Hedge Funds Underdogs

Date: Friday, September 16, 2011
Author: Credit Hedge Funds

Credit Hedge Funds continue to be the underdogs of the hedge fund world. However, institutional investors should not ignore them as they offer a unique risk/reward proposition. Their conservative investment approach, low leveraged and robust investment business processes will deliver attractive returns over the long term.

2011 is being a very difficult year for all hedge fund strategies. Credit Hedge funds are struggling to deliver attractive absolute returns considering their low leverage, today’s low credit yields (UST10yr yielding 2%), the unpredictable European sovereign crisis and the weakening economic growth and labour markets.

The volatility generated by the European sovereign crisis has not benefited Credit Hedge Funds. None of the established credit hedge funds have dared to place aggressive bets on PIIGS’ debt instruments. The MTM risk is just too big. At most some hedge funds have been buying opportunistically short dated paper maturing in less than 3 month from stressed banks and sovereigns.

Liquidity has also fallen considerably with bid/offer spreads widening again. In August 2011 high yield bonds MTM fell an average of -3.65%, leveraged loans fell -4.38% and CCC-rated bonds fell-7.06%. The iTraxx Europe Crossover 5yr index jumped from 440bps at the beginning of August to 800bps by mid September 2011. Today’s credit spreads are pricing in a combination of recession risk, higher defaults and lack of liquidity. So, is it time for institutional investors to run for the door and ignore Credit Hedge Funds? Definitively NOT if you are in for the long run!

For example, one of the main credit hedge fund strategies is Distressed Credit. The distressed debt market for large debt issuer has nearly vanished. At the beginning of 2010 we all read (and believed) about the multi-billion maturity wall that was going to create immediate investment opportunities for distressed hedge funds. The par-weighted default rate for high yield bonds in November 2009 stood at 14.18% and the capital markets were closed for high yield issuers. In theory, there was no way that leveraged companies were going to be able to refinance their debt. The reality has been that High Yield companies have managed to refinance their bonds and leveraged loans and rebalance their capital structures at even cheaper prices.

The abundance of liquidity has transformed the humongous maturity wall into a little hill. To name a very recent example, on 26 July 2011 HCA Inc sold $5billion of high yield debt. It is amazing that HCA originally planned to sell only $1billion of notes.

The abundance of liquidity has pushed the default rates to historical low. In August 2011 there were no defaults in the leveraged credit market. The par-weighted default rate for high yield bonds is around 1%. Well below the 25-year average of 4.2%. At current levels default rates can only go up and history tells us that sooner or later they will.

Meanwhile, there continue to be opportunities to invest in distressed debt from middle market companies with capital structures of $500-$2billion. Smaller credit hedge funds (AUM of $200-$1,000mio) can be more nimble and get attractive returns with $50-$200mio tickets trading at heavy discounts.

In today’s market Distressed Credit Hedge funds have to work harder to find opportunities. The same goes for the other main credit hedge fund strategies: Long/Short, Event Driven, Structured Credit and EM Credit.

My conclusion is that fundamental credit analysis of balance sheets and debt legal documentation is definitively not as trendy as complex macro or quantitative trading. But, over the long term credit hedge funds with robust investment processes and teams will deliver attractive stable returns. It might not be trendy, but profitable.