Credit waves – time to change course?
Did you hear the one about the credit investors in the little rowing boat? With calm waters and rowing with the current, all went swimmingly; but with rapids ahead (an excessively levered and overvalued market, higher interest rates, inflation, defaults, poor underwriting standards) a few of our Sunday sailors stood up and began gesticulating. It all went south from there. The story has a soggy ending.
Credit strategies have enjoyed handsome returns since the beginning of 2009. But when I read recently that Finland’s $53 billion Varma Mutual Pension Insurance Company had turned negative on credit, possibly in favour of global macro strategies, I had to ask whether this could be the first sign that credit investors are beginning to stand up in the boat and express alarm at the choppy waters that might lie ahead?
The myth of liquidity
In August this year a large Swiss asset manager had to gate investors with an exposure to its flagship absolute return bond strategy after it was inundated with redemption requests following the suspension of the manager. Further analysis revealed that some of the holdings were very illiquid.
Back in December 2015, a US mutual fund, Third Avenue Focused Credit Fund, suspended redemptions (later closing), due to a sharp market selloff of junk bonds. This raised concerns about the stability and liquidity mismatch of credit funds, in response to which the US Securities and the Exchange Commission launched a review of potential liquidity risks posed by high-yield bond fund managers.
These incidents wrong-footed many investors who had presumed that the ability to redeem from a fund on a daily basis was their right, and a fund obligation. The old adage that liquidity is the ultimate coward – at the first sign of trouble, it disappears – will always hold true.
Gating is designed to preserve the value of investments and not force liquidations at the worst possible time. Fund management groups argue that gates are often put in place to save investors from themselves. But if everybody else is selling similar assets, then mark to market losses become widespread. For investors, few things are more disconcerting than watching the value of their investments melt away and not having the wherewithal to do anything about it.
Caught between a rock and a hard place
Many credit managers are under pressure. Credit spreads are tight, average coupons for high yield bonds are close to historic lows, trading costs are high, liquidity is low and credit quality has weakened significantly. Fuelled by the availability of cheap money, both the high yield and leveraged loan markets have ballooned since 2010. Andrew Lapthorne at Societe Generale pointed out back in Q2 that “Leverage in the US is grotesque for this stage in the cycle. At the moment you’ve got peak leverage at peak prices. It’s not like you have to dig deep to find a problem.” High yield bond prices are trading close to par and average call prices are around 102; the high yield bond owner therefore has a capped upside and 100% downside. In addition to this, JP Morgan research has shown that the duration of the US bond market is higher than it has ever been at any time since 1990. In other words, the bond prices are more sensitive to changes in interest rates than they have ever been coming out of a period where we have seen the end of QE with a pathway of rising interest rates ahead. Bond investors could be in for a very sharp shock.
The trading framework for credit products is very different today compared to ten years ago. Banks no longer warehouse risk, due to changes in regulation, so there is no natural liquidity provider to a market in decline. In a survey by Greenwich Associates, a majority of participants indicated that fixed income liquidity had continued to decline over the last three years, particularly in Europe, where over 78% of institutions say trading, liquidity and security sourcing has become more challenging.The environment for credit trading and investing is choppy to say the least.
Will Varma be the first of many credit investors to change course? If so, what catalyst will cause a sea change? And will the market accommodate the shift? Only time will tell.
As for the Aurum funds, their portfolios are tilted towards those strategies that benefit from higher volatility and they maintain a focus on liquid trading orientated strategies. There is no direct credit exposure in the portfolios and that is unlikely to change any time soon.
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