their portfolios and those, bluntly, who have not.
The size of the US CLO market currently stands at USD 426.5 bn, over half the size of the total amount of levered loans outstanding. This is an opaque, trade by appointment market with an active investorbase ranging from real money accounts to hedge funds. CLOs are separated into ‘tranches,’ which range from equity pieces to senior notes. Most of the latter are rated AAA. As the chart below shows, default performance for CLOs has been exceptionally strong when compared with general corporate default rates.
US corporate cumulative default rate, S&P2
We believe strongly that BBB, BB and selectively B, and equity CLO tranches offer highly compelling risk-adjusted rewards at current levels. We are seeing the most compelling opportunities in BB tranches with exceptional levels of subordination trading at 10-13% yields.
What you’re tapping into here is the fact that regulation – Volcker Rule, FRTB and SEC scrutiny, to name a few – has made it distinctly harder for some banks to hold CLO tranches without incurring punitive capital charges. There’s also a perception issue surrounding CLOs. Because they were associated with sophisticated ABS assets in the wake of the Credit Crisis, CLOs are seen by some as risky, complex securities. In fact, they have performed mostly as expected even during periods of stress. Losses have been minimal even far down the capital structure and there has never been a default at either AA or AAA in a CLO4. The so-called 2.0 CLO vintage, issued after the Credit Crisis, is typified by lower leverage, better investor protection and more constraints on what kinds of loans managers could put into their deals. With the right analysis, it is possible to seize upon a double dislocation here, with stressed, technically-driven pricing in both the underlying leveraged loan market and in the CLO tranches which reference them. There is distress in the marketplace, certainly, but pricing levels have dropped across an entire universe of securities, far in excess of what is justified by underlying fundamentals. That splashing sound you can hear? It’s babies being thrown out with the bathwater.
EUROPEAN DISTRESSED SECURITIES
Galia Velimukhametova Portfolio Manager
We believe that there are already a number of opportunities showing themselves in this dislocated market. We are at the start of the distressed cycle that we believe will endure for some time – we anticipate several months of widening spreads and increasing default rates. Energy is already being hit hard and we think should, therefore, emerge from the cycle first, so it is here that the opportunities are most pressing. The energy industry is an ideal target: it’s an asset-rich sector, and those assets are expensive to replicate. These businesses are highly operationally geared and so, if you buy into them at the right time, you can make very impressive returns once the market normalizes.
There are potential opportunities with oil and gas companies as well as those servicing the energy sector. The stress in this area is already beginning to tell. We’ve just seen Vallourec, a French firm which produces steel pipes for the oil and gas industry, halve its capacity utilization and announce a EUR 1 bn emergency rights issue. Shipping, particularly the dry bulk market, is also starting to implement capacity reductions, and we expect supply and demand to re-balance in the next 12-24 months.
The other big driver of distressed opportunities will be lack of access to financing. There are a vast number of companies which are over-levered and have been limping along in recent years. Banks are going to be increasingly capital-constrained going forward and we believe there will be a reversal of the loose credit environment when even risky companies had been able to borrow at 6-7%. Now, only the most credit-worthy companies will be able to access the debt markets to refinance their loans and fund growth. Many others will be forced to restructure.
In short, this is the kind of market that distressed investors have been waiting for, and we believe technical and fundamental signs to be particularly constructive currently. We see numerous opportunities opening up, initially in energy, then in energy and commodity-related industries, then more broadly including retail and, of course, financials.
US DISTRESSED CREDIT
Himanshu Gulati Head of US Special Situations
The current opportunity set in US High Yield and Distressed Credit is as compelling as any we have seen since the financial crisis. Dislocation that was originally expected to be limited to the energy sector spilled over to other commodities and general industrials, then to financials, and, in our opinion, the contagion is unlikely to stop there. We have seen sectors that are exhibiting decent growth and should be relatively immune to any economic headwinds trade lower in sympathy, providing some strikingly attractive investment prospects. We continue to believe a US recession should be treated as a question of when and not if, which we believe will lead to an even larger opportunity set.
