By Hamlin Lovell, NordicInvestor
Muzinich is one firm who believes that High yield corporate credit continues to offer attractive yield relative to deposits, government bonds and investment grade. “The yield on European HY, of c. 3%, understates return potential as additional gains could be made from roll-down and credit selection”, says Muzinich portfolio manager Hugo Squire, who sits in the London office.
However, this yield is not far from historical lows, leading some to believe that valuations are stretched. This analysis somewhat overlooks the improving quality of the market: “Ten years ago, the European market was roughly 50% single B rated and 50% double B rated. Now it is 72% double B and 28% single B. Purely based on those ratings, you would expect spreads to be lower than their historic average”, Squire points out. “Fundamentals are also in a good place with leverage not showing signs of rising and interest coverage ratios close to the highs. Companies have also generally termed out their debt, so there’s no near-term maturity wall” Brian Lieberman, portfolio manager based in NYC, adds.
But whilst HY remains attractive on a long-only basis, the recent spread compression and flows into the asset class have also created mis-pricings and opportunities for Long/Short strategies. Muzinich believes that strategies with access to an extensive toolbox of trade types may improve risk-adjusted returns, often reducing volatility and drawdowns.
This opportunity set is evident in rising dispersion seen in both US and European credit markets. High dispersion allows managers with stock picking expertise and flexible strategies to seek to generate profits on both sides of the book through a combination of arbitrage trades, outright longs and shorts. Cash versus CDS basis trades may also generate additional carry, although Muzinich remains mindful that the basis can blow out in stressed conditions and so enters these trades sparingly.
“A flexible strategy also allows us to set sensible hedges to protect the portfolio against a broad repricing of risk” remarks Lieberman. For example, one can reduce sensitivity to widening spreads through use of out-of-the-money put options, partially financed using non-directional arbitrage trades. “Credit volatility is comparably low at the moment, in part due to ECB intervention in credit markets and a more dovish fed, so it is a good moment to look at buying option structures that can protect the portfolio”, says Squire.
In the US, Lieberman is also using the short book to hedge tail risks with a variety of instruments, including equity options, which can also be used to hedge both general downside and binary events. “There is no silver bullet to hedge high yield. Hedges need to look at different facets of the asset class. A basket of hedges used includes single name CDS; index total return swaps; equity or credit puts; and Treasuries” he says.
Net exposure in both strategies can also be dynamically adjusted to help preserve capital. For instance, in May, the US strategy was market neutral to slightly net short on a beta-adjusted basis over the course of the month. Tail risk hedges also helped in May, and both managers were swift to monetize them.
A Different Approach between Europe and the US
The US strategy is an actively managed, absolute return, long/short strategy, with a wide range of market sensitivity that can go flat or net short at times. In Europe the strategy has a structural long-bias and is more focused on capturing the full upside of the market over the cycle whilst limiting drawdowns.
The US strategy has delivered much lower volatility and drawdowns than the high yield market, whilst the European strategy tends to have a similar volatility to the market in normal times and a lower volatility in times of stress. “The expected beta is between 0.4 and 1.1. The European strategy typically has 60-70% overlap with our long-only European strategies”, says Squire. Both strategies in fact draw heavily on the expertise of the long-only teams at the firm, Lieberman confirms.
Global synergies within the firm
Ideas are shared between and within teams in the US and UK and indeed the emerging markets teams. The firm has a global perspective on macro and research coverage, with asset allocation meetings taking place monthly, and PM videoconferences twice a week. Average analyst experience at Muzinich is 17 years, so most of the team have lived through at least three credit bear markets: 2016 in the US, the 2011 sovereign crisis in Europe and of course the global financial crisis in 2008.
The US strategy has over the past 18 months leveraged the expertise of the European team to bring non-US exposure from zero to around 20%. This can mean buying European credit or US credits denominated in Euros. Likewise, the European strategy keeps at least 70% in European investments but can seek to exploit opportunities in other regions. Both strategies have recently benefited from longs in Turkish banks and arbitrage trades in emerging markets CDS for instance.
The firm’s expertise in bank credit means that both strategies can invest in contingent convertibles (CoCos), with a particular emphasis on this in the European strategy. “That bucket has been as high as 11-12% and now stands around 3-4%” remarks Squire.
Having an established levered-loans team provides yet another lever for the strategies to pull. “We can allocate tactically into loans when it makes sense versus bonds. Right now, it seems like that’s a sensible trade for Europe, and potentially a short-term opportunity in the US where we can selectively trade up in the capital structure at similar yields to unsecured bonds. However, we need to be cognizant of potential US Federal Open Market Committee rate moves on the horizon that might impact the trade”, Lieberman adds.
This ability to dip into compelling trades in different geographies and areas of credit, along with having the full suite of investment tools at their disposal, ultimately allows the two managers to find and seek to exploit other sources of return away from pure market beta and carry.