A brief history
Even the man in the street loves to hate the credit markets. One often hears the euphemisms “credit crunch, credit crisis” and such like… clearly the asset class has received the burden of blame for the current economic malaise. But is that justified?

Perhaps not justified, but certainly not surprising, given that the credit crunch began with banks not lending to each other, i.e. not extending credit, and then cascaded into a general systemic breakdown in lending, and a drying up of liquidity in a number of asset classes including equities, commodities, and of course credit.

However if history teaches us anything,it teaches us that disasters create opportunities. It is important to look at the past insofar as it allows us to better understand where the opportunities lie going forward. One will recall that in the early summer of 2008, we began to see the first signs of the dislocation, a significant increase in overnight LIBOR rates, and TED spreads. This was principally a result of banks beginning to understand the significant mismatch between assets and liabilities on each other’s balance sheets, which then led to a complete breakdown in interbank lending, a situation I compare to a game of musical chairs.
The second-order effect of banks’ unwillingness to lend is what caused the real problems. These included suspension of new mortgages, banks reining in or reducing working capital lines for businesses, the disappearance of consumer lending, and in the financial arena margin calls, significantly reduced financial gearing and stock lending, and the commensurate effect on the prime brokerage model and hence the hedge fund industry.

The financial system came under significant pressure as a result of banks’ unwillingness to lend. Structured products, leverage products, and even wholesale banking depended on the freely available liquidity that banks had historically offered.

Dislocation, illiquidity, and uncertainty oftentimes bring opportunities especially in asset classes such as credit where the financial health of the company’s balance sheet can clearly be analyzed, its ability to repay can be measured, and its ranking in its industry in terms of financial health and revenues can be gauged.

Where we are today
The credit crisis has created the most significant opportunity since 1932 in investment grade and speculative grade credit. The principle forces contributing to this opportunity have been the forced deleveraging, significant margin calls, and of course the well-heralded hedge fund redemptions by funds of funds and other investors.

Attempts across asset classes to model the black swan or fat tail effect unfortunately assumed that significant market dislocations would not adversely affect global liquidity in low risk instruments and money supply. These assumptions were completely erroneous, and as we know margin calls and forced deleveraging resulted in funds having to sell the most liquid, and hence highest-rated securities, due to lack of liquidity in any other instruments.

The credit crunch initially presented investment opportunities in the most liquid and highly rated asset classes such as investment grade debt, US treasuries, blue chip equity and other highly rated liquid asset classes.

This led to the well documented rally in the second quarter of this year, once the dislocations of the market began to be addressed and resolved through global banking system bailout, significant increases in money supply, and other actions by governments and regulators.

This article will seek to identify the opportunities that now exist in credit and how best to exploit them going forward.

Market cycle
Fig. 1 shows the cycle of opportunity in the credit markets. As the market cycle matures, risk appetite significantly diminishes, as does access to capital both from the capital markets and banks. In the final stages of the market cycle, restructuring and bankruptcy exit skills become critical. The credit cycle requires a number of different strategies at different times in order to maximize returns. Initially a long bias is appropriate, moving next to a market neutral long short approach, then to a short bias as companies begin to default, finely culminating in a distressed long bias strategy once bankrupt companies begin to restructure and exit bankruptcy.

In the initial stages of the credit cycle, strategies that focus on dislocation, recapitalizations, and stressed investments are the appropriate and most profitable. Typically in the firstfew stages of the credit cycle there is an abundance of rescue capital, bank capital, and investor capital. Therefore looking for exploitable dislocations – with the expectation that a large number of investors will be biased towards rescuing the company, lending it money, becoming more senior, or buying in outright in a trade sale or acquisition – should lead to a long bias at the initial stages of the credit cycle.

As the credit cycle matures, nimble managers ideally should begin to increase short exposure. They should become more market neutral, increase relative value and outright shorts in companies where they believe the company cannot service its capital structure, and/or has an inappropriately large balance sheet, i.e. cash flows will not be sufficient to service interest and working capital needs. As the cycle matures, typical sources of refinancing such as banks, capital markets and direct lending tend to dry up.

In the final stages, we begin to see debt restructuring, bankruptcies, and large-scale corporate failure. This is when it becomes appropriate to seek distressed opportunities. These opportunities manifest themselves through debt-for-equity swaps, workouts, sales of businesses and new equity listings. Perhaps one of the best examples of this is Italian food group Parmalat.

One of the most disappointing asset classes recently has been distressed. Seeking to replicate the outsized returns made in the past two distressed cycles 1991-93 and 2001-03, investors piled into distressed funds. Simply put, these investors entered too early: while there may have been a number of distressed situations, the likelihood of significant deterioration of value through bankruptcy, and the corresponding ability to buy assets at a fraction of their long-term value, rely on rescue finance, capital markets lending, and other forms of support not being present.

