Managers predict skill will win out

07 February,2018 - 03:00 pm UTC

Author(s): by Grace Jennings-Edquist
We asked managers to predict the year ahead across a range of credit strategies. Overall, they had a positive outlook.
Direct lending: some sectors are at risk of major correction
"This depends a bit on the jurisdiction. The one we’re closest to is Europe and I think the basic principle there for us is the continuation of this bank disintermediation idea, which has been around now for the best part of 10 years since the crisis. 

So banks are still looking at capital adequacy and shrinking balance sheets, and they’re thinking about Basel III and IV. The era of regulation is nowhere near past. You’re going to get more of it. If you have the right manager, then you could be looking at high single digits.”

Paul Berriman, global head of funds, Willis Towers Watson

"The significant flow of capital towards direct lending mandates has created a time-bomb.

Companies that would otherwise have been forced to restructure have been able to obtain financing from non-traditional sources. Too many zombie companies are tapping this market for liquidity. Non-bank direct lenders believe that they can step into situations where banks and other traditional sources of financing are unable or afraid to go, but the reality is that there is an over-abundance of capital out there thirsty for yield and trying to put money to work.

Over the past few years, many entrants into direct lending believe that the absence of volatility (no mark to market) means lower risk. Clearly that’s dangerous. With few or no covenants, increasing leverage ratios and an outlook for rising rates, certain industry sectors face the risk of a major correction."

Michael Barnes, co-chief investment officer and managing partner, Tricadia Capital Management

CLOs: value lies in wings of capital structure
"Within the CLO structure itself, we predict steepening, with triple A/double A spreads expected to be resilient and even to tighten. On the other hand, we are concerned about “the middle”, ie debt tranches rated A and lower.

However, we like the other end of the capital structure, the equity tranches, for several reasons:

their embedded optionality, with triple A notes likely to refinance at lower rates that would benefit the equity loan spreads are expected to widen (although less than high yield bonds and CDS), so better arbitrage opportunities should emerge
CLO structures themselves, which increasingly favour the equity."

Renaud Champion, head of credit strategies, La Française Investment Solutions

"We think sector selection will continue to be a key differentiator of CLO manager performance in 2018.

We believe that it is important to not only be thoughtful about exposures within sectors which are currently out of favour (such as retail and wireline) or have provided recent volatility (such as commodities), but to also think prospectively about potential headwinds facing certain industry sectors.

Despite current economic strength, we are increasingly focusing our attention on issuer and sector cyclicality as we get into the later stages of the cycle... We are concerned that reduced access to liquidity could significantly increase the likelihood of restructurings for cyclical businesses with weak free cash flow in a downturn. This furthers our sensitivity to investing in cyclical issuers at par at this point in the cycle.”

Jim Wiant, head of structured credit and portfolio manager for MidOcean’s CLO strategy

Corporate long/short: latter stages of cycle will create short opportunities
"It is mind-bogglingly difficult to do it well. Corporate long/short is one area where there will be massive dispersion between the good, the bad and the ugly. Managers that do well are going to make you high single digits, because as we approach the latter phases of the current cycle there will be more opportunities to make money from a short book than there have been for years, we believe. So that’s the case for getting enthused about it.

The best managers could do seven or eight, which is a great return in this environment. But I think there are lots and lots of managers who could disappoint too."

Paul Berriman, global head of funds, Willis Towers Watson

"While in recent years credit investors have benefited significantly from market beta to drive returns, 2018 may be better for long/short alpha credit or fixed income approaches.

At the end of 2017, credit spreads have reached some of their tightest valuations since the global financial crisis. Over the coming year sector and stock selection will be critical to driving future performance and that requires a well-resourced and rigorous bottom-up credit analysis capability.

Credit spreads are closer to fair value, but we expect credit market dispersion to increase, particularly in the high yield market where earnings may be more volatile and leverage is higher. Market dispersion will also be driven by a strong corporate appetite for M&A activity, which tends to impact only specific companies and sectors, increasing the importance of stock and sector selection.

Although increased M&A is a global theme, it is particularly relevant in the US following the passage of the administration’s tax reform plan, as a number of companies will repatriate assets held offshore and may look to M&A as a route to improve shareholder returns.

With spreads increasingly driven by company fundamentals and the possibility of adverse reactions to M&A activity, a long/short approach can appropriately hedge or even take advantage of negative market reactions, as well as offer opportunities to add value given the increased divergence of credit returns."

Andy Burgess, fixed income investment specialist at Insight Investment

"We see opportunities here as markets start to dislocate. This will lead to higher levels of dispersion, creating more long/short opportunities."

Renaud Champion, head of credit strategies, La Française Investment Solutions

"Outside of the retail, telecoms and healthcare sectors, correlation among performing corporate credit continues to be high and with low dispersion, which will likely lead to another challenging year for long/short corporate credit strategies.
However, peak valuations may provide opportunities for select short positions at attractive levels, particularly in sectors of possible idiosyncratic events, such as retail, TMT and healthcare.

On the long side, yield-chasing will generally continue to keep spreads tight.

So with good fundamental credit research and a disciplined, active portfolio management, it may still be possible to create attractive returns in this sector."

Michael Barnes, co-CIO and managing partner, Tricadia Capital Management

High yield (US and Europe): tourist money may leave Europe
"We do not favour either European or US high yield, with normalisation beginning. Spreads are very tight and high yield investors are hardly compensated for the associated risk.

Also, for European high yield in particular, the European Central Bank (ECB) has been a major buyer of investment grade bonds for about a year and a half and it is expected to decrease purchases in 2018. Consequently, investment grade bond spreads are expected to widen.

In turn, institutional so-called “tourist money”, which flocked into high yield thanks to the ECB’s crowding out of the investment grade market, is expected to flow back into investment grade. In the US, idiosyncratic risks are worrying, especially for the energy and retail sectors.”

Renaud Champion, head of credit strategies, La Française Investment Solutions

"We do not expect to see US high yield default rates change materially in 2018. Tax and regulatory reform, and the expected continuation of corporate earnings growth, will likely lead to a stronger economy and spreads will likely grind tighter throughout the year. We are not that concerned with rates as a risk in the near-term, as pensions and insurance companies may become better funded (both assets and liabilities) and may look to reallocate more to fixed income investments."

Michael Barnes, co-chief investment officer and managing partner, Tricadia Capital Management

"Given our cautious view on high yield valuations overall, we think now is an interesting time to evaluate the short sale of US high yield as a hedging strategy.

We believe our research team is uncovering situations where low-yielding credits have high loan-to-values, thin free-cash-flow margins, and are facing potential headwinds for industry or company-specific reasons.

While there are index products available to implement this hedge, we believe that industry and credit performance will diverge as the business cycle nears an inflection point, and a US high yield short strategy is better implemented through a bottom-up driven credit-picking strategy rather than through index products.

Under our base case, a bottom-up driven US high yield short strategy will only produce a de minimis drag in 2018, while producing outsized benefits in the event the cycle or high yield credit valuations turn sooner than we anticipate."

Tom Hauser, senior managing director and senior portfolio manager, Guggenheim

"We expect European interest rates to increase at a slow pace in 2018, but they may move significantly higher sometime in 2019. Reports also indicate that discussions on raising the deposit rate from -0.4% are finally beginning.
Despite the significant overall tightening in yields and credit spreads, we believe the high yield sector still looks relatively attractive from an income perspective – even in a gradual rising-rate environment. The ECB announced that it would reduce its monthly asset purchases from €60 billion to €30 billion per month for nine months from January 2018. There was no commitment to setting an end date; however, calls from ECB members for the purchases to end this year are also increasing.

We expect the reduction in ECB support to impact investment grade investors, which were squeezed out of the market due to the low level of yields. These investors entered the European high yield market instead in search of more attractive yields.

As ECB support gradually fades this year, investors may switch back into the European investment grade credit from high yield, or invest less this year compared to 2017 in the European high yield market."

Ulrich Gerhard, senior portfolio manager, Insight Investment

"We have a relative preference for the US over Europe. European high yield returns less than 3%, which is just weird by any sort of historical measure. So what we’re saying is, you’ve got to presume more defaults for 2018, which makes it less interesting.

US high yield return is at 5.5% today. You’ve got to take something off for default risk, and maybe you take, let’s say, 1%, maybe 1.5%. That leaves you with 4%-4.5%. But in Europe, even if you just take 50 basis points off for default, the result on that is just over 2% – so the return on that is not that exciting for us anymore."

Paul Berriman, global head of funds, Willis Towers Watson

Distressed credit: disruption will drive opportunities
"Tricadia anticipates that opportunities in distressed corporate debt should continue to rise over the coming few years. Retail, telecoms and healthcare are clearly areas of increased stress as “old world vs new” changes in technology, consumer preference and regulation create disruption.

There is still significant available capital to focus on a limited amount of distressed situations and very limited opportunities to be short.

We see many investors currently holding distressed debt for the yield it offers, but who have little to no experience in restructurings and work-outs; this could give rise to forced selling opportunities.

For 2018, Tricadia will also be on the lookout for more idiosyncratic market situations, as over-leveraged companies come under stress from rising rates as well as the limitation of interest deductibility in the recently approved tax bill.
For the near-term, we do not anticipate major broad-based sector sell-offs, such as that seen in 2015/16 driven by energy, but longer-term we would anticipate lower-rated, highly levered corporate debt to come under pressure."

Michael Barnes, co-chief investment officer and managing partner, Tricadia Capital Management

"Distressed credit has been looming as a strategy of interest for investors for some time. However, the business cycle has lasted longer than most forecasters anticipated and the low default rate environment means that the distressed opportunity set remains thin.

With the shakeout in the energy credit sector in 2016/17 now mostly behind us, many of the credits that remain distressed today have been impacted by a disruptive element in their industry, not least the widely publicised “Amazon effect” in retail, grocery and other sectors. Evaluating the impact of this disruption, and whether it will be transient or permanent, is difficult and we caution that the typical failure rate (ie defaults that result in liquidation) in retail is much higher than many other industries.

With that said, we do think that distressed opportunities exist in all market cycles for investors who have the resources and expertise to understand medium-to-long-term business and industry drivers.

Looking ahead, while the opportunity set is not yet ripe today, we nonetheless believe investors would be prudent to evaluate an allocation to a dedicated distressed strategy."

Tom Hauser, senior managing director and senior portfolio manager, Guggenheim

Structured products: RMBS will benefit from millennials’ moves

"Mortgage-related investments will continue to perform well in 2018. Residential housing will benefit from the continued formation of households among millennials, which will continue to drive single-family rental and new-purchase housing demand.

Commercial real estate, on the other hand, will continue to experience secular challenges in retail-related properties and suburban office space. Hence, we are bullish on RMBS but selective on CMBS.
CLOs will continue to perform well, given the expectation of low corporate defaults. However, rising rates and changes in tax law could impact highly leveraged businesses and have long-term effects."

Renaud Champion, head of credit strategies, La Française Investment Solutions

"In the securitised world, there are so many types of structure. I think, generically, the focus should be on finding the right manager that’s an expert in the right strategy; I think that’s where you might be looking at double-digit returns."

Paul Berriman, global head of funds, Willis Towers Watson