Avoca Capital

Opportunities in long/short credit continue to grow

Originally published in the September/October 2012 issue

The health of European credit markets is the focus of global markets. For asset managers, the credit theme spills over into a number of investment strategies covering global macro, fixed income and debt. In the current environment credit prices have risen as underlying yields have fallen dramatically. Equity market volatility and a negative macro picture for shares have encouraged investors to continue allocating to credit even though it is very difficult to see value in government bond yields.

This has had a knock-on effect on European corporate credit, the area where the Avoca Credit Absolute Return Fund operates. It trades mainly bonds, but will also trade credit default swaps, particularly when the managers want to go short.

“What differentiates us is that we hedge out interest rate risk so that the fund is duration-neutral,” says Simon Thorp, portfolio manager and Chief Investment Officer for fixed income with Avoca Capital. “Investors are a little bit concerned about how low yields have got as any underlying rise in risk-free yields would spell losses for them. So being able to generate returns from mispricing in the European corporate credit market with zero correlation to interest rates is attractive.”

Growth market
One of the attractions of European corporate credit is that it is a growing market. Banks are deleveraging in order to push up capital ratios and are stepping back from extending fresh lending. Public credit markets are taking a bigger role. Even so, only about 25% of corporate loans in Europe come from public credit markets compared with 75% in the US. The European high yield market, for example, has doubled in the past three years through new issuance. Given this growth and the broad levels of demand from institutional buyers, there should be opportunities to benefit from mispricing in the market for some years. In addition, the strong demand for yield in the corporate bond space is likely to throw up a range of good opportunities to short particular issues.

In most cases, the Avoca fund will carry directional beta. If Thorp and James Sclater, senior portfolio manager, are very positive on the market, it will be 30-40% net long on a risk-adjusted basis. If they are deeply bearish it will be around 20-25% net short. In the third quarter of 2012 the portfolio was around 15-20% net long (risk-adjusted) (See Fig.1).

“At the heart of what we do is to try to find improving credits that we can buy for the long side and find deteriorating credits that we can sell for the short side,” says Thorp. “To do this you need to have great credit research and you need to be able to know how to value it. Putting those together should allow us to realise whether a credit is improving and cheap or vice versa.”

The experience of the managers is extensive with an 11-year positive track record. They have researched every company that has come to the European credit market for over 15 years and meet with company managements regularly. The managers also have specialist knowledge of the regulatory environment and European legal jurisdictions, which can be invaluable, especially in a distressed scenario. Around 80% of the book is invested in Europe with 20% invested elsewhere.

“Credit is an interesting asset class for long/short investing because of the asymmetry,” says Thorp. “Good news has a small impact on bonds but there are much bigger down moves when problems arise, particularly when investors fear for their coupon or worry about getting their capital back.”

Euro uncertainty
The uncertainty plaguing the euro’s future is making it tough to attract more investors. Thorp believes the single currency will muddle through as there is too much political and historic capital invested in it, but that it may be set up very much differently in five years’ time.

“US investors are very interested in the European credit market,” says Thorp. “If the Eurozone crisis can get resolved or get to a point where investors can feel comfortable with the situation then we will see a lot of money come from US investors to tap into opportunities in Europe. But on balance they have been keeping out given the difficulties.”

One sector the strategy is bullish on is cable television, which in the UK has emerged from extensive restructuring. Investor perceptions about the bonds issued by cable operators Virgin Media and Spanish firm Ono have undergone a major shift.

“Investors have seen them finish digging up the road and begin generating strong cash flows to pay back loans,” says Thorp. “The clue has come from the US where the business is more mature. US investors saw the European market as cheap. Now you can feel confident these firms will service their debt.”

Typically a short play involves a sector where the operating environment has deteriorated, leaving a company with difficulties to service its debt. The strategy is bearish on several sectors, including paper manufacturing, chemicals, as well as commodities and basic materials that are exposed to any reversing of the commodities super cycle or a slowing Chinese economy.

The strategy has $140 million in assets. It is run through offshore and UCITS funds. Since the fourth quarter of 2011 Avoca has also offered a managed account. The UCITS delivers around 75% of the return of the hedge fund as it uses less leverage and has smaller positions. It invests this way owing to having weekly liquidity compared with the monthly terms of the offshore fund.

“This is an asset class that has punched above its weight,” says Thorp. “Generally speaking in high yield you get historically overpaid for the risk that you take.”