Ahead of the Curve: Strange days in credit
Amar Reganti looks for alternative sources of capital gains and income streams within a moribund fixed-income asset class
These are indeed strange days for credit investors. Spreads at relatively tight levels, combined with historically low risk-free rates, have led to low yields, frustrating investors with liability-based targets. Credit forms an important component of meeting those liabilities for institutions and individuals who depend upon fixed-income markets not only for capital gains, but also for the income stream that they are supposed to generate.
The solution appears obvious to the sophisticated investor: be patient, do not invest in credit markets when spreads are priced for poor returns, deploy your money in other worthy investments or cash. Large drawdowns in credit impair future returns. While the statement appears to be a truism, the rationale is more nuanced. My colleagues in equity markets have the benefit of receiving exponential returns when they have selected securities that are priced for outsized returns. A good credit investor knows there is often a cap on their capital gains (a bond, after all, is worth about par at maturity), and bond investors risk, on a euro-for-euro basis, more capital than they stand to gain. Hence, a cautious approach is justified. But, instead of credit, what are the obvious places in fixed income in which to invest?
The option most discussed is an allocation to private credit in the form of long-lock up distressed debt or direct lending, the relative newcomer. Distressed, as an asset class, can outperform its high-yield counterparts at the right point in the cycle. However, allocating to distressed is making a call on market timing. The large amount of capital allocated to distressed is in locked-up vehicles that are suffering from a shortage of deals. Given the scarcity, distressed investors often leap into the fray and suffer subpar returns when they purchase large segments of a stressed sector. The story of distressed investments in the shipping industry should serve as a warning regarding the occasional perniciousness of distressed investing.
Additionally, this type of private credit investment is generally involved in the largest deals, is unable to short, and has a significant opportunity cost as the capital is locked up.
The other alternative within the private credit space is direct lending. By giving up liquidity, investors hope to garner a higher return in the post-Dodd-Frank world of making loans. This may or may not be a wise decision, which only time and underwriting will determine.
So if one is cautious in credit, admitting it is hard to say exactly when a private credit solution such as a locked-up distressed allocation will yield glamorous returns, what, then, should a fixed-income investor do?
“One possibility is to approach credit from a long/short perspective, which has the potential to generate returns in the current environment”
One possibility is to approach credit from a long/short perspective, which has the potential to generate returns in the current environment by investing in special situations, distressed/stressed credit, and post-reorganisation opportunities. The key with this approach is to scrutinise downside risk and selectively short single-name credits that are subject to deteriorating operating and financial conditions.
Such a strategy could allow investors to target several objectives.
First, it seeks to maximise the ability to garner returns during periods when credit markets are operating normally.
Second, it aims to outperform generic credit when spreads widen during market sell-offs such as late 2015 and early 2016.
Finally, with this strategy, investors are well-positioned to redeploy capital during periods of historically high defaults akin to the early 2000s or the global financial crisis in 2008.
Managed appropriately and with a focus on downside protection, which is critical owing to the asymmetric returns of credit markets, such a strategy could facilitate outperformance in the high-yield market, with less volatility, over the last three years. Hence, there is much credit investors can do. They would do well to take a more differentiated approach that is suitable for several different market conditions.
Amar Reganti is a member of GMO’s asset allocation team