To put in perspective what has happened in the credit markets, here are a few statistics to consider:
- The HY Index is trading at a spread of 866 bps (759 bps excluding energy), its widest level since 2008/95
- The CCC Index is trading at a spread of 1,843 bps (1,536 bps excluding energy), its widest level since 2008 /96
- Implied default rate is 9.13% vs 3.22% a year ago and vs. ~15% in 20087
- YTW % of index trading greater than 10% has increased ~300%8
- <6% YTW on 31% of HY Index vs year ago of 58%
- 6%-10% YTW= 30% of Index vs. year ago of 28%
- >10% YTW = 39% of Index vs. year ago of 14%
- Total High Yield Market has grown to >USD 1.8 trillion vs. USD 1.0 trillion in 20089
- Maturity Wall starts to mount in 2018, with ~15% of High Yield maturing prior to the end of 201810
JPM CCC Index
Barclays HY Index-YTW Distribution
Source: Barclays Credit Strategy, GLG Partners.
With the S&P 500 still within 10% (as of February 25, 2016) of its record high and trading at 16x-17x P/E, and a sluggish and declining US economy, we believe the credit markets offer much more attractive investment possibilities, with current dislocations more profound and numerous in credit than elsewhere. The valuation differences between credit and equities are most pronounced in sectors such as aerospace, transportation, financials, metals, mining, and non-energy commodities. In our view, trading levels are highly distorted, implying imminent defaults and limited recoveries. While we are not bullish on the US economy, it is our view that the market is pricing many securities incorrectly, creating an abundant opportunity set for the discerning investor who is able to correctly assess downside risk.
We believe this situation, with the growing pipeline of non-refinanceable debt, will lead to the most compelling investment landscape in credit since the 08/09 financial crisis, and better than prior recessions. Credit fell first and furthest in the panics of 2008 and 2011, then rebounded hard, giving investors some compelling returns. We have seen the initial dive in this most recent sell-off, and while there will be significant volatility ahead, we believe now is the time to start looking very closely at investment opportunities in credit.
Neil Mason Senior Managing Director
The general theme is this: the markets are entering a new phase of the cycle and the more swiftly investors acknowledge and react to this, the better. While pain is being taken in the equity and credit markets, the volatility and panic are producing numerous opportunities for investors with the ability to act. There is technical pressure on many in the markets and, in every case, what is needed is a clear eye for fundamental value, an ability to discriminate between those assets which have been overvalued by a frothy market and are being correctly penalized, and those that are being dragged down unjustly. We believe there are real opportunities to achieve returns that have been notable by their absence in recent years, prospects for increased diversifi cation and access to new and attractive asset classes. Above all, we believe that 2016 looks set to be a complex, fascinating year, and one in which focused investors with an eye for value should have reasons for optimism, despite the red on the trading screens and the general gloom of the headlines.
1. The gross return of these deals is based off share prices as of February 10, 2016 and is calculated by taking the spread of the deal and dividing this by the current market price of the target company multiplied by 100. The gross fi gure is then calculated as an annual rate to provide its theoretical annualized return. The formula used to calculate gross annualized return is: gross spread* (365 days to completion), so 10% gross closing in 6 months = 10* (365/182) = 20%. Days to completion are estimated by the Portfolio Manager.
2. US Corporate Cumulative Default Rate is per S&P, for 1981 to 2013.
3. US CLO data is from S&P, for all rated tranches from 1994-2013, and includes 7 tranches that were rated CC as of year end 2013, which implies that ‘default is a virtual certainty’.
4. S&P , for all rated tranches from 1994-2013.
5. Bloomberg, February 24, 2016.
6. Bloomberg, February 24, 2016.
7. JPM Credit Strategy, February 25, 2016.
8. Barclays Credit Strategy and Man GLG, February 24, 2016.
9. JPM Credit Strategy, February 26, 2016.
10. Barclays Credit Strategy, February 25, 2016.