Decoupling from the asset class and peers

The strategy is managed by Barend Pennings, working closely with Deputy Portfolio Manager, Jan Mroczkowski. Both are highly experienced credit investors, having honed their craft over many years. The strategy’s worst drawdown of just -3.69% over the past three years is a fraction of the prior one, and its correlation to the Bloomberg High Yield index has more than halved from 0.6 to 0.26. “We aim to learn from our mistakes to continuously improve the process. In the fourth quarter of 2018, we were harmed by unexpectedly rapid rises in interest rates. Although we did not anticipate rate hikes in 2022, we were prepared for them in several ways. We mainly had shorter duration on the long book, and more senior secured exposure with better downside protection. We also owned names with more asset backing and stronger pricing power that could thrive in an inflationary environment,” explains Pennings, who has also been quick to cut losses, particularly as he is a material investor in the strategy. Meanwhile, single-name event-driven catalysts such as amortisations and refinancings have helped to reduce correlations.

Contrarian shorts

Another factor that has helped to reduce the strategy’s correlation to peers is its short book. “We hunt down shorts that are not accessible to the largest alternatives managers. Whilst many larger hedge funds like to short via CDS, which is a much larger and more liquid market, we prefer cash bonds with no CDS, which are more volatile,” says Pennings.

For example, the strategy currently owns a basket of bond short positions amongst various European auto parts manufacturers. “The French government has a ‘golden share’ of Renault, but auto parts companies are not household names, and thus there is less sensitivity to restructuring their liabilities. During the Global Financial Crisis, pricing in the industry was cut to the point that bankruptcies were inevitable. Today there appears to be similarly strong headwinds, with European car manufacturers facing an onslaught of Chinese competition. These short positions, though not cheap, are on the right side of favourable asymmetry in our view. All the short positions were initiated close to par, and we are already seeing movement lower,” says Pennings.

A spectrum of five sub-strategies

Investing across the capital structure, the strategy is split into five proprietary sub-strategies: bend-but-don’t-break; safe carry; catalyst asymmetries; value asymmetries and shorts.

Bend-but-don’t-break

“Credits can often sell off due to specific issues that may be transient in nature. This can happen to companies that are perceived to be in trouble, even though deeper analysis may reveal an underappreciated resilience. Furthermore, they may benefit from an event dynamic, such as an upcoming maturity or asset sale. With a permanent impairment of capital unlikely, price fluctuations can create compelling opportunities in these capital structures. We look to identify securities that offer double-digit returns, despite a high likelihood of successful turnaround,” says Pennings. This category provided some of 2023’s biggest winners, such as Norway’s Odfjell Drilling, which re-financed debt, spun off a parts rental business and announced a dividend for the first time since 2014.

Safe carry

Somewhat related to the category above, safe carry paper differs by focusing on high-coupon bonds that trade close to par. “The company may be past a particularly challenging period but is yet to receive full credit for an emerging cash-generating profile. These ideas tend to be secured bonds with low Loan-to-Value (LTV) ratios, low leverage, and balance sheets that are relatively clean or clearly deleveraging. Some carry bonds have investor-friendly features such as de-risking through amortisation above par. Such investments typically lack a catalyst but provide a steady stream of income to the portfolio at low risk,” says Pennings. Following the aforementioned events, Odfjell migrated from the “bend-don’t-break” to the “safe carry” bucket, offering a double-digit yield to first call.

Catalyst asymmetries

These investments tend to occupy the lower echelons of a company’s capital structure and suffer from a deeper misunderstanding than the more linear credits already described. Consequently, the market often more heavily discounts a stressed or distressed scenario, and institutions typically exhibit a negative bias. Pennings explains: “When investors believe a company will be locked out of capital markets, motivated sellers push down prices to deeply discounted levels. Asymmetric investments offer a positively skewed risk-reward profile, with relatively limited debt-like downside protections combined with equity-like returns in the event of a turnaround or restructuring. Such investments require a contrarian mindset, as well as deeper research into the situation and why it is so misunderstood”. Distressed debt, out-of-the-money convertible bonds, and credit-related equities suffering from an overhang in the capital structure can all fall into this category.

Examples included Just Eat Takeaway, which has Grubhub bonds that have appreciated in anticipation of the New York fee cap on food delivery being lifted, and Delivery Hero, where cost discipline is the main driver behind a rehabilitating credit story in what was a crowded equity short. Both firms became inflated in 2021 by Covid-friendly business models, but later came under heavy selling pressure.

Value asymmetries

Similar to the opportunity described above, deep value investments involve securities with asymmetric potential, but no immediate catalyst for value realisation. They are very cheap options that can be played through credit instruments and occasionally equity. “Given the potential for slower realisation, the upside hurdle for inclusion is very high. These opportunities often arise from market inefficiencies or sector dislocations that obscure fundamental value. As such, they require thorough valuation analysis to build strong conviction and establish a margin of safety. In other cases, they can be pair trades on securities issued by the same borrower, where one of the bonds has an equity component. Investors may have to wait longer for the market to recognise the inherent value of these investments due to the lack of a clear timeline,” says Pennings.

Examples included three UK homebuilders, which had come under selling pressure due to fears that they would struggle against a backdrop of higher rates. However, the businesses have proven to be relatively resilient.

Shorts

Easy access to funding has led to many companies having unsustainable capital structures. “Overburdened by leverage, with flawed business models and inflated valuations, these companies can provide a rich seam of opportunities for shorting. We identify companies that are ill-equipped to navigate financial stress. Catalysts are preferred to lower the impact of negative carry,” Pennings explains. The short positions also tend to mitigate the impact of market downturns on the long portfolio.

Some individual shorts may have refinancing problems, but the short book was a small detractor in 2023 because catalysts are not yet widespread enough, for various reasons. “Though central bank rates may be higher for longer, companies refinanced in 2021 at rock bottom rates. Whilst Germany and the UK slipped into mild technical recessions last year, something longer lasting would likely be needed to result in real corporate distress. Weak covenants are also delaying the reckoning in some cases, and we are seeing some creditor-on-creditor tension, aided and abetted by forum shopping, that lets some creditors opportunistically appropriate collateral and subordinate other investors,” says Pennings.

Truly different

The portfolio’s diversified payout structure framework is a key differentiator versus many other strategies that only invest in one type of credit such as performing, carry or distressed. Further differentiating the strategy is its investment universe, as it concentrates on dislocated, overlooked areas of the market where there is less competition. “This not only means greater inefficiencies to exploit, but also that the portfolio is a genuine diversifier because we invest in securities which are not widely owned,” says Pennings. Finally, the strategy’s relatively small size means it can access areas of the market that are off the beaten track. These investments can have an outsized impact on portfolio returns in a way they cannot for larger managers.

After three strong years, Pennings is confident about a fourth, given these differentiating factors, higher interest rates and reduced fund costs.