Opportunities in Complex Credit

Transcription

1 Opportunities in Complex Credit Lindsay Holtz, CFA Managing Director Diversified Global Asset Management Corporation Toronto A Traditional liquid credit spreads seem to be priced fairly at best, but with more downside than upside depending on investors expectations about the economy. In this environment, complex credit opportunities, such as credit relative value, loan pools, mortgage derivatives, credit sensitive asset-backed securities, and private lending, offer attractive risk-adjusted returns. This presentation comes from the Global Fixed-Income Management conference held in Toronto on June 211 in partnership with the Toronto CFA Society. number of themes support the opportunities in complex credit, ranging from investor preferences to regulatory constraints. Complex credit is sometimes referred to as nontraditional credit or even alternative credit. The term used is less important than the actual characteristics of the asset class. Complex credit instruments are assets that are complex in a particular characteristic, such as structure, transparency, due diligence requirements, monitoring requirements, valuation, tax, or illiquidity. Examples of complex credit strategies include credit relative value, loan pools, mortgage derivatives, credit sensitive asset-backed securities (ABS), and private lending. Over time, some of these opportunities will probably play out and new opportunities will become available. Institutional investors continue to focus on more liquid and less complex assets. This preference exists for a few reasons. First, economic uncertainty has reinforced investors desires to keep investments simple and liquid. Second, many investors moved to more liquid assets during and following the global financial crisis and are reluctant to adjust that positioning. Third, many investors already own a fair amount of legacy complex or illiquid instruments. For instance, in speaking with others about complex credit opportunities, one institution recently indicated to us that about 45 percent of its investments are already invested in illiquid assets, such as private equity, infrastructure, and real estate; therefore, its ability to take on more illiquidity is quite limited. In other cases, investors are still tied into illiquid assets purchased prior to the crisis and do not have much capacity or appetite to add more illiquidity to their portfolios. Investors who do have an interest in complex credit, given that volatility and dispersion continue to be high, have a number of options available that involve more complex and active trading rather than focusing on long-only credit strategies. The opportunity in credit has moved from a systematic approach to capture the beta of an oversold market to an idiosyncratic environment to capture an array of micro-market inefficiencies. Simply put, the opportunity is no longer like that of the second quarter of 29, when investors could buy any credit and the worse the quality, the better it did. Diligent analysis and structuring of prospective credit investments have become paramount. Imbalances between the supply and demand of capital continue to be an issue. These imbalances are driven by investor preferences and reduced demand from a large set of other investors, including bank proprietary desks, specialty finance companies, collateralized debt obligation vehicles, and business development companies. Before the crisis, these investors were big buyers of complexity and illiquidity, but today they either no longer exist or have cut their exposure. Further reducing demand is the fact that market participants recognize that these complex credit assets have high barriers to entry. Sophisticated infrastructure is required to invest in and manage them properly. Firms cannot replicate that infrastructure overnight, which limits the speed with which new capital can come into this market. Regulatory constraints are another challenge, ranging from regulatory capital changes as a result of the Basel Accord to rating agency considerations and measures in the U.S. Dodd Frank Wall Street Reform and Consumer Protection Act. Against this backdrop, expected returns are estimated to be in the low to mid-teens for investors that are interested in accepting some illiquidity and complexity risk. These assets should provide a fairly low correlation with equities, hedge funds, and other alternative assets. 38 DECEMBER Diversified Global Asset Management Corporation cfapubs.org

