Long/Short Credit

Looking for minimal risk and maximum performance

AUDE LAGEY and PATRICK ZEENNI, CFA, DEXIA ASSET MANAGEMENT

Take advantage of opportunities in the credit space, regardless of the market environment – this is the objective of Long-Short Credit strategies which generally, seek exposure to credit-sensitive securities, long and/or short, mostly based upon the credit analysis of issuers and securities, and on credit market views.

Long-Short Credit: turning relative return into absolute return
A Long-Short Credit strategy can be defined as the combination of cash products (e.g. straight bonds, which include a credit spread exposure (implied default risk) and an interest rate risk) and hedge overlays (which include three parameters: flexibility for short exposure, the hedging away of unwanted risk [interest rates, currency, market beta…] and potential for leverage). Such a combination provides a Long-Short Credit strategy with absolute returns, increased alpha and a low correlation with the other asset classes.

The strategy is based on a broad investment universe. First, at a geographical level, with a worldwide scope. Second, at asset class level (investment grade, high yield, convertible or distressed). And finally, at instrument level, with cash bonds, credit derivatives or bank loans, i.e. any securities that are directly or indirectly linked to an issuer’s ability to repay debt.

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A wide diversity of approaches
The expansion of Long-Short Credit strategies dates back to 2002, with the development of credit derivative instruments such as Credit Default Swaps (CDS). First, with CDS on single names and, more recently, with CDS on indices. These tradable credit derivative products enable managers to rely on liquid hedging instruments and propose them a “real long short dimension”.

Nowadays, given the diversity of investment styles and instruments traded, it is difficult to classify the Long-Short Credit strategies in a single category. As an example, the data provider HFR (Hedge Fund Research, Inc.), leader in the alternative investment industry, distinguishes Relative-Value Fixed Income-Corporate strategies from Event-Driven Credit Arbitrage strategies. Both are Long-Short Credit sub-strategies but with different approaches.

Under the HFR definition, more typically, Relative Value Fixed Income-Corporate strategies involve general market hedges which may vary in the degree to which they limit fixed income market exposure. Good examples are pair trading, curve trading and cash/derivatives basis exposure, while Event-Driven Credit Arbitrage strategies, which involve arbitrage positions with little or no net credit market exposure, are predicated on specific, anticipated idiosyncratic developments. This category implies event and merger arbitrage, senior vs. subordinated debt or debt vs. equity. Below, we focus more specifically on the Relative-Value profile.

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redit Relative-Value
Pair trades and basis trades are the two main ways of implementing this approach. A pair trade usually involves two positions (one long, the other short) where the price or spread is expected to converge or diverge, based on fundamental, quantitative and/or technical views. Investments in such positions are mostly (but not necessarily) in the same industry. Let’s take an example.

Take a Long position on BASF (chemical sector, Germany, rating A1) and a Short position on VALEO (automotive sector, France, rating Baa3) through CDS, not cash bonds. With a spread between the two issuers of around 120 bps (October 2011), this level seems too low given the ratings (5-notch differential), the country risk, the company size and the diversification level. The rationale here is to take profit from a potential divergence. The optimal exit of this trade, tough, would have been in January 2011, with a spread of around 225 bps. By using pair trades, market and industry risk are largely removed; issuer-specific risks (called also idiosyncratic risks) are the main focus.

The other main relative-value strategy is the basis trade, which consists in capturing the “basis”, i.e. the premium or discount between the cash market and the derivatives market (basis = CDS spread – Bond spread). Given that the derivative has the same underlying as the cash bond, there is a close relationship between the two types of asset, which manifests itself in the basis and its magnitude. Fluctuations in the basis give rise to arbitrage trading opportunities. We observe “negative basis trade”and less frequently “positive basis trade”. In the event of a “negative basis”, the potential arbitrage involves buying the bond and buying protection on the same reference name. To illustrate this, we describe an example with the issuer Ford Credit Europe.

The bond identified here (the Ford Credit Europe 9.375% of January 2014, a EUR-denominated bond rated Ba1 / BBB-) was observed as trading at a negative basis on 2 December 2011. In the space of 34 days, the basis had tightened, and the trade unwound with a positive P&L of +2.1% flat (or +22.9% annualised).

Opportunities for basis trading arise due to technical factors and changes in the liquidity premium market. In the cash bond market, liquidity levels can be low, depending on the name (e.g., Investment Grade vs. High Yield), and they should therefore be considered.

