Every three to five years some piece of the fixed income market blows up, and most people who have been in the market for 10 or 15 years or more see this as an entry point." So says Steve Zamsky, a former credit strategist with Morgan Stanley. Zamsky is now a Managing Director with US hedge fund manager Pequot, and Head of its Credit Strategy.

Fixed income, in the wake of last summer's credit crisis, continues to be something of an anathema to seasoned hedge fund investors. Family office managers who wax lyricalabout China long/short strategies go abruptly quiet when US corporate debt is brought up. It has become the elephant in the room that many funds of funds would prefer to ignore. But for Zamsky, it is an opportunity, both from the long and short side. He has been here before, after all, and was witness to the 2002 balance sheet blow out. "It is a confidence issue," he says, "a combination of fundamental down-trade blended with natural, and significant, deleveraging." In his view, hedge funds that are comfortable with investing in credit markets at this point in the cycle are going to be ideally positioned to capitalise. He is seeing opportunities on the short side from a tactical perspective, the result of current dislocation, and on the long side recent and ongoing market turmoil is creating attractive entry points.

Pequot, the $7.5 billion multi-strategy fund launched by Art Samberg in 1986, has made a habit of spinning off sector-specific funds from its core strategy. In May 2003 it created a long/short credit fund to be managed by Zamsky. Two years later it added a short credit fund, also under Zamsky's aegis, in anticipation that credit spreads were bound to widen. Between them, the credit funds have over $700 million under management. Despite the fact that some hedge funds have dropped out of this space recently as hard times have returned, Pequot remains optimistic on credit opportunity: volatility in the credit markets and the economy as a whole is creating the potential for profit.

Pequot Credit Opportunities Strategy

Pequot launched its Credit Opportunities Strategy to invest in corporate bonds, credit derivatives and preferred stock. It also takes positions in US Treasuries or Treasury derivatives and/or interest rate swaps in order to hedge interest rate risk. Its main thrust is the identification of "compelling relative value opportunities" across the credit markets, both on the long and the short side of the portfolio. It does this by owning a diversified portfolio of long positions coupled with a more focused short portfolio (consequently leaving it net short on a typical month). Zamsky aims to keep a relatively neutral day-to-day exposure to general movements in the credit market, and actively manages the volatility of both the long and short sides of the portfolio.

Pequot has an investment culture that is based very much on fundamental, proprietary research. It combines meetings with the management of individual companies with ongoing industry analysis and market knowledge. Supported by a team of three analysts and two traders, Zamsky is also able to talk to colleagues outside the credit team in order to tap into the rich reservoir of internal intelligence that Pequot possesses. This helps him to identify which industries are likely to yield good returns over the long term as well as capitalise rapidly on changing company fundamentals.

This culture is part of a growing trend within both the hedge fund industry generally, and asset management at large, to invest in internal resources to provide proprietary data tailored to a fund manager's own criteria. It is an industry-wide trend driven partly by an appetite for under-researched securities, and partly by a lack of faith in the research that investment banks were traditionally providing to the market. In Pequot's case, this independent 'take' on company research has allowed it to continuously reorient itself towards sectors that exhibit volatility, change, and liquidity.

Pequot's risk/reward approach is designed to maximise the likelihood of success by highlighting areas where its funds can gain, while cutting down on the potential losses that could be incurred. The credit team typically focuses on seven or eight sectors where it feels that it has an insight, or where Pequot as a firm can bring some level of proprietary expertise to the equation. The stress here is on keeping close tabs on a sector's fortunes, and being ready to removeit from the hob when it goes off the boil.

As a house which relies on its fundamental credentials, Pequot follows a bottom-up portfolio construction process which includes in-depth financial analysis and regular discussions. Zamsky, for example, can draw on the expertise of the distressed team which sits in Los Angeles, or any of the substantial pool of analysts currently working for the firm, covering a range of markets and sectors. Once a hedge fund reaches the scale of a multi-manager shop like Pequot, it begins to assume the characteristics of an institutional money management shop, with many of the formalised information-sharing processes that go with it.

Short Credit Strategy

The short strategy is based on credit default swaps, indices of CDS, and synthetic tranched credit portfolios. The Pequot Short Credit Strategy invests primarily in these short credit positions and aims to pay its CDS premiums and the interest on its short bond positions in excess of the interest it has on its cash balances.

Pequot was one of the first firms to launch a dedicated short credit strategy, and has stuck to its guns during the rougher going in the credit markets recently. This is partly thanks to its ability to monetise trades, and an appreciation for where the scale limits are for such a strategy. As with the long positions Pequot takes, it relies on a fundamental approach to guide its positioning.