2 Opportunities in Complex Credit Complex Credit in Institutional Portfolios Complex credit opportunities exist in part because there has not been any meaningful allocation to this area by institutional investors, despite recognition of the obvious attractions. Complex credit assets seem to fall in a gray area in the institutional asset management framework, often with no clear owner or champion. For example, the fixed-income mandate in most cases is focused on investment-grade or government bonds. When it does incorporate credit, it is usually only the most liquid credit instruments. One U.S. pension fund I know has moved credit entirely out of its fixed-income bucket, and its return expectations for its fixed-income allocation are a modest 3 percent. Most institutions have a hedge fund allocation mandate, although it too tends to be focused on the more liquid end of the spectrum. Some hedge fund mandates include complex credit assets, but often as an exception and with a small allocation. Complex credit assets do share a number of characteristics with private equity mandates, but institutions generally focus on equity or, in some cases, distressed corporate credit. In addition, investors in private equity prefer to operate with control and are typically targeting returns of 2 percent or more. Complex credit assets have diversification characteristics and may represent a quality riskadjusted return, but they do not meet the return threshold for private equity in most institutions. Some institutions have a special investment bucket for opportunistic situations, although it tends to be a fairly small allocation. One typical example is a group I recently spoke with that indicated it has about a $1 million allocation to opportunistic strategies, but that category covers a large variety of categories of assets. The most that it would allocate to complex credit might be in the $2 million to $3 million range, which is not meaningful given the size of this opportunity set and the institution s balance sheet. Complex credit is compelling when assessed against current expected returns for other asset classes: Cash is earning next to nothing, government bonds and investment-grade bonds are in the 3 percent range, leveraged loans are in the 4 percent range, high yield is in the 6 percent range, and equities may achieve mid- to high-single-digit percent returns. At the same time, the typical actuarial return assumption for many pension plans is in the 7 8 percent range, which begs the question, How will investors meet their liabilities with the current asset mix? Market Environment The market environment is supportive of a persistent opportunity in complex credit. The economy continues to face headwinds. This issue is important because of investor preferences. In the midst of this uncertainty, investors tend to stick with assets they know well and that are easy to understand and liquid. De-leveraging for consumers, companies, and governments is expected to continue for some time. This process affects both supply and demand in complex credit markets. On the supply side, there are too many assets for sale. On the basis of data released by Goldman Sachs and Morgan Stanley earlier in 211, U.S. banks have announced asset disposal programs in the $8 billion range and European banks have announced programs that add another $1.4 trillion. Recently, the Federal Reserve started to sell its Maiden Lane portfolio of residential mortgage-backed securities (RMBS). This portfolio is a $4 billion face value portfolio that was acquired for $2 billion from AIG (American International Group). AIG did offer to repurchase the portfolio for $16 billion, but the Fed decided to do its own auctions. In the most recent auction, about 5 percent of what was offered actually cleared at prices at which the Fed was willing to transact. For the most part, a large price gap still exists between buyers and sellers of these types of assets. On the demand side for complex credit, there is less leverage available in the system today and correspondingly less capital available to invest. Fortunately, investors do not need much leverage to take advantage of complex credit. Many market participants that used to be buyers of complex credit either do not exist or are sellers today, such as banks, collateralized debt obligation (CDO) structures, shadow banking entities, and mortgage agencies. Performance Expectations Expected returns of various complex credit strategies and the associated investment horizons are shown in Figure 1. The left side of the chart shows that short-term, liquid credit assets offer uninteresting returns. The right side of the chart shows return expectations for alternative credit assets with investment horizons from one to five years. At the most liquid end of the spectrum, credit relative value is an interesting portfolio opportunity because it is tactical and more liquid than other complex credit assets. It offers investors an opportunity to take advantage of temporary dislocations and provides a more dynamic asset allocation strategy. The far right of the chart captures private lending opportunities, an area cfapubs.org DECEMBER

