Credit – a strategy for all seasons

Thoughtful institutional investors, regardless of their investment philosophy, will generally have (or should have) a medium term macro-economic view. This view might involve an opinion on whether we are heading for deflation or inflation in the medium term or, frequently, no opinion at all, but rather a “wait-and-see” approach. However, no matter what the approach, it is important for institutions to be able to assess their portfolio within this contextual view and predict how it will perform under alternative scenarios.

Among our institutional clients, we have seen a notable uptick of interest in the credit area. Initially, this has been manifested through the inclusion of longer duration investment-grade instruments added during the window when spreads on these instruments were boosted by the general financial malaise. As equities tumbled and deflationary fears took hold, this seemed like a prudent low-risk place to hide. We have also seen a retrenchment to short-term government credits as the only safe haven (albeit a low yielding one) amid the same malaise. Finally, we are seeing some window shopping in the distressed credit area as credit is touted as the new equity opportunity and spreads on first-lien paper widen to historic levels.

So how will all three of these exposure areas react in the different scenarios?

There is little doubt that the current climate has short-term deflationary forces, and fixed income traditionally has acted as a deflation hedge within a portfolio. If deflation proves to be more of a medium-term phenomenon, the discount-boosted high coupons on investment-grade debt should make for robust returns, to the extent that they are not swamped by spread widening, reflecting real or feared credit quality deterioration. Thus, credit selection is critical, even among high-quality investment-grade issuers. For investment-grade credits, deflation over the medium term might reduce turnover, margins and asset values, thereby eroding debt service coverage ratios and raising leverage, leading to negative rating agency and market responses. Of course, subinvestment-grade issuers will suffer worse in an economic contraction, and many are breaching loan covenants, while the number of payment defaults and companies entering administration or bankruptcy is projected to accelerate.

A confluence of factors — namely financial distress among highly leveraged issuers and distressed holders of leveraged loans (CLOs, SIVs and highly leveraged hedge funds) and rapid deleveraging by prime brokers — exacerbated the problems of credit deterioration and virulent global recession on the credit sector. The extraordinary spread widening, particularly for leveraged loans, illustrates the exposure of credit investors to economic fundamentals (recession) and market technicals (forced selling, rapid deleveraging of investment vehicles) simultaneously.

As the extreme selling pressure abates, investors in credit are left with the underlying fundamental exposures they originally signed on for: The early data points on bankruptcies and voluntary reorganizations point to far lower recovery rates on “secured” loans vs. previous recessions. Unsecured creditors generally get even less in bankruptcy or reorganization. Broadly speaking, deflation lowers resale or salvage value for assets (particularly commodity assets or operations) and thus undermines recovery values.

At the other end of the quality spectrum, government bonds might be viewed as a hedge for deflation, particularly medium to longer term bonds. In a prolonged deflationary environment à la Japan, real interest rates will widen as deflation sets in. Even if credit risk is minimal (though no longer zero), longer duration bonds expose investors to significant price risk if inflation returns or governments must raise yields to finance budget deficits. At current “flight-to-quality” levels, they also provide little return, so are hardly a medium-term solution under any scenario.

Not so long ago markets were grappling with rising inflation (primarily driven by wage pressures and steep commodities price increases). Doomsayers raised fears of a return to 1970s-style stagflation. As the demand pull imploded and commodities gapped downward, these fears have abated, but most market participants, including Clontarf Capital, are of the view that the fundamental drivers of commodity price rises (emerging markets growth and finite resources) have not changed over the longer term. Furthermore, governmental intervention in the form of record low interest rates, quantitative easing and stimulus packages are likely to create renewed inflationary forces in the medium term.

While inflation will ease the debt burden for operating companies, it will erode the real return of fixed-rate fixed-income instruments, even those with historically wide spreads in the current market. Traditionally pension funds have used instruments such as Treasury inflation-protected securities or inflation overlays to protect against inflation in their portfolios, but currently TIPs represent poor risk/reward while inflation overlays have been expensive — so expensive in fact that many funds have declined to use them, waiting for a more opportune entry point.

For traditional fixed-income instruments, longer duration exposures are obviously more exposed to inflationary risks while shorter durations reprice more frequently. However, for certain credits trading at stressed or distressed prices, inflation might benefit the investor. The basic idea is that inflation can bail out asset-secured debt (mortgage debt and in many cases leveraged loans) because it can increase the nominal value of the underlying collateral vs. the nominal value of debt. Of course, some companies whose input costs are highly sensitive to inflation (e.g. chemicals, plastics or fertilizers companies) might have margins squeezed even more and might go out of business. Overall re-inflating asset prices should help bail out many overleveraged borrowers, thus increasing the probability that the debt gets paid off. The strategy of buying discounted debt today and betting that inflation will increase the pay-off/exit price strikes us as a natural inflation hedge.

Whatever scenario is contemplated, it is critical that fixed-income portfolios are diversified by duration, instrument, geography, issuer type, industry, sector and currency. This is acutely important during times of market stress, when correlations can become distorted and an entire asset class can become tainted by irrational selling (for example, leveraged loans during the fourth quarter of 2008). It is also important that each individual area within fixed income is itself diversified, and within the stressed and distressed credit area it is possible to build a portfolio that evolves with the opportunity set — taking advantage of the many bites of the apple that are likely to present themselves sequentially.

For example investing today in performing stressed credits, as well as specific cash-pay instruments such as U.S. agency-backed residential mortgage POs (principal-only) will provide a current yield that is attractive in the current environment and should perform well in a deflationary scenario characterized by low interest rates. If the environment remains deflationary some defaults will ensue, but the low interest rates should motivate some borrowers to refinance, thus accelerating discount accretion on the POs. If the environment turns inflationary, the price appreciation based on stronger prospects should boost returns on many leveraged loans. Looking further out, over the course of 2010, we expect to find pockets of inflation hedging protection in credits tied to commercial real estate assets, as those assets fall into the hands of secured creditors.

So we believe that adding a “stressed/distressed” component to a core fixed income portfolio serves a valuable role in making that portfolio “all-weather” given the current uncertainty regarding the course of the coming few years.

The inflation hedge component in a credit portfolio is based on fundamental properties rather than an explicit hedge to a specified liability stream, which tends to be prohibitively expensive if obtained through derivative overlays or other immunization strategies. It also does not come at the expense of current yield, unlike TIPS. The only “price” implicit in using the distressed component of a fixed-income portfolio to combat inflation is time horizon, the effort required in careful manager selection and potential mark-to-market volatility, particularly if the secondary markets seize up again for technical reasons or general risk aversion.

The stressed/distressed opportunity is a medium to long term one. Institutional investors who see it as such and choose very carefully the stewards to guide them should reap multiyear rewards that are well worth the wait.

Aoifinn Devitt is principal; Elizabeth Carey, director; and Richard Lewy, adviser, at Clontarf Capital, London.