In addition to having CDS on individual names, the fund broadens its exposure to credit spread widening by using indices and other portfolio derivatives. This can also help to reduce the portfolio's negative carry position (incurred from having to pay CDS premiums and other interest charges) as well as allowing Zamsky and his team to exploit the occasional mispricing opportunity in these instruments.

There have been considerable concerns raised about the CDS market in the wake of the credit crunch, including the vulnerability of insurance counterparties and the difficulty of unwinding the vast mountain of outstanding CDS issuance that casts its long, dark shadow over Wall Street. Zamsky freely accepts that some of those hedge funds that got into difficulties in the second half of last year did so because they were over-extended in the CDS market. "It was a market that got very crowded," he says. "Some people may still use them, but not exclusively." He still buys CDS, but stresses that other instruments will take a growing role in the portfolio.

One has to ask Zamsky what he thought of the CDO bonanza, and the role of the ratings agencies in perpetuating it. "It was pretty ridiculous," he admits. "They got it incredibly wrong, and they deserve a lot of the criticism. People were buying AAA CDOs and should have seen they ought to be way cheaper than they were. In short, financial innovation went too far."

Avoiding the pain

The current crisis is bigger and more complicated than the last credit blow-out, and due to the problems with structured credit, like the CDO and CDS markets, it feels a lot worse. "We've seen a lot of new strategies and instruments emerging in the last few years," says Zamsky. "It has been a march towards innovation that has relied on leverage."

Pequot's credit funds have not had to reinvent themselves in the wake of the credit crisis, and instead have stuck to their guns, navigating a course which did not depend on the esoterica of structured finance for its success. "We are not doing anything different," the portfolio manager explains. "We didn't buy into the leverage, and we've not gone too far down the complex derivatives path either. All the pain is with the more exotic instruments."

In short, while the portfolio strategy may not have changed, the opportunity set has. Many big credit investors are being forced to dump perfectly good positions, and funds like Pequot are there, waiting to pick them up. It is because of the fact that Zamsky has stayed on course that he is now on the buyer's side of some good deals, while other credit hedge funds are grappling with the liquidity implications of some of their more opaque investments. He describes the current fire sale as "a wholesale slaughter" with plenty of investment grade corporate credit coming onto the market at knockdown prices.

"The basis spread between corporate bonds and credit default swaps has led to some big mismatches," Zamsky says. He has had a certain amount of basis risk in his funds, and has seen spreads widen from the zero to 80 range over the last 12 to 16 months, up to 100 by the end of March. "Reasonably intelligent people thought the 25 basis point differential was worth pursuing. Despite the current uncertainties, hedge funds are still going to be enticed into using CDS and bonds against each other."

Zamsky feels efforts the Federal Reserve is making to increase liquidity and address the basis differential, as well as the counterparty risk and funding risks embedded in CDS trades will be successful. "It will go back to normal eventually," he says. "This is helping the guys who are hurting at the moment."

On the margin the cash bond market is more active than it used to be, while the CDS market has encountered liquidity issues that have made it more challenging. "Cash looks more attractive on the valuations right now, and it is easier to trade," Zamsky explains. "People have so many CDS out there that are away from the standard maturity points. Maybe the propeller heads are in trouble, and it could be a bad thing for those funds that are CDS-focused. I would be interested to know what the liquidation values of some of the unwinds will be. Unwinding all of this is going to be hard."

Back to basics

Zamsky is sanguine: he sees US credit returning to a back to basics environment. Times are tough right now, but they need to be if the market is going to return to the fundamentals, and it is the fundamentals that are Pequot's bread and butter.

"The Fed should have let Bear Stearns go under," he says. "They showed they were willing to bail out the system from the risk that was embedded in Bear, but it has created another huge issue. The Fed has drawn a line in the sand. It's unlikely we'll go to that brink again."

A number of large investment banks are now thought to be working on a strategy that will create a clearing house for the credit derivatives market and hopefully restore a modicum of confidence to the market, as well as dispelling persistent fears over counterparty risk. The format would allow institutions with solid capital bases and credible trading histories to clear trades in the CDS market via a central counterparty. Zamsky sees this as a sign that practical steps are being taken to resolve some of the issues that have clogged up the credit derivatives markets, and is hopeful that confidence will slowly return to the market. The US IG Index reached 197 basis points at its widest point, and is now around 100. "We've seen a 50% decline in credit spreads in six weeks," he says. "This is an audible sigh of relief, but it still ignores some of the cyclical risks."

Zamsky feels the market is ignoring the coming battle within the US economy, being too focused on some of the liquidity and counterparty risks outlined above. It will be an environment ripe with opportunity for an astute credit manager, with both systemic and cyclical risks to take advantage of, and a basis differential which will create opportunity.

