Market conditions today seem particularly ripe for investors to consider this strategy, Lofgren said. “Long short credit strategies are designed to perform in all environments, but we believe it especially helps to offer maximum utility in the current environment. Less room for further spread compression against a backdrop of potentially higher interest rates increases the likelihood of negative total returns from traditional credit strategies. Furthermore, we believe the credit market is ripe with security-level catalysts that can be uncovered through solid security selection, and the ongoing broad market compression has driven many credits to valuations that we believe are not commensurate with their fundamentals, which can be expressed through relative value trades. We believe the robust toolbox that long short credit strategies provide makes them potentially attractive for this environment,” Lofgren said.
MIM believes long short credit strategies should embrace four key tenets.
First, Lofgren said, the strategy should focus on deep credit research capabilities and an experienced trading desk to develop the best total return ideas that run the gamut from investment grade to high yield to emerging market debt.
Second, strategies should have minimal interest rate sensitivity, and the portfolio construction process should identify idiosyncratic trade ideas that are inherently low duration rather than simply implementing a rate hedge overlay on a typical credit portfolio, he said.
Third, long short credit strategies should have a low correlation to broad fixed-income indices, such as the Bloomberg Barclays Aggregate Bond Index and “a muted correlation and a very low beta to more credit-heavy indexes. We think that allows long short credit the opportunity to be an attractive diversifier and volatility dampener within a broader asset allocation,” noted Lofgren.
Lastly, a long short strategy should prioritize the mitigation of downside risk through a rigorous risk management framework that employs highly effective tools such as stop-losses on all risk positions. “The goal should be to protect the portfolio during sell-offs while still being able to participate in the upside of rising markets.”
Appropriate for multiple investors
Lofgren stressed that long short credit can potentially benefit a wide variety of institutional investors beyond the family offices, endowments and foundations that primarily have been absolute-return investors. “Long short credit may be a compelling alternative to traditional bond strategies as well as an attractive complement to traditional strategies that can help reduce overall portfolio volatility. It may not be the first strategy that investors think of when they think about diversifying their fixed-income exposure, but we believe long short credit could definitely play a role in more innovative portfolio solutions across a very wide investor base.”
Among those investors: plan sponsors who are derisking. One of the challenges for a plan sponsor is trying to minimize surplus volatility. “Therefore, allocating to long short credit can help reduce drawdown risks while still providing the potential for attractive risk-adjusted returns,” Lofgren said. “Or if plan sponsors still need the duration but don’t want to take spread risk, particularly with credit spreads at current levels, they can pair long short credit with a futures overlay to synthetically create a longer-duration asset that has the potential to generate alpha in multiple environments.”
A long short credit strategy’s emphasis on liquidity should also be a main focus for institutional investors, Lofgren said. “There have been times in the past where credit managers have been caught with illiquid credit exposure at the wrong time,” he said. “When capital preservation is a primary goal of the strategy, you want to be in a position where you can quickly adjust your net risk positioning, either to take advantage of opportunities or to protect the portfolio during sell-offs. Liquidity in the market today is pretty reasonable, but liquidity is fleeting. What’s liquid now may not be liquid during a risk-off environment. You don’t want to be in the position where you identify a good security selection idea, get the performance that you’re looking for, and then you can’t monetize it.”
A strict risk discipline
A strict adherence to stop-losses is critical to reducing volatility. “Our risk discipline is such that we set stop-losses on every position that we put on,” Lofgren pointed out. Liquidity is a consideration here as well. “If we get in a situation where we’re in a risk-off environment and liquidity gets poor, we want to be sure that we can take action on those stop-losses. We don’t want to go back to an investor and say, ‘We picked great securities, but we’re not sure how to get out of them.’ ”