Despite the market volatility of recent weeks, credit markets are up dramatically over the past year. The broad credit markets have rallied over 60% from the lows of March 2009. Corporations that very recently were thought to be at risk of imminent default have successfully refinanced via new issues to the unsecured and secured bond market, extending their debt maturities. Despite the rally of 2009 and these signs of strength, the credit markets do not appear to be overheated. As evidence, we note that credit spreads remain two to three times their 2007 tights and that the structured credit markets have only barely re-opened.
Nonetheless, many investors believe that the credit markets are treading a fine line between a violent sell off and a renewed rally. Our expectation is that over the next 12-18 months both scenarios, while not impossible, are unlikely. Rather, several features of today’s markets suggest a balanced and sustainable position albeit with risks around the tails.
We believe a sustained credit rally from here is unlikely because of a major shift in the underlying investor. The investor base that drove the rally of the past year is less leveraged and more stable than the hedge funds and structured credit buyers that drove the 2005-2007 rally. This changed investor base is less leveraged and therefore less likely to drive spreads back toward zero.
For example, today unlevered mutual funds are taking up 70% of new bond deals and with only 15% going to levered hedge funds and bank prop desks. Similarly, in new leveraged loan issuance, structurally leveraged collateralised loan obligations (CLOs) have declined from 60% of the deals pre-crisis to under 30% today, and hedge fund allocations have fallen from nearly 30% to about 15% with mutual and prime rate funds stepping in to make up the difference. In addition, the recent run up in loan prices has been driven in part by the strong bid from existing CLOs. We believe this “CLO bid” will fade because within the next 18 months most of these existing CLO’s will reach the end of their reinvestment periods and will use loan repayment proceeds to pay down their debt (not buy more loans).
In addition, unlike the 2005-2007 period, there is virtually no bid for credit coming from new synthetic corporate structured credit vehicles. While we believe that many corporate structured credit vehicles have sensible matching of liabilities and exposures and serve a legitimate purpose of efficiently distributing credit risk, the distribution process is now much more difficult and the market will reopen only very slowly.
Moreover, much of the pre-crisis business was about ratings, regulatory capital arbitrage and the abdication of investor accountability. In contrast, over the next few years, chastened ratings agencies, regulators and investors will not only keep a lid on the worst excesses of the structured credit market, but will likely dampen the re-growth of even the prudent market players.
On the other hand, when we consider the other possibility, a dramatic credit spread sell off, we recognise certain forces that could push spreads wider but we think that these will be contained.
First, let’s consider interest rates. The low interest rates have undoubtedly been a positive for risky assets and fuelled borrowing. Inevitably, interest rates will rise – maybe sooner than later. However, the historical evidence of the effect of such rises on risky credit spreads is, in fact, mixed. On the one hand, one would expect that credit spreads would adjust wider to maintaina relatively constant proportion to risk free spreads. On the other hand, rising rates draws more investors into the fixed rate bond market and indexed investors need to buy credit. It is also the case that rising rates tend to accompany improving economic fundamentals. On balance, most studies show that spreads actually compress as the risk free rate rises.
Second, let’s look at the likely impact of the end of the Fed’s mortgage buying program. Mortgage-backed security (MBS) spreads will widen and this will have an indirect impact on the prices of other credit asset classes. However, the end to the program has been telegraphed to the market, the Fed is being measured and disciplined in withdrawing support and, as a result, the impact will be modest, perhaps pushing spreads out slightly.
Third, there is the question of the refinancing pipeline. We recognise that even after the flood of recent corporate issuance significant refinancing needs remain in both the high yield and investment grade markets. However, like the withdrawal of Fed support for MBS, this size and scope of corporate refinancing needs are well known. We also note that the supply/demand dynamic for new issue bonds and loans could be temperamental, especially if flows into bond mutual funds slow (or reverse quickly given daily liquidity), either because of perception of better opportunities elsewhere or a loss of confidence in the market. However, the unleveraged nature of the investor base – and lack of systemic interconnectivity – reduce the chances of another systemic meltdown.
Finally, we do not dismiss the prospect of “fat tails” and the risks that could potentially cause another meltdown. We are concerned about European sovereign default and possibility of catastrophic contagion, though the response of the EC and the IMF has been more proactive than the response of the official sector in 2008. There are of course other potential downsides scenarios that we cannot imagine right now, but we are confident that the operating environment today is much more stable and supportive of a dampened downside than Q4 2008.
If credit markets do remain roughly where they are today for the next couple of years, investors must look beyond unlevered index longs or leveraged market directional wagers in order to earn outsized risk adjusted returns. The credit markets price in binary outcomes, i.e., survival or default. If markets are pricing in roughly the right level of defaults, then buying the market or an index will not generate outsized risk adjusted returns nor will paying away premium on a broad market short. Rather, we believe that relative value credit investments are the best way to generate superior returns with lower volatility and reduced risk to tail events.
At BlueMountain, we may not be able to predict the level of defaults in the economy as a whole better than the market, but we can recognize inconsistent default expectations within and across markets. Whether this means the secured debt of a company is pricing in dramatically different default prospects from the unsecured debt of the same company, or the equity of the CLO capital structure is pricing in a riskier path than that of the unsecured credit market, the job of a relative value investor with a comprehensive view across credit markets is to spot these inconsistencies and tactically invest into or around them.
There are a number of reasons why such disparities arise and very often this mispricing is a result of the artificial constraints that most credit investors face. More than in any other market, credit investors are subject to structural constraints and restrictions on their ability to invest freely across the very broad range of credit instruments and markets. Whether the restraints are based on asset class, ratings, tenor, sector diversification, or geography, they can have a profound impact on the size and direction of capital flows.
While many of these restraints offer crucial protections to the underlyinginvestors, they regularly create meaningful price disparities between similar credit risks. It is up to the relative value investor to identify and capitalise on these disparities.
However, simply investing wherever these disparities occur, without consideration for their underlying cause, is a treacherous business. Only by knowing and understanding why, for example, the loan market is behaving differently from the bond market, or why the cash credit market is diverging from the synthetic credit market, can an investor make an informed judgment as to whether this relationship will correct or get worse. Moreover, success requires an integrated understanding of corporate fundamentals, market technicals and quantitative analyses.
While the pronounced market disparities of early 2009 have diminished in absolute terms as markets have rallied, on a relative basis, they remain acute. Accordingly, being nimble, opportunistic, and thinking intelligently about relative value between companies and instruments will mark out true alpha generation in credit over the next couple of years.
ABOUT THE AUTHOR
Prior to co-founding BlueMountain, Stephen Siderow was an Associate Principal with McKinsey & Company. Previously, Siderow was a corporate attorney with Cleary Gottlieb. He holds a J.D. cum laude from the Harvard Law School, B.A. magna cum laude from Amherst College and was a Fulbright and Sheldon Scholar in Israel.