Sona Asset Management: Credit Alpha

Abundant opportunity in liquids and illiquids

Hamlin Lovell
Originally published on 28 June 2022

The old Irish word for good fortune and good luck is sona and its symbol in ancient Celtic script sits on the office wall of the eponymous firm’s headquarters in London’s St James’s Street. Sona Asset Management, founded by John Aylward in 2016, is renowned for its leading footprint in European credit, especially high yield; it also trades US credit with a New York office. It runs two strategies: liquid all weather long/short credit launched in 2016, spanning high yield, investment grade and financials, as well as convertible bonds, in the US and Europe, and an illiquid locked up capital solutions strategy active in Europe, launched in 2020. Firm assets exceed $2 billion.

Sona runs the gamut from private to public credit and invests across the capital structure from senior secured to equity linked. In the spring of 2022, liquid credit repriced to factor in higher rates and wider risk premiums, and Sona is also identifying extraordinary opportunities for further yield pickup from the illiquid deal flow it accesses, often on an exclusive or preferential basis.

European industry faces enormous challenges: gas costing 15x as much as in the US, huge budget deficits, slowing economies, and withdrawal of ECB support.

John Aylward, Founder, Sona Asset Management

The 33 staff have in many cases worked together and been friends for between ten and twenty years, and several of them were Aylward’s colleagues when he ran European credit strategies at Claren Road Asset Management and Highbridge Capital Management. “The team share a strong cultural fit and a DNA focused on using differentiated perspectives to deliver convex return profiles,” says Aylward. Throughout his investing career, Aylward led teams managing credit strategies that generated a similar return profile to Sona: double digit average annual returns with low correlation, a strong asymmetric skew, minimal drawdowns and mainly positive months.

Aylward started on the sell side, joining Deutsche Bank in a high yield trading role after law school at Dublin’s Trinity College; he never contemplated legal practice. “I always knew that I wanted to work with numbers, markets, finance and commerce and viewed law – the most sought-after profession in Ireland – as the best route into it,” he says.

All weather performance

Sona’s objective is to make equity-like returns consistently over the medium term, and this has been achieved. Highlights of performance drivers between 2018 and 2022 show how versatile the strategy has been in very different years. “The last five years have all been very difficult, with risk off in 2018, risk on in 2019, drama in 2020, recovery in 2021 and challenges again in 2022. There has been a lot of change and we have performed well in each year in up and down markets. Though we might not always expect to outperform a long only strategy during bull markets, we have actually done so thus far, and we do aim to be uncorrelated and outperform at times of stress,” explains Aylward.

In 2019, longs and high yield contributed most, but even then, three of the top ten trades were shorts. In early 2020, the book was broadly balanced entering Covid, and having shorts in place ahead of the crisis helped the strategy to end March 2020 with positive performance and limit its intra-month drawdown to below 1%. Sona also had dry powder to take advantage of volatility including the sharp selloff in investment grade credit and a lack of discrimination that perversely saw some more liquid but Covid resilient names sell off harder than some less liquid but Covid sensitive names. “We had the confidence and liquidity to execute and trade,” says Aylward. In 2021, the strategy profited mainly from single name selection on long and short sides amid record tight spreads. Towards the end of the year, Sona became alert to inflation and supply chain challenges and started reconfiguring the portfolio, which has continued performing well in 2022. By April 2022, the opportunity set had moved more towards high yield, a net short stance and generally greater dispersion and differentiation within credit markets: “Going forward less central bank intervention and secular European challenges are a very good backdrop,” says Aylward.

Short exposure and long volatility

The strategy is not market neutral, though its net credit beta exposure, historically fluctuating between +30% and -30%, has been comparable to, or tighter than, some strategies that are labelled as “market neutral”; the range hitherto is not a hard limit and is open for discussion. Shorts are intended to generate alpha even if they are not always absolute profit centres. It is sometimes sufficient for shorts to underperform credit markets and generate positive alpha; similarly in a climate like the first four months of 2022, longs in absolute terms might lose less than the wider market and the short book. The liquid strategy emphasizes trading rather than clipping income. The carry of the book could be positive or negative to the tune of tens of basis points per month and has been slightly negative most of the time: “Being long of volatility, optionality and convexity, can sometimes entail a degree of negative carry. Sometimes we get it for free and sometimes we pay for it,” says Aylward.

Feeling the pulse of markets

Sona has a mix of longer term, strategic trades, and shorter term, tactical trades, and is unrestricted most of the time. It has its finger on the pulse of issuance and corporate events and consequently gets “wall crossed” and restricted from trading around 400 times per year, typically for periods between hours and weeks. Sona wants to stay liquid and therefore needs to envisage a cleansing event before restricting the team. Reasons for wall crossings include new issues, market soundings, SPAC/PIPE mergers, and convertible bond activity. These situations provide both investment opportunities and market colour: “New issues can be a good way to deploy capital in size and gather intelligence,” says Aylward.

John Aylward, Founder, Sona Asset Management

Four books but one cohesive team

The four books – European high yield, European investment grade, US high yield and investment grade, and convertible bonds and equity linked – also provide a broad perspective on credit markets, but trading is within rather than between the verticals. Sona does not take cross asset class views such as between financials and high yield. All four books aim to use long/short strategies to generate all weather returns and have achieved that aim in most months. The four books have been lowly positively correlated but will have their best opportunity sets at different points of the cycle, such as 2020 for investment grade and 2022 for high yield, or even at different times of the day, since discussions are continuous, and allocations are fluid. “The firm is structured as one team rather than pods or siloes, so portfolio managers accept that capital may sometimes need to flow to other areas, and there is no pressure to allocate fixed or minimum amounts of capital to any strategies. We have a lot of dry powder most of the time and rarely pedal to the metal. That said, European leveraged finance has been the dominant strategy over the cycle, and it displays the most dispersion and idiosyncratic opportunity,” says Aylward.

Europe predominates

European credit is especially inefficient in the context of credit markets that are generally prone to anomalies because a high proportion of the market is long-biased, index-focused, and credit ratings driven. “Ratings downgrades can lead to mechanical outcomes such as forced selling that generate opportunities for others,” says Aylward. “European credit markets are less efficient than US credit markets, given 27 countries and jurisdictions and many languages. Sona has invested in businesses that have a footprint in all 27 markets, but the corporate structures have been mainly in the major domiciles of UK, France, Germany, Italy and Luxembourg. There have also been cases of firms moving between domiciles. We do also find anomalies between US and European markets sometimes relating to the same issuer, and the European team share views with the US credit team led by Chris Louw,” adds Aylward.

Eclectic trade types

Individual trades can be one or more of fundamental, event driven and relative value in nature and the opportunity set for each ebbs and flows. “Summer 2021 was very quiet for event driven while spring of 2022 started to see more activity. All three interplay to some extent. Ultimately, we need to understand why credits are going higher or lower and we cannot do event driven without understanding relative value. Fundamentals alone can be a value trap without any catalyst. Relative value is not just about numbers, we need to understand companies, capital structures and asymmetries between capital structures,” says Aylward.

Sometimes the repertoire of trades is applied to the same names, such as a cruise line operator, which was traded long, short and via capital structure arbitrage trades at different times. “Expertise spans the credit spectrum. On a European credit management merger, we covered a short and then took advantage of capital markets activity to use CDS to create an asymmetric long/short structure,” recalls Aylward. Cash versus CDS basis trades that are arbitrages can also interact with event triggers such as re-financings.

Multiple legal features are analysed: “They include make wholes, exchanges, tenders, change of control provisions and ratchets. Anything that might change pricing based on events around the company could be relevant. We are at the forefront of being accurate and insightful over these developing situations, and mainly use external counsel,” says Aylward.

Some sub-asset classes, and trade types, are sensitive to the market regime. SPACS are one example. “In the low interest rate regime SPACs provided a variety of opportunities for merger arbitrage, volatility arbitrage, and document arbitrage. For instance, low duration cash box SPACs sometimes had yields around 2% with upside optionality. Now that there is pressure on growth companies in a higher interest rate regime, they are generally less relevant but there are still some interesting oddities,” says Aylward.

Energy and ESG

Energy can include transition opportunities and strategic renewables, although renewables are not always the most attractive from a credit perspective: “Spreads are too tight on some renewable projects. We need to be selective around rules, pricing and industry dynamics for renewables, because the underlying volatility is not great for credit,” says Aylward. “Energy transition needs enormous investment and ignoring the traditional side creates challenges.”

