Outlook: Distressed

Current distressed cycle provides unique opportunities

Originally published in the May 2008 issue

Although equity markets and other economic factors are currently in flux and the expectations for equity markets remains uncertain, the current economic environment holds many opportunities for hedge fund manage.

Q1 provided excellent examples. Although the MSCI Index returned -8.9% in the first quarter, certain hedge fund strategies including macro and commodity trading advisors (CTA) demonstrated positive performance as trends in interest rate markets, commodities and currencies supported returns. In addition, short-term trend followers continued to benefit from the heightened equity market volatility over the period and positive returns resulted from trades including long US treasuries; long commodities (including gold); short credit; and short USD/long Euro.

Looking ahead with regard to equity markets, we believe that whilst the overall direction for markets will be mixed, stock-picking opportunities will reassert themselves for equity long/short managers as soon as the impact on the US economy in Q1 becomes clearer. Despite concentricity of the problems in the US from a directional basis, we favour US markets over others in the current environment of heightened equity risk premiums. During the second half of the year, we also expect to see asset price inflation in Asian and emerging markets.

Credit markets are currently experiencing significant deleveraging and are arguably oversold on fundamentals. As a result, current spreads do not reflect either current or nearside corporate delinquency rates. However, we do expect to see a second trough towards the end of 2008early 2009.

Outlook: distressed

In this economic context, we anticipate the most compelling hedge fund story of 20082009 to be that of the distressed strategy. This will be due to a number of factors including current indirect lending to mid caps; distressed mortgage-backed securities and asset-backed securities (predicted for Q3 2008); leveraged loans; and long USD denominated/short local currency emerging market debt. Assuming the continued absence of the structured credit financing bid for the remainder of 2008 and a US recession, 2009 may witness a rise in default rates that would precipitate traditional distressed opportunities.

It is our view that the next distressed cycle will be characteristically different to the previous one. This is due to the following:

  • During the last distressed cycle, which occurred in 2003-04, the largest holders of credit were banks. In contrast, during the current cycle, investors in collateralised debt obligations are the most significant holders of credit. The more complex capital structures of these investments may result in rating downgrades that could precipitate faster selling by a more widely dispersed group of holders of credit.
  • During the previous cycle, there was a focus on a smaller number of fund managers. During this cycle, there will be more numerous individual distressed positions due to securitisation issues and the liquidity crunch. This may require substantial human capital to understand and to take advantage of the opportunities. At the same time, openings will be shorter, as capital will be able to flow to the securities more quickly.
  • The new US Bankruptcy Code, overhauled in 2005, will be tested for the first time, potentially resulting in shorter bankruptcy litigation periods and more out of court settlements.
  • The credit default swap (CDS) market, immature during the last cycle, is now more than twice the underlying cash market size. This may make it easier to execute a bearish view, although after a default, the technical pressure to sell will be replaced by pressure to buy and cover shorts.

The next distressed opportunity is likely to be precipitated by excessive leverage levels, declining real estate values and reduced consumer spending.

Longer term opportunities

The outlook for mergers and acquisitions is unclear at this stage. Deals following the re-leveraging of balance sheets will not occur for the near future. As targets cheapen, those companies with significant sustainable cash balances could engage in transactions in the commodity sector. Further consolidation in the banking sector is anticipated as well as significant new financial regulation, which will throw up anomalies/opportunities for hedge fund managers.

We expect the environment for macro managers and CTA’s to remain fertile during 2008. As the two major monetary authorities in the West continue to exhibit divergent economic policies, we expect to see further opportunities in both interest rate and currency markets during the second half of 2008 and 2009 as these economies slowdown or move into recession.

Longer term, we believe that deleveraging as a theme during 20082009 will generate opportunities for hedge fund managers. We have seen the damage that US subprime and deleveraging in structured credit alone has done to the balance sheets of financials, although the traditional source of damage to banks balance sheets-that of bad debts due to an economic slowdown/recession-has not yet occurred. We expect to witness this in 2009. This will necessitate further deleveraging of balance sheets over the next 1 to 2 years. For investment banks, the situation is even more acute. This will have significant consequences for the re-pricing of instruments.

In conclusion, our assessment is that hedge fund managers can profit in Q2 2008, and onwards, by taking advantage of changing economic conditions precipitated by the credit crunch, reduced consumer spending, and deleveraging.

HAIL’s investment team continues to focus on those managers who are in a position to benefit from these longer-term dynamics.

Tim Gascoigne is the Head of Portfolio Management at HSBC Alternative Investments Limited