3 CFA Institute Conference Proceedings Quarterly Figure 1. Expected Return of Various Complex Credit Strategies Expected Default Adjusted Return (%) Year Holding Period High-Yield Bonds Leveraged Loans 1 5 Year Holding Period Credit Relative Valve Mortgage Derivatives Credit- Sensitive ABS Residential Loan Pools Small-Balance Commercial Loan Pools Private Lending where banks are less active, particularly in smalland mid-cap lending. In the following sections, each of the strategies is described in more detail. Credit Relative Value. The credit relative value strategy seeks to take advantage of volatility and dispersion in credit markets by using a relative value approach to portfolio construction. This approach typically results in a position that is not net long credit markets. The thesis is based primarily on taking advantage of trading opportunities. These may include relative value trades that are idiosyncratic in nature, correlation trading, and structured credit trading primarily through CDO tranches and collateralized loan obligation (CLO) equity. As shown in Figure 1, credit relative value is the most liquid of the complex credit strategies. In addition to offering an attractive risk-adjusted return in the percent range, it is also typically spread neutral and duration neutral. In a portfolio context, the liquidity characteristics can provide some flexibility for moving capital in and out of this strategy to take advantage of other opportunities in complex credit that may be more attractive as investors move through the cycle. To be clear, credit relative value is certainly not as liquid as owning long-only corporate credit. This opportunity exists for a number of reasons, including (1) increased volatility in credit markets, which is creating attractive trading opportunities; (2) a supply demand imbalance because the traditional holders of this risk namely, the bank proprietary desks have pulled back; (3) significant barriers to entry because of the infrastructure required to manage the information, risks, and execution of the strategy; and (4) the issue that much of the security pricing occurs through the credit derivatives market, so it is not a straightforward task to source and manage such assets. The favorable environment for credit relative value trades is illustrated in Figure 2. Panel A shows the dramatic reduction in leverage that would be required today to earn a 1 percent yield by trading the spread between the 25th and 75th percentile of the five-year investment-grade credit default swap (CDS) index. Taking a simplistic view, at various points in time, investors would have needed 6 7 times leverage to achieve that return. In reality, this extreme level of leverage was not used (or available) in the years illustrated. What Panel A is meant to illustrate is the path these markets have taken, where they are now, and how much less leverage is required to earn an attractive return today. Similarly, Panel B shows the actual spread between the 25th and 75th percentile of the same index. The spread increased substantially during the crisis but remains wide compared with history, providing attractive trading opportunities. Loan Pools. Loan pool collateral includes whole-loan residential mortgages or even smallbalance commercial mortgages. Small-balance commercial mortgages are assets that typically look like a first lien commercial real estate loan, but they are smaller (on average, less than $1 million of unpaid principal value), fully collateralized by the real estate, and often include a personal guarantee. The strategy involves sourcing, investing in, and servicing a set of performing and nonperforming loans with the intention of actively exiting these loans through a variety of strategies to obtain the highest net present value. Exit strategies range from taking the loan through the foreclosure and real estate owned (REO) process to the negotiation of shorterterm, lower-cost exit alternatives, such as short sales or note sales. They may also include refinancing through government programs or through more traditional refinancing mechanisms. The asset class does present some interest rate sensitivity given the relatively fixed nature of the strategy s expected internal rate of return (IRR). However, with some exceptions, when interest rates rise, there is generally an accompanying recovery in 4 DECEMBER 211 cfapubs.org

4 Opportunities in Complex Credit Figure 2. Leverage and Credit Dispersion of Credit Relative Value Trades, April 24 April 211 Leverage (x) 8 A. Leverage Required for 1 Percent Yield Apr/4 Apr/5 Apr/6 Apr/7 Apr/8 Apr/9 Apr/1 Apr/11 Spread 35 B. Credit Dispersion Apr/4 Apr/5 Apr/6 Apr/7 Apr/8 Apr/9 Apr/1 Apr/11 Source: Based on data from Bloomberg. the property markets. This recovery potential improves the attractiveness of the strategy. Loan pools present an asymmetrical return opportunity. Consider the assumptions that are priced into earning a percent return in loan pools versus the assumptions priced into liquid credit. Current loan pool pricing typically assumes a further 1 15 percent decline in house prices, most loans defaulting and going through the foreclosure process, and extended liquidation time lines. Many teams that we work with do not actually think these draconian market events will transpire, but they are able to acquire loan pools with a mid-teens percent yield using these dire assumptions. These loan pools present a return profile that should provide better downside protection than corporate credit against any setbacks in the economy given that liquid corporate credit instruments appear to be pricing in elements of an economic recovery with limited to no bad news. If there is any economic cfapubs.org DECEMBER

5 CFA Institute Conference Proceedings Quarterly recovery, there is meaningful upside versus these assumptions. Despite this return profile, as with other complex credit strategies, a supply demand imbalance exists. There are simply more assets for sale than there are buyers, and the barriers to entry for participants in this market are quite high. Figure 3 and Figure 4 illustrate one of the reasons why the loan pool market is attractive. Figure 3 shows the massive amount of nonperforming loans on the balance sheets of the four largest U.S. banks. This group totals about $23 billion and does not include the regional banks or structured vehicles Figure 3. Value of Nonperforming Mortgages at Four Major U.S. Banks as of October 21 U.S. Dollars (billions) JPMorgan Chase Bank of America Wells Fargo Citibank Foreclosure Delinquent Source: Based on data from Weiss Ratings. Figure 4. Percent 16 Percent of Small-Balance Commercial Loans More Than 6 Days Delinquent, January 25 March Jan/5 Jan/6 Jan/7 Jan/8 Jan/9 Jan/1 Jan/11 Note: Data include foreclosure and real estate owned properties. Source: Based on data from Intex. 42 DECEMBER 211 cfapubs.org