Sona has an ESG policy but views ESG as being in something of a state of flux with potential for nuclear energy to be seen as more positive. Sona has identified some firms such as insulation makers as beneficiaries of ESG tailwinds and is also cognizant of ESG risks that could make it difficult to exit investments.

Bearish and murky 2022 outlook

The strategy has swiftly adapted to the volatility of 2022, which has had multiple drivers: Russia’s invasion of Ukraine, spikes in energy prices, food insecurity, quantitative tightening, rising interest rates, flattening yield curves and inflation/stagflation. “The first half of 2022 was very unusual in having an 11-week hiatus of high yield issuance between early February and late April,” says Aylward. Some issuers were perhaps psychologically in denial about the change of environment and hoping for a swift normalization of the sort that they had grown accustomed to over so many years. Aylward observed that credit spreads in aggregate are still not as wide as after the 2011/12 Eurozone crisis, though there are some individual position level relative value dislocations.

In April 2022 Aylward saw potential for more adjustment: “Given how far rates have moved wesee credit could be still in a period of transition towards wider spreads going a lot further. We have been net short because we see spreads widening, with names hitherto bought by the ECB likely to be first. Some zombie companies may struggle to refinance, and others may not be able to cope with energy costs after their hedges roll off. A simple long energy producers and short energy consumers trade has worked well,” says Aylward. Sona is not directly trading macro variables such as inflation and interest rates but both are hugely important for credit markets and refinancing. “For some borrowers a 7% rate is the new 4%,” says Aylward.

The Sona team’s long history in the credit markets makes them less surprised than some less seasoned participants. “The new normal is more normal than the old normal. The entire portfolio is adapting to the new paradigm of less central bank support, combined with soaring energy and input costs. Some businesses cannot pass on the costs and others can but ultimately may face demand destruction,” says Aylward. Credits with low margins and limited pricing power could be short candidates and others may become so when they refinance at higher rates or fail to do so: “Some business models are anchored to old credit market conditions,” adds Aylward.

The current environment is in some ways harder to underwrite credit risk in than Covid. “Though Covid was unique and broad in effect, we had confidence that many companies would ultimately normalize again. Now we are speculating whether parts of the European industrial base could become cashflow negative at some stage given the pressures such as energy and electricity prices. European industry faces enormous challenges: gas costing 15x as much as in the US, huge budget deficits, slowing economies, and withdrawal of ECB support,” points out Aylward. “The US also has different issues with spiking mortgage rates,” he adds. Market consensus has been slow to respond. “The consensus forecast is for near zero defaults, but we expect not only more defaults, but also lower recovery rates,” says Aylward.

Some zombie companies may struggle to refinance, and others may not be able to cope with energy costs after their hedges roll off.

John Aylward, Founder, Sona Asset Management

Notwithstanding the net short stance, Aylward remains flexible enough to entertain more constructive outcomes. “We are certainly entering a higher volatility regime, but we are not convinced that spreads will widen further since there are scenarios, such as peace in Ukraine, which could be helpful. We are also mindful that if negative sentiment becomes more pervasive, asymmetry could fade.”

The liquid strategy can tactically shift its directional bias but Aylward is confident about even better security selection opportunities: “If central banks are no longer suppressing volatility we should see more broad dispersion in credit markets,” he says.

In mid-2022, the firm sees abundant windows of opportunity to deploy fresh capital in both strategies.

Illiquid opportunities in capital solutions

Sona’s illiquid capital solutions strategy has analytical, informational and deal sourcing synergies with its liquid strategy. The team’s strong 20-year networks will often secure preferential or exclusive access: “Over half of our deal flow has been on a preferred or exclusive basis. We are a leading hedge fund in European high yield and get the first call on bespoke deals. There is also some potential position overlap within the event driven vertical, which could make up 20-30% of the capital solutions portfolio, though only liquid positions would appear in both strategies,” says Aylward.

The Covid dislocation provided the genesis for a $150 million allocation to Sona’s capital solutions strategy in June 2020, which was then doubled in November 2020 and further increased in December 2021 with a leverage facility. The strategy net IRR is in the mid to high teens but realized returns can be higher when crashes, crises and other dislocations throw up exceptional opportunities. Returns overshot the target after the Covid crisis and recently in 2022 some individual investments have generated absolute returns as high as 60% in 6 weeks. (It does not make sense to annualize such unique trades into a triple or quadruple digit IRR however since the same deals cannot be sequentially repeated ten times a year.)