We have had a classic example recently of two bankruptcies in the automobile sector which vary dramatically, General Motors and Lear.

General Motors
In the case of GM, the company entered administration with no debtor in possession (DIP) financing. Significant asset sales were mandated by the government in exchange for its short-term support. In this particular situation, key assets must be sold in order for the company to continue as a going concern. The problem is without financing in waste to assist in the normal operation of the company, GM will be forced sell several of its principle revenue generating divisions.

Lear
In the second example and automobile parts manufacturer Lear also entered bankruptcy through Chapter 11. Critically, DIP was available and this has resulted in the company’s ability to continue as a going concern without asset sales being necessary. This is a very good example of the beginning of access to capital becoming more selective.
The treatment by the markets of senior unsecured debt reflects market perceptions quite clearly. GM senior debt has traded down approximately 50% since the company entered bankruptcy, Lear senior debt, by contrast, rallied almost 100% after the company entered bankruptcy. I think we will begin to see more bankruptcies where there is very selective access to capital as the credit cycle matures, leading to significant restructuring and workout opportunities.

Opportunity
In the current credit crisis companies can be divided into four types of stressed or distressed credit. Opportunities exist in all four situations if strong fundamental analysis is applied.

1. Good company, good balance sheet
These companies have a strong cash flow and a healthy balance sheet. Either their top line is recession resistant or they currently are free cash flow positive and should remain so through the economic downturn due to a flexible cost structure. They do not need to come back to the financial markets for many years and thus can independently service there debt. Examples include UPC, IESY and KDG, cable companies which have financed their business plans for next five years. Bonds were trading in the mid 60s in November 2008 and now trade close to par. Opportunities currently exist to hold this debt at solid yields of 8%-10%.

2. Good company, bad balance sheet
These companies have a strong cash flow but an unhealthy balance sheet. They are typically an industry leader that has the ability to maintain its top line and control cost structure through the economic downturn. Their balance sheet, however, is ‘front loaded’ i.e. they have a lot of short term debt maturing in the coming two years. Such companies have to borrow from their banks to refinance short term debt and extend the maturity profile of their balance sheets. While banks are not willing or able to lend, these companies are able to strengthen their balance sheets through though a combination of new equity and investment grade, high yield or even convertible debt. Examples include Rio Tinto, MGM, Virgin Media, Wind Telecom and Softbank. Significant opportunities exist in buying short-term debt at 10%-15% yields, and in the longer term and subordinated debt, as refinancing takes, circa 15%-30%.

3. Bad company, good balance sheet
These companies have a deteriorating cash flow and business model, but a healthy balance sheet. They are typically in a cyclical sector that has no pricing power and little cost control through the economic cycle. Their balance sheets, however, have no near term liquidity issues or are light on bank debt as percentage of total debt. Banks are forced to ‘play ball’ with these companies as they do not wish to see their bank debt impaired in the event of covenant breaches and fire sales of assets in a weak market. Therefore, banks and senior lenders give such companies covenant waivers in the hope that a turnaround will happen. Such firms will be able to survive in the medium term; however, recovery in the event of default is less likely as subordinated debt gets layered and the business cycle worsens. Examples include Ineos, Lear and GM. Opportunities exist here in buying debt that is priced close to a zero or less than 10% recovery chance, but is worth more due to potential equity value in the debt as the business is viewed as an ongoing concern and assuming the company continues to pay coupons over the next 12 months.

4. Bad company, bad balance sheet
These companies have deteriorating cash flow and business models and an unhealthy balance sheet. Typically they face significant liquidity problems and short-term maturities and are either already breaching covenants or about to. Balance sheets have significant amounts of secured bank debt coming due in near term, and banks are not willing to extend maturities. Banks will not ‘play ball’ with these companies and lenders are forced to take impairments on their investments. Jurisdiction of debt and equity holders becomes a significant determination of value as the company defaults and goes through either liquidation or reorganization. Creditors vary from banks and collateralized lenders to the public debt market. A quick reorganization is sought by creditors, but is difficult to achieve. DIP financing is hard to find and the result is a significantly lower level of recovery than originally anticipated by the market. Examples include Lehman Brothers and LyondellBasell. Companies go through an auction to determine recovery rate for credit default swaps (CDSs). As a significant amount of CDS investors hold on basis, such auction results tend to be below the company’s real value. Therefore, opportunities exist as courts sort out liabilities and the company gets DIP financing. For example Lehman Brothers settled at 9.75% and LyondellBasell settled at 2%, while debt currently trades at 14% and 6%, respectively.

