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Hedge funds circle cheap credit opportunities

Date: Monday, October 24, 2011
Author: Laurence Fletcher, Reuters

Opportunistic hedge funds are picking up bargains in corporate bonds after a sharp sell-off this summer, preferring the sector to pricey-looking government debt.

A number of managers believe credit markets are now pricing in too-deep an economic slowdown and default rates that are too high, and are picking up high-yield bonds in the United States and Europe, often favouring short maturities, as well as senior secured bonds.

"Credit offers a very good risk-reward, especially after the last few weeks," said Omar Kodmani, president of fund of funds firm Permal Group, which runs $21 billion (13.17 billion pounds) in assets. "High yield is very attractive in our view."

The average spread of high-yield bonds over government debt has rocketed from less than 500 basis points in May to 1049bp earlier this month, according to Bank of America Merrill Lynch, as investors cut positions amid fears over the extent of Europe's debt crisis.

That rise took spreads within sight of the 1,134bp hit in August 2009, just as the European high-yield boom got underway, although they have since fallen back to 877 basis points, helped by renewed hopes euro zone politicians can resolve the crisis.

Permal's Kodmani said he is raising exposure to credit hedge funds by around 10 percentage points across the group's portfolios, attracted by a sell-off in U.S. high-yield he describes as "indiscriminate."

"In the U.S. one-quarter of high-yield securities trade on a yield of more than 10 percent," he said. "The overall spread level is pricing in very high default rates of 8 percent, and we don't see that materialising given our views that the U.S. will avoid recession."

He said he sees opportunities in non-agency residential mortgages. "A lot of paper is pricing in further falls in house prices, but in some areas you have good housing market conditions."

Traditional fixed income investors are also moving back into the high yield market.

M&G Investments, which manages more than 108 billion pounds of fixed income assets, said last month its institutional funds are buying high yield bonds for the first time since the credit crunch, enticed by a yield pick-up of 5.5 percent over investment grade paper.


Patrick Armstrong, joint managing partner at Armstrong Investment Managers, which runs around 250 million pounds, said yields on corporate bonds look attractive compared with sovereign debt.

German 10-year bond yields, for instance, are currently less than 2.1 percent, having traded below 1.8 percent earlier this month.

"Credit spreads ... are now at levels that have historically been seen only in recession," he told Reuters. "We are attracted to the higher yield as an alternative to government bonds, which are yielding significantly below levels of current inflation."

He particularly likes bonds with short maturities, given the uncertain long-term outlook.

"A short duration profile protects against a worsening longer-term credit environment and from potentially higher interest rates in general, while still providing a yield significantly above current levels of inflation," he added.

Meanwhile, Simon Thorp, who runs $130 million in hedge fund-style credit funds at Avoca Capital, also favours short-duration bonds.

He had sold bonds in some cyclical sectors in May and June but has recently begun buying back into senior secured bonds in sectors such as healthcare and telecoms after the sell-off.

"Selling of these credits has taken place because they are more liquid names, yet most continue to do well, and as an investor one is protected because of the seniority of the bonds and the security package," he said.

"Senior secured paper with short maturities to run (under 18 months) look especially attractive, where the key calculations are around short-term liquidity rather than how the business is likely to be performing in two-to-three years' time."

However, Thorp has also found short-selling opportunities, amongst some senior unsecured bonds whose spreads traded close to secured bonds, and in consumer-facing areas such as retail and food as he argues margins are coming under pressure.

He has also shorted Lloyds' contingent convertible bonds (CoCos) -- bonds that boost capital by converting into equity if a bank runs into trouble -- but has now actually bought into the bonds after the summer sell-off.

"We felt that a number of investors who held the paper would be shaken out if there was a market sell-off and yields on the paper were sub 8 percent. Now that the market has backed up we have turned the position around, going long at yields between 12 and 13 percent."