Yield pickups

Yield pickups on private deals can be measured in various ways, including spread per turn of leverage, but Sona applies a variety of metrics rather than any single measure. In absolute terms Sona is seeing some borrowers pay as much as 800 basis points in excess of the yield on their legacy public debt, though the spread over any contemporaneous public issue might be smaller given spread widening this year.

There are debates over whether return premiums in private debt should be viewed as one or more of illiquidity, complexity, structuring or sourcing premia and Sona prefers the term “ability premium”. Aylward questions whether much of an illiquidity premium exists in plain vanilla mid-market direct lending, which could be an overcrowded area. “Illiquid bilateral deals alone are insufficient for a substantial yield pickup, but higher returns can come from non-vanilla deals,” he points out. “Larger premiums could come from complexity, unusual instruments, bespoke deals, subordinated bonds where most of the debt is senior and secured, or ticket sizes below benchmark size that are too small for public bond issues which average EUR 375 million in size.”

Eclectic mandate

These examples should not be used to make useful generalisations about the strategy, which has a very flexible mandate. It is not an SME (smaller and medium sized enterprises) lending strategy per se, since borrowers are often multi-billion companies. And Sona is very selective about taking junior risk: most of the deals – 70% to 80% – are senior or senior secured. Some deals can be rather exotic, esoteric or complex, but equally there is some more traditional leveraged finance that involves private equity sponsors. The overall mandate is broad in that it might involve asset-backed or cash-flow based lending or combinations of the two, including some more bespoke creative solutions. The industry split is broadly diversified so long as there are assets and cashflows, but Sona prefers to avoid more “binary” industries such as venture technology, unproven technology or biotechnology. “In credit the most you get back is usually par, so we want to be diversified with strong downside protection. Such firms are more naturally shorts in my experience,” says Aylward.

There are three verticals: financing solutions, liquidity or rescue financing, and event-driven deals. Financing solutions usually revolve around acquisition finance and can involve a variety of sponsors. Senior convertible or equity linked debt could offer high single to low double-digit yields, with equity upside at low premiums. The underlying companies can be public or private and are mainly pre-IPO if private. These deals can produce very attractive IRRs: “It is sometimes possible to structure deals with a low loan to value ratio and equity upside,” says Aylward.

Liquidity or rescue financing will replace existing lenders at the top of the capital structure often in complex situations: “During Covid we financed a tourism asset in Ireland, earning 11% for a 50% loan to value ratio in a complex structure that involved property collateral, concessions, cashflow sweeps and security documents,” explains Aylward.

Event-driven deals require fundamental value and catalysts, and often involve making a judgment call on recent dislocations. Here Sona is looking to actively drive processes and engage with stakeholders but is not in the business of public activism or replacing boards.

Some deals will perch astride all three verticals: “Secondary loans could be acquired at discounts, then new financing may be done, and there could be event catalysts based on relationships with the sponsor,” says Aylward.

Portfolio allocations amongst the three verticals are somewhat opportunistic but not completely unfettered because a balance between the three deal types is seen as desirable for portfolio diversification and the return profile. In May 2022 Alyward envisaged a higher weighting in event driven because he saw such compelling deal-flow, and because the situations are often shorter term so that the capital can be redeployed elsewhere. Over time long term financing solutions could become the largest.

Legal structures and adverse scenarios

Legal structuring and choice of jurisdictions can be important. “English law is the most commonly used, as we find it the most creditor friendly, but we have also used other local jurisdictions and been involved in multi-jurisdictional deals. There have also been fluid situations where vehicles moved between jurisdictions,” says Aylward.

The strategy is not a distressed debt approach, but it will sometimes encounter stress and distress. Sona is prepared to exercise creditor rights when they need to, and have gone through restructurings and workouts, but they are not an adversarial lender and have a partnership ethos rather than a loan to own mentality. “We try to avoid workouts and do not want to wait years to monetise value. Monetisation and security are top of mind. Restructurings could involve capital optimized tenders, runways, or asset sales,” says Aylward.

As credit markets adapt to a new geopolitical, economic and financial market climate, Sona is confident about the runway of opportunity for its strategies.