Outside the US the fund will typically have between 10-30% invested, mostly in mature markets like Australia, Japan, and Europe. It avoids emerging markets for the most part. Zamsky takes a global view on his non-US positions, and in particular is on the look out for good relative value plays. In the fourth quarter of last year, thefund had little invested outside North America. "We weren't seeing the cyclical consumer moves we wanted to see in Europe," he says.

In Asia, particularly Japan, the fund has been focusing on the financial sector recently. In Australia it has been M&A activity and the superior liquidity in the CDS market that has sparked interest, and the fund has been involved with a variety of names in that region. Like other short credit hedge funds at the moment, Zamsky is paying close attention to the UK, which is expected to follow a similar economic path as the US has, but with a six to 12 month time lag. The financials and housing sectors are being monitored closely, and a variety of potential shorts in the consumer stocks space are under consideration. As such, Pequot is part of the wall of hedge fund money poised to take advantage of short and distressed opportunities in a number of UK sectors over the next year or so. "On a cross-border basis, we look at US versus UK consumer exposures," says Zamsky.

The expected consumer slowdown aside, Zamsky, like some of his competitors, is also acutely aware of the potential LBO hangover that could affect some large names in Europe. The same goes for the US, where there have been some massive LBOs driven on cheap finance that may prove unsustainable now. Zamsky feels the US is already technically in a recession, although he admits there are differing views as to how prolonged or difficult it will be. "The increasing amounts of leverage in this market have fuelled a lot of growth, and now that era is dead, probably forever," he says. "The trend line will be a lot lower. For instance, I think we're going to see zero to one percent growth in the US for a long time to come."

As a credit manager he is particularly aware of the glut of debt that the private equity business injected into the US corporate sector between 2005-07. While LBO deals done in 2005 might have seemed realistic, it was obvious by 2007 that the massive size and leverage of the deals being done was unsustainable. As a consequence, he is expecting some high profile defaults from some of the firms involved in these buy-outs, and soon. "There's been a lot of price damage done there," he says, comparing it to the bonds crisis in the 1960s, or the savings and loans in the 1980s. "A lot of the traditional bond guys didn't buy the loans."

Pequot's risk management process for the fund is a robust one. For the short credit strategy, it avoids long credit risk positions, and generally there will be no short credit exposure representing more than 30% of the fund's total capital. Leverage is kept in the range of 400-800%, and the portfolio is periodically rebalanced to maintain a 3-4% negative carry per annum, allowing for gain capture during periods of spread widening, as we have seen recently.

The main credit opportunities strategy follows pre-defined risk parameters, with no more than 20% of the fund's NAV invested in companies domiciled outside the US, based on the time the investment was made. The fund keeps exposure to single names under 15% net on the long side, with again the short credit exposure kept within 30% of fund capital. On top of this, Zamsky and his team aim to keep their sector exposure within 30% as well.

Risk monitoring of both strategies focuses on gross and net portfolio level exposure analysis, paying attention to name specific exposures and rating category exposures. Stress testing and scenario analysis is also carried on a regular basis.

Conclusion

Talking to Pequot managers, it is easy to see how this stress on a fundamental approach to investing permeates the firm at a multitude of levels. The disconnection in the credit market that has undermined the credibility of the ratings agencies, and affected much of the data set that some credit managers have traditionally relied on, has not made Zamsky blink. He relies on the feedback from his team of analysts, not external opinion. As he sees it, there is still a game to be played if the ratings agencies get it wrong, and Zamsky's team sees an opportunity. "They have a tough job, with limited information," he says of the agencies. "They're not in an easy position."

The fall-out of the 2007 credit debacle is leading to a new landscape for credit hedge funds to patrol, and Zamsky is hoping to find plenty of gems as he picks his way through the ruins of the credit blow-out.

"We've not seen the end of it," he argues. "There is still going to be a huge re-pricing of risk, and the default rate hasn't ticked up yet. The number of downgrades has not reached a point that accurately reflects the real health of the credit market." There is more pain ahead, but more opportunity too.

BIO: STEVE ZAMSKY
Managing Director, Pequot Capital
Steve Zamsky is responsible for Pequot's credit strategy. He was previously a Managing Director and Head of Investment Grade Strategy at Morgan Stanley. He was ranked top in investment grade strategy on Institutional Investor's All-America Fixed Income Research Team. Prior to this he worked as both a strategist and a credit analyst at Morgan Stanley. Before going into the investment bank, he had a similar role with US fund manager Fidelity. He graduated with a BS in Accounting from Oregon State University, and received his MBA from the University of Chicago.