The credit cycle – a historic opportunity to invest
Fig. 2 analyses the default rate implied by corporate spreads over the past three credit crises. We have graphed the US and European high yield indices over the past 25 years. One interesting observation is that the European index tends to significantly underperform in difficult economic environments, but it correlates very highly to the US market in times of economic expansion. Our initial observation is that European corporate spreads tend to overreact in times of difficulty, and as a result may offer more interesting opportunities for European credit managers than their US counterparts. What we see in 1991-93 is that credit spreads widened to 1000 basis points over LIBOR. Using Black-Scholes, we can derive implied two-year defaults rates from market spreads. In 1991, spreads implied a default rate of 22%, 2003 spreads implied that 32% of high-yield issuers would fail.

Current market spreads imply that 38% of sub investment grade companies will default over the next two years, 22% in one year alone.

What we find it very interesting – and which creates a significant opportunity in the asset class – is the historical mismatch between the implied fail rates and actual observed default rates. Actual defaults were 14%: if one takes the implied default rate and subtracts the observed default rate, the asset class produced an excess return of 8% in the 1991-93 recession. Using the same methodology, in the 2001-03 recession, the excess return was 24%.

When looking at past default cycles, Moody’s Investors Services and Standard and Poor’s tend to be reasonably accurate predictors of actual defaults on a two-year basis, notwithstanding the fact that they tend to revise their observations quite frequently. The global speculative grade default rate observed for the first half of 2009 was 10.1%. Moody’s has just revised downwards its expected entire 2009 default rate to 12.8% from 13.8%.

Using the same methodology as employed in the past, and substituting the Moody’s estimate in place of observed defaults, we believe that global speculative grade credit could produce an excess return over the next two years of between 18% and 22%. Empirical evidence clearly shows that the market overshoots in times of difficulty, and is therefore currently very cheap on a risk-adjusted basis, significantly compensating investors for the level of risk.

Additionally, Europe looks cheap relative to the US as Europe tends to significantly overshoot but has similar levels of default in economic recessions.

One of the most frequent questions investors ask me is: have we missed the rally? I believe that the answer to this question is clearly no. Fig. 3 shows that we have seen approximately 2000 basis points of widening from before the crisis to the nadir of December 2008. However we still have a further 1400 basis points of tightening to go before we return to pre crisis levels. Moreover, a stable spread environment, even at elevated levels, remains a very attractive investment proposition when one considers income generation the compounding effect, and the fact that equity dividends are approaching all time lows.

Fig. 3 shows the three major asset classes compared over the past 25 years. The gray areas, which represent the past three sessions, show clearly that equity takes the longest period of time to begin to perform and that high yield debt recovers the fastest.

Principal reasons for this are the compounding effect of high yield and the fact that it’s a coinciding indicator of economic health and recovery. Moreover, the equity markets are barometer of expected future earnings and earnings growth, while credit is a measure of the current financial health of the company.

This point is significant insofar as fixed income investors typically look at the financial health of a company, and its ability to make its interest payments, and therefore the analysis centres on the leverage, interest coverage, cash flow analysis, and other financial health metrics.

Equity investors on the other hand attempt to model and forecast increases in earnings and revenues, the reestablishment of dividends, and the ability of the company after it’s made its interest and bank payments to upstream dividends to shareholders. Put simply, they are the last to get paid.

Timing in investment grade and high yield is much less critical than it is in equities. As Fig. 4 shows, equity returns tend to lag returns those of fixed income, and returns in equity are concentrated over a short period of time, i.e. the slope of the line is steeper once they begin to recover, but only begins to steepen later in the economic recovery cycle.
Fig. 4 compares the total return of an equity portfolio (the S&P 500) and a high yield portfolio (Merrill Lynch’s high-yield index). The assumptions are that the investor holds a portfolio for at least two years and takes three months to invest fully.

The black bar shows the ideal time to invest in each asset class, and the total return of that investment. In equities, the optimal time to invest and hold for two years would have been April 2003 and the return to the investor would have been approximately 22%.

An optimized investment in the credit market had an almost identical total return of approximately 22%. The optimal date for investment in the case of credit would have been November 2002. The chart then shows the returns if the investments have been made too early (to the left of the black bar) or too late (to the right of the black bar).

What is interesting is that the timing of an equity investment is absolutely critical, especially if you are too early. However, being too early into a fixed income investment makes far less difference to the overall return. In fact, diminishing returns occur when one is too late to a fixed income investment.

Conclusions
There are significant opportunities for outsized returns from investing in credit, and as the business cycle evolves, different strategies must be adopted in order to maximize returns. In looking at historical data, credit markets tend to overshoot to the downside, and offer the best return characteristics shortly after the recessionary cycle begins and the selloff occurs.

As an asset class, credit does not need to be as carefully timed as investments such as equities where the entire return typically is due to capital gains. Factors such as a stream of interest payments make fixed income investments for the medium term investor attractive. Finally investments made in credit as an asset class are better made early than late.

Louis Gargour founded LNG Capital in 2006 and is the Chief Investment Officer. Previously he was Head of Fixed Income at RAB Capital, and has held senior roles at Goldman Sachs and JP Morgan, and began his career at Salomon Brothers in New York.