2007 to date

Anyone reading the financial section of the newspapers over the last three months could be forgiven for doubting the wisdom of investing in the credit market. The liberal scattering of terms such as 'credit crunch', 'money market seizure', 'banking crisis' and the high-profile collapses of several hedge funds offered little reassurance that credit hedge funds were immune to the problems.

So when investors hear that Specialist Credit has been one of the highest performing hedge fund strategies in 2007, understandably they express surprise. Specialist Credit hedge funds (managers that emphasise a fundamental, research-driven approach, categorised as Credit Value, Long-Short Credit and Credit Arbitrage) returned 2.69% through the third quarter and 12.62% year-to-date through September1.

However, when the behaviour of the best Specialist Credit hedge funds managers is studied, it becomes easier to understand why this has been such a profitable year, and why the credit space is one of the most fertile grounds for skilful investors to exploit going forward.

There are three primary reasons for the strong performance over the first nine months of this year:
 

• First, credit managers realised that, due to historically tight credit spreads, there was no value to be had in being long high-yield debt per se. It made more sense to be long certain previously-distressed companies that were on the road to recovery, but whose debt and equities remained undervalued.
• Second, investment-grade companies globally were in the midst of a leveraged buy-out frenzy, driven by the flood of assets into private equity. Therefore the best trades at the high-quality end of the credit spectrum were to be selectively short the credit of takeover targets.
• Third, many top tier managers were commenting as far back as the beginning of last year that unscrupulous lending practices had left the US housing market dangerously unstable, and that they were looking for ways to exploit the situation. They went short homebuilders, short financials, and (most profitably) short sub-prime asset-backed securities – all of which were winning trades.

Thus, the concept of a 'credit crunch' was seen as an opportunity for the well-positioned hedge fund.

In addition, the better Specialist Credit managers tended not to use excessive leverage in their portfolios. As a result, they were largely unaffected by the tighter lending requirements introduced by prime-brokerages due to the problems in the banking sector, and they were insulated from the violent left-tail losses incurred by some highly leveraged relative value strategies during August.

To the objective investor in hedge funds, the silver lining of the credit-crunch cloud is that the highest-quality credit hedge fund managers were revealed. Over the past three years, the tailwind from ever-tightening credit spreads and low default rates made it easy to be long and levered in credit and generate decent returns, regardless of true skill. That is no longer the case, and the managers who were not doing sufficient fundamental research; who did not understand the environment; or who took undue risk suffered. We are now in a more uncertain world and credit differentiation skills are more important than they have been for a number of years.

Where are we now?

Despite the well-publicised problems in sub-prime and the associated seizure of the commercial paper market during the summer, there is the possibility of significant further deterioration of credit markets, and credit spreads are still tight by historical standards. While managers made small gains from opportunistically buying at the bottom during the technical spike, hedge funds need to be cautious of aimlessly entering the market just because spreads have left their all-time lows.

In credit markets, lending by high yield companies remains plagued by covenant-lite debt (once the sole preserve of investment-grade companies), leaving the door open for further turmoil if the environment deteriorates. As a result, the ability to know a company at an extremely deep level will become a more important factor differentiating the best Specialist Credit hedge funds in the current economic climate.

The area gaining the most attention now is corporate loans, where banks are struggling to place the $300 billion or so of pipeline LBO capital, and as a result yields on high yield loans are higher than they have been in recent years. In response, several hedge funds have launched vehicles to take advantage of this opportunity.

However, we remain cautious about this area. The credit managers we have invested in over the years have generated their strongest returns from areas other than the primary markets for loans – and when they outperform it is usually due to contrarian ideas formed from solid fundamental research, or from their ability to uniquely recognise specific securities which are under valued.

Looking forward, the asset-backed market remains one of the most intriguing sources of return for hedge funds. The US housing market continues to fall with no bottom yet in sight, and there are considerable numbers of US homeowners on adjustable rate mortgages due to reset to higher rates over the next 12 months. Security selection in asset-backed markets and in associated corporate debt will continue to offer attractive returns to the intelligent long/short credit investor for some time yet. The slump in the US housing market will serve only to exacerbate the plight of the US consumer, potentially leading to fundamental weakness in the US economy (if not outright recession) over the next two years. In this environment of increased default rates and commensurately wider credit spreads, the opportunity set for skilful Specialist Credit hedge fund managers will be considerable, and we are optimistic about continued strong returns from this strategy.

Note:1. Represents an asset-weighted average of returns among all dedicated credit portfolios managed by FRM, in USD net of fees

Financial Risk Management

Financial Risk Management (FRM) is a fund of hedge funds manager investing approximately $13 billion for institutional and sophisticated investors worldwide. FRM was founded in 1991 and has over 200 employees in offices in London, New York, Tokyo, Sydney and Guernsey.

FRM manages various Credit portfolios including open-ended commingled products, and FRM Credit Alpha Limited, a closed-ended investment company trading on the London Stock Exchange.