Long/Short Credit Strategy

Why it should be a pillar of any dedicated fixed-income allocation

Florence Duculot, Portfolio Manager, EIM S.A

Long short credit strategy should be a pillar of any dedicated fixed-income allocation as a return/risk enhancer and as a complement to fixed income arbitrage strategies that are in a more mature stage and therefore limited by some overcrowding. The ongoing development of complex trading instruments is indeed reinforcing the barriers to entry in credit-related strategies, which gives a competitive advantage for the specialists with sophisticated tools to capture market mispricings and explore new niches.

LONG SHORT CREDIT STRATEGIES: RISK PROFILE (Source: EIM)

  Default Risk Credit Spread Risk Correlation Risk Illiquidity Risk
Inter Issuer  
Intra Issuer  
Capital Structure  
Tranched Credit  
Correlation  

Credit hedge funds in vogue since 2002

The expansion of credit hedge funds has gone hand in hand with the development of credit derivatives instruments in the past five years. It is now difficult to put all the credit strategies in a single box given the large diversity of investment styles and instruments traded.

US managers have been the pioneers in credit strategies, taking advantage of the country's historically large stockpile of high yield debt. However, European managers now seem to have taken the lead in developing more complex strategies based on sophisticated credit derivatives instruments such as Credit Default Swaps (CDS), Collateralized Debt Obligations (CDO), etc.

These instruments have encouraged even the "fundamental" managers to take on more risk thanks to the possibility of taking a long or short position in a credit in spite of the unavailability of bonds. Above all, these instruments have allowed managers to trade the different risks embedded in corporate credit. The development of tradable credit derivatives indices has simply been a revolutionary item for this strategy, enabling managers to rely on liquid hedging instruments and propose a real long short strategy.

Exploiting a rich set of risks

Credit hedge funds seek to isolate one or all the specific risks related to credit instruments. The traditional credit risks being traded are 1 the default risk, 2 the credit spread risk and 3 the illiquidity risk.

Inter-credit relative value trades are the most common long/short credit trades. Examples: Long Issuer A vs. Issuer B, removing the sector risk.

Inter-credit trades are other typical trades that can be regrouped in three types: 1 term structure (trade that plays the credit curve of a single issuer); 2 capital structure arbitrage (trade that seeks to capture the mispricings between the different levels of "seniority" of debt papers from a single issuer); 3 basis trade (that consists of capturing "the basis", i.e. the premium or discount between the cash market and the derivatives market).

The issuance of collateralized debt obligations (CDO), the latest generation of credit derivatives instruments, has created a new risk, the so-called default correlation risk. The default correlation measures the degree to which multiple credit defaults in a pool of credits will occur. The central strategy has so far been to take long positions in tranches of CDO and hedging the credit spread risk of individual names via selected long single name Credit Default Swap (CDS) positions, a strategy referred to as "tranched credit trading".

The other most common strategy is the so-called "implied correlation trade", which consists of taking a view on the level of implied correlation of default within a pool of credits by taking relative value positions on tranches of a same pool of credits, for example: long equity tranche vs. short mezzanine tranche. These trades have become increasingly popular with the development of Itraxx standard tranches, tradable indices that have enabled hedge funds to go short in CDO.

The role of a long/short credit fund in a fund of funds portfolio

An active long-short credit strategy will hardly beat the attractive carry trade a passive holding of a basket of diversified high yield bonds may offer under favourable credit conditions.

However, it will limit the damage during phases of major credit spread correction. Previous cycles indeed tell us that the credit market can surf on calm waters for years but that when it breaks, the correction is usually quite harsh. The long credit spread volatility profile of many managers in this style is therefore quite helpful over an entire credit cycle.

One of the key benefits of the long short credit strategy in a fund of hedge funds is the uncorrelated returns these dedicated managers offer in relation to the other main alternative strategies. This is also a style where the correlation between the dedicated funds is usually very low. Indeed, credit markets are still highly segmented due to their high legal and cultural barriers, making it difficult, for instance, for a US manager to succeed in trading European credit and vice versa.

Outlook

This strategy will continue to welcome innovative instruments and managers and will remain a fertile ground for uncorrelated returns. The flip side of the coin is that the lack of market breadth in certain instruments can also be painful when the few players involved decide to unwind their trades at the same time.

The unstoppable innovation in credit instruments is also at odds with a still untested "legal" framework. Investors tempted by these uncorrelated sources of returns should also carefully assess the disguised risks (like implied leverage) some funds exhibit. The current stage of the credit cycle is characterized by a tight level of credit spreads but mounting pressures stemming from a substantial adjustment in interest rates. The current low level of default rates and healthy balance sheets make the risk of a major adjustment a bit remote. However, warning signals are usually scarce before a major disruption and a prudent stance is therefore warranted.

In an increasingly challenging environment, long short credit funds have delivered positive returns in the recent period, i.e. generating twice the performance of the cash year-to-date. Looking ahead, we continue to expect the same type of returns with low usage of risk for long short credit funds with strong hedging and/or good trading ability. These funds should currently be the backbone of any dedicated credit or fixed-income allocation.