Risks to consider
For any investment in the credit markets, certain “traditional”risks, e.g., interest rate risk, credit spread risk (implied default risk), must be considered. In order to find attractive investment opportunities and avoid the maximum credit spread risk, strong analytical expertise is required. Fundamental and quantitative analyses, carried out by experienced fund managers and analysts, are the cornerstone of performance. Furthermore, in the current context of high market dispersion, a rigorous bond-picking selection with solid conviction represents real added-value for a Long-Short Credit strategy. However, with the 2008 financial crisis and particularly its impact on the credit markets (and the ensuing negative terminology: “credit freeze”, “collateral requirements”, “margin calls”, etc.), a number of other risks are even taken into account to ensure an attractive risk/return profile.

First, we quickly got down to the aforementioned concern about basis trades: liquidity risk. Liquidity generally varies over time and across markets, but since 2008 credit market liquidity risk has stayed latent. Compared to the derivatives markets, the cash bond markets have permanently to cope with liquidity risk, especially in the case of High Yield bonds. And,with each market stress, this risk has resurfaced. It could be a source of opportunity (e.g. basis trades) provided the liquidity risk is well evaluated and the portfolio diversified.

Through its frequent recourse to the derivatives markets, the Long-Short Credit strategy is also exposed to counterparty credit risk. Diversification, moderate leverage, and regulatory changes in the derivatives markets (such as the development of contracts with “Credit Support Annex”, CSA) are possible solutions to limit and deal with this issue. As these risks are an integral part of a Long-Short Credit process, risk management is key to such a strategy. A dedicated risk management team, frequent stress-test calculations, strict stop-loss and take-profit discipline are important considerations to optimise the risk/return profile of a Long-Short Credit strategy.

Favourable outlook in current environment

Dispersion and volatility should continue given the combination of persistent sovereign risk (Greece, Portugal and Spain) and the uncertain macroeconomic context.

That said, the outlook is favourable for the Long-Short Credit strategy. The high dispersion of the credit markets currently offers many opportunities for relative-value trades. The arbitrage between cyclical and non-cyclical names is a good example, as is the arbitrage between European issuers (peripheral countries or not).

Another supporting factor is the low interest rate environment. With historically low government rates and a negative real return on risk-free investments, opting for a Long-Short Credit Fund is a good alternative for investors seeking yield with managed volatility. On the Investment Gradeside, “core European” BBB issuers with short-term maturities are good candidates for directional strategies (long or short with high conviction). And, on the High Yield side, the carry is attractive. With an effective yield of 7%, the Corporate High Yield BB/B market pays you more than 3.5 times European Government rates, with an equivalent duration.

Dexia AM and a good example of a successful Long-Short Credit strategy
Dexia Asset Management, European leader in Alternative Investments for more than fifteen years now, developed in 2009 a Long-Short Credit strategy within a UCITS framework.

The specificity of this strategy is a conservative and conviction-based approach. The management team adopts a conservative approach by actively selecting private issuers, exclusively “Corporates” (i.e. non-financial), within the Investment Grade and High Yield (BB/B segment) universe. As Patrick Zeenni, CFA – Head of the Long-Short Credit strategy at Dexia AM, would remind us, “We carefully select our credit names through fundamental analysis, quantitative research and legal expertise, all developedinternally.”

To fully exploit the opportunities offered, this team combines Relative-Value credit strategies (pair trades and basis trades) and directional strategies based on high conviction picks (long and/or short credit positions, with dynamic bias management). The result is a very low correlation with other asset classes, whether these be government bond, equity or High Yield markets. The Long-Short Credit strategy was therefore able to deliver positive returns in a High Yield bear market, as in November 2011,when it posted a performance of +0.1% while the European High Yield market lost more than 5%.

Finally, flexibility is essential to optimise the management of such a strategy. “Adjusting the net credit exposure based on market trends, a high turnover of positions, dynamic interest rate hedging, a partial tail risk hedge… all these are part of the investment process,” to quote, again, Patrick Zeenni.

The Dexia Asset Management Long-Short Credit strategy should take advantage of both the current environment and of a structure minimising the risks.Since its inception, it has outperformed the EONIA Index by more than 300 bps with a realised volatility below 1.20%, giving it today one of the most interesting “risk/return” profiles on the market.

Patrick Zeenni is Senior Fund Manager and Deputy Head of High Yield & Arbitage Credit management. He has 16 years of market experience which he gained working for Société Générale and Bayerische Landes before joining Dexia in 2003

Aude Lagey has been Alternative Investment Specialist for Dexia since September 2011. She began her career with Dexia AM in 2001 when she was appointed as High Yield Portfolio Manager, becoming Senior High Yield Portfolio Manager in 2008.