6 Opportunities in Complex Credit that are also selling these assets. Figure 4 shows how small-balance commercial loan defaults have increased over time. Although the rate of increase has stabilized since early 21, the damage has been done. A delinquency level of around 14 percent in a $5 billion market suggests a supply of about $5 billion to $75 billion. Concurrently, investor demand amounts to only a fraction of that amount at about $2 billion to $3 billion. Mortgage Derivatives. Another strategy to consider in the context of nontraditional credit opportunities is mortgage derivatives. This strategy involves trading and investing in interest-only (IO) or principal-only (PO) strips, which are structures derived from collateralized mortgage obligations backed by residential fixed-rate mortgages in the process of tranching prepayment risk. Typically, the underlying collateral is Agency mortgages or the highest-quality non-agency mortgages. Credit risk should be low because structurally, the IO tranche tends to be near the top of the cash flow hierarchy and the underlying collateral is among the betterquality collateral in the U.S. mortgage market. The key risk that investors are paid for in this strategy is prepayment risk. This market has performed well over the last months; it is up more than 12 percent year-todate as of June 211. At current option-adjusted spreads, which do depend on the embedded prepayment assumptions, net returns for the next 12 months should be in the low to mid-teens, and with some spread tightening, expected returns could reach the upper teens or low 2 percent. These returns assume that the interest rate exposure has been hedged. Many hedge funds do not hedge interest rate risk in this strategy because they are using the IO trade as a way to hedge against inflation; the reason is that IO securities benefit from lower prepayments in a rising rate environment. For a portfolio of complex credit assets, the idea is not to make an interest rate bet but to capture the return premium resulting from mispricing the prepayment profile and the complexity of these instruments. This opportunity is expected to persist for some time because the prepayment environment is unlikely to change in the short run. A Deutsche Bank research report from March 211 stated a number of reasons why the low prepayment environment is expected to continue, including (1) the high cost of refinancing, such as the cost of mortgage insurance and origination fees; (2) continued low house prices, which means continued negative equity; and (3) tighter underwriting standards, which mean that only the highest-quality credit borrowers can refinance, and many of those have already done so. There is very little evidence that suggests prepayments are going to spike at any time in the near term. Figure 5 illustrates the gap in the current environment between mortgages that would be assumed to refinance (those that are in the money) and mortgages that actually are refinancing. Figure 5. In-the-Money vs. Prepaid Mortgages, January 22 March 211 In the Money (%) Conditional Prepayment Rate (%) Jan/2 Jan/3 Jan/4 Jan/5 Jan/6 Jan/7 Jan/8 Jan/9 Jan/1 Jan/11 Agency 3-Year Fixed Fraction in the Money (left scale) (>=5 bps rate incentive) 3-Year Prepayments (right scale) Sources: Based on data from Bloomberg, Intex, Loan Performance, and Ellington. cfapubs.org DECEMBER

7 CFA Institute Conference Proceedings Quarterly Similar to the other strategies, an imbalance in the supply and demand of capital also exists in this market. Agencies were formerly one of the largest buyers of these assets, and they are not adding to their balance sheets. Bank proprietary desks are also no longer buyers. Today, it is a small group of specialist investors that are buying these assets, and that situation is not expected to change any time soon. Credit Sensitive ABS. The credit sensitive ABS strategy involves investing and trading in credit sensitive tranches of securitized products. The non-agency residential mortgage market is the largest part of this market, but it also includes a variety of other consumer assets, such as autos and credit cards, and commercial assets, such as small to medium enterprise loans and equipment leases, among others. Some of these opportunities are driven by regulatory capital requirements as banks try to sell these assets or enter into structured solutions to obtain the necessary regulatory capital balance sheet relief. Many banks seek this relief because lower-rated ABS securities receive very poor regulatory capital treatment and are thus very expensive for banks to own. We prefer to invest in this strategy with teams that hedge any residual interