Don't miss a golden age for relative value credit bets

Tue Nov 13, 2012

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Let the world's deleveraging work in your favor.


Joseph Marren

By Joseph Marren

During the next decade investors in credit-related arbitrage and relative value hedge funds are likely to experience risk-adjusted returns that are significantly above historic norms. This compares with highly risky market conditions for long-only credit managers and a mixed outlook for equity investors.

Generally, credit-related arbitrage and relative value hedge fund managers need two market conditions to be able to generate attractive returns: volatility in the credit markets and credit spreads that are above average levels. It is highly probable that both of these conditions will exist in the next decade thereby ushering in a golden age of investing in these strategies.

Every day investors are bombarded with news of the risks that they face. Most lists include at least several of the following: Middle East tension, the European sovereign debt crisis and likely breakup, the trillion dollar deficit in the U.S., states under severe fiscal pressures, a stubbornly high unemployment rate, central banks interfering with markets, the fiscal cliff, the debt ceiling crisis, riots in Greece, Spain and elsewhere protesting austerity measures, the slowdown of Chinas growth, the prospect of inflation, the aging of the population in developed nations and the enormous social insurance promises that cannot possibly be kept.

The one constant underlying many of these concerns is leverage. Most developed nations are significantly overleveraged and their peoples are dependent on deficit spending to support unsustainable lifestyles. A corollary to the reported deficit spending is rampant under-reporting of the true cost of their social programs. For instance, in all of the news coverage of the PIIGS debt crisis have you ever seen a discussion about meaningful cutbacks in their social welfare programs? The real economic deficits and balance sheets are far worse than reported figures. In addition, leverage levels at their regional and municipal governments are also very high. One of the predictable outcomes is that the electorate will not react well to needed austerity measures. The demonstrations in Spain and Greece confirm this notion. This ensures constant political turmoil as the electorate opts for new leadership pushing less austerity and more growth. Within the next decade this political upheaval will clearly impact the credit markets, both in terms of volatility and credit spreads.

At the moment, most investment committees are sitting tight with their fixed income allocations as returns have been terrific. Some realize that the game is up for long-only credit managers as it is difficult to envision a future where interest rates decline meaningfully. The remaining hope is that there is one more positive pay off associated with the flight to safety due to the Euros collapse. It should also be noted that some are reaching for yield to maintain performance. It is exactly the wrong part of the cycle to be initiating positions in lower quality debt.

Fund managers, investment committees and their consultants have begun to move funds out of their long-only credit portfolios into credit-related arbitrage and relative value managers. Why? Because they understand that this change significantly improves their portfolios risk/return profile. Furthermore, the move is easily explained to committee members that have historically supported a significant allocation to long-only fixed income. It can be characterized as investing in the same credit space only substituting managers that can and will invest long or short depending on market conditions.

The actions already taken by central banks around the world have had and will continue to have a profound impact on the markets. Generally, all credit asset prices have been inflated in 2012. However, there will be a day of reckoning. It is not hard to envision a time in the not-too-distant-future when excellent corporate credits will trade at lower yields than Treasuries. In recent months heavy and concerted interventions by central banks has calmed volatility levels in the equity and fixed income markets. At what cost? The central banks have inflated their balance sheets to buy increasingly less secure securities. The only impact that this has had on a long term basis for each nation is to increase its consolidated debt level. The idea of solving a nations debt crisis or stimulating its slow growth economy by having its overleveraged balance sheet stretched further by central bank purchases defies logic. These actions have only bought a small increment of time.

In the coming decade higher volatility and larger than historic credit spreads are also warranted by the likely disregard that governments will exhibit for the rule of law. There will be numerous circumstances when the rule of law will be ignored and debt holders will be forced to bear more than their share of pain. Recent examples include the experiences of lenders with the automotive industry and with Greek bonds and CDS.

Another favorable factor is that proprietary trading desks have been eliminated at most large banks. The vast sums allocated by these prop desks have come out of the market, which has positively impacted spreads. A final favorable factor is the overall demand for high quality fixed income. Population aging has driven increased demand for fixed income. However, the risks inherent in the fixed income markets and the dearth of high quality investment options will cause many of these investors to search for better credit-related alternatives.

The market trend of allocations increasing in alternative managers is clear. Alternative mutual fund and alternative ETF assets have soared. Despite the surge in assets into these vehicles, the best risk-adjusted returns are likely to be generated in the hedge fund universe. For institutional investors this will mean building up their portfolio of direct investments or adding a fund-of-hedge-fund that specializes in credit-related arbitrage and relative value managers.

All of the above augurs well for credit-related arbitrage and relative value investors as these strategies are particularly well-suited to the expected difficult economic, political and market conditions. It is reasonable to conclude that the golden age of arbitrage and relative value investing is upon us and above average risk-adjusted returns are foreseeable and achievable.

Joseph Marren is the president and chief executive officer of KStone Partners, which manages absolute return funds of hedge funds for institutions and high-net-worth investors.