Fed action need not stymie credit strategies

For the first time in the past few decades, credit investors have to contend with duration risk in their portfolio. Default risk has historically been perceived as the primary risk of investing in the debt of leveraged companies, with duration risk being viewed as largely negligible. Given the recent announcement by the US Federal Reserve about the impending reduction of bond purchases in 2014, many market participants are now asking if credit strategies still have legs in a rising rate environment?

Our base case is that although we expect more capital to flow out of long-duration assets, the demand for credit strategies should remain strong in 2014 as the global hunt for yield continues. Much of the yield has been squeezed out of the large, liquid credit and, as such, astute yield hunters will likely continue to seek opportunities in less travelled paths in the credit market. Let’s take a look at different areas of credit strategies and potential positioning for various interest rates scenarios.

Scenario 1: Interest rates, particularly on the long end of the curve, will rise as expected. This is our base case. In this scenario, we expect the speed of the rise to be fairly gradual and that the Fed under Janet Yellen will continue on the path of telegraphing expected policy changes to the market. We expect investors to continue rotating out of long-duration assets such as agency mortgages and long-dated corporate bonds, and into short-duration and event driven credit plays specifically, as well as floating-rate assets generally. 

Although we expect reduced appetite for longer-dated fixed-income assets, we continue to expect a positive return from short-duration and floating-rate assets due to low spread levels, with most of the expected coming from coupon payments. We anticipate limited upside from price appreciation and spread compression, and that investors should expect a benign default environment over the next 12 months. As a result, in order to generate attractive returns, investors will need to flex their creative muscles and look beyond the traditional opportunities in large, liquid issuers and issuances (ie, the ‘index names’). The credit bears often cite valuation, strong capital inflows in the past few years into high yield, and the high percentage of index names trading to 2014 or 2015 call pricesas reasons for caution in the credit market. These investors are absolutely correct when it comes to issuers and issuances in credit indexes. However, the key point here is that there are still attractive return opportunities for investors who are willing and able to venture beyond the traditional on-the-run opportunities and venture further out on the credit or liquidity curves.

In order to illustrate how alternatives can help investors access different sub-asset classes in credit, let’s take a closer look at floating-rate assets, particularly bank loans. Based on analysis of loan indexes, loans do offer relative value compared with high yield. As of early January 2014, the spread for the Credit Suisse High Yield Index is 426 basis points (bp) compared with a 478bp discount margin for the Credit Suisse Leveraged Loan Index. Looking at price, many high-yield bonds are also trading above par while loans are still trading slightly below par. In early January, the average price of the bonds in the Credit Suisse High Yield index is $103.70 while the average price for the constituents in the Credit Suisse Leveraged Loan Index is $98.80, compared to the par value of $100. So from a valuation perspective, it does appear loans offer better relative value compared with high yield. Despite limited upside, loans also benefit from lower volatility, lower loss upon default, floating rates, and potential technical support due to increased demand as rates rise. 

So does this mean all is well in loans? Not so fast. On an absolute basis, for many investors an expected net return in the 5% range offered by the loan index is nothing to write home about. In our opinion, middle-market, second-lien loans and the mezzanine and equity tranches in collateralised loan obligations offer more attractive ways to gain exposure to bank loans. However, as mentioned, venturing out on both the credit and liquidity curves should only be done in conjunction with the ability to separate the ‘wheat from the chaff’ and a true understanding of the nature of technical drivers in these markets.

Scenario 2: Rates rise sooner than expected because economic growth surprises to the upside. Not only is the Fed expected to speed up the pace of tapering bond purchases, it may also start to raise interest rates sooner. In this case, the market will see both tapering and tightening taking place earlier than previously expected. There may be a short adjustment period, but a strongly growing economy is not the worst-case scenario for credit investors. Nonetheless, Morgan Stanley estimates in the past 22 years that two-thirds of the average return of the high-yield index has come from rate compression. If interest rates rise and rise sooner than expected, there will be significant volatility in the broad high-yield market.

In this scenario, there are areas within the credit market that will be highly levered to the recovery in economic fundamentals. For example, we could expect to see a marked increase in corporate events such as mergers and acquisitions, divestitures, asset sales, and leveraged buy-outs as management and investors get better clarity on the future growth prospects of borrowers. Credit hedge fund managers are well suited to carry out the task of identifying the companies most likely to engage in these transactions, determining the range and probability of likely outcomes. 

Current stressed and distressed assets are also expected to reap particular benefits in this scenario. These assets may benefit from fundamental improvement as the assumption of loss and default is revised for the better. They may also benefit from improved technicals as new investors previously unable to invest in distressed assets come into the market. Many credit hedge funds, despite low rates of corporate default, have found opportunities buying assets at distressed prices or from sellers hoping to avoid distress by cleaning up their balance sheet. The latter has been seen particularly in the aftermath of the shake-up in the banking sector. A recent example of this theme is the wave of sales of trust-preferred securities by commercial banks as a result of expected new regulatory treatment for the instrument. Credit hedge funds that have purchased trust-preferred securities cite attractive valuations because of the low entry point as one of their key theses, as well as wanting to have exposure that will capture recovery in commercial real estate and macroeconomic conditions.

Scenario 3: A watched Fed never tightens. In other words, economic growth surprises to the downside. In this scenario, despite its prior stance, the Fed reverses course by slowing down the speed of quantitative easing tapering and pushes rate increases further into the future. Here, similar to scenario 1, positioning in the senior secured part of the capital structure as well as a focus on quality ‘off-the-run’ credit are expected to provide relative safety while still generating income so that investors are getting paid while they wait. Investors who have switched to short-duration and event-focused credit may be disappointed and feel that they miss out on further rate compression. However, we feel that the search for yield will continue to remain strong as the risk-free rate remains extremely low; furthermore, the upside/downside probability means the risk is negatively convex.

The scenarios we have laid out for 2014 point out the various ways investors can position their credit portfolio to capture the opportunities in different interest rate regimes. There are three common threads that underlie successful portfolio construction regardless of Fed action. First, investors are well advised to venture beyond the traditional large and liquid credit opportunities. This can be achieved by venturing further on credit quality, accepting lower liquidity, or focusing on specific idiosyncratic events. Nonetheless, a large ‘buyer beware’ sign needs to be heeded. Second, flexibility is your friend. More flexibility – both in terms of investment mandate and structuring – allows investors to be opportunistic as we face an inflection point in rates. Third, higher volatility is here to stay. The economy may very well provide some surprises both on the upside and the downside. Combined with greater flexibility in the way one invests, investors can focus on the long run and use short-term pull-backs as buying opportunities.

Putri Pascualy is a managing director and senior credit strategist at Pacific Alternative Asset Management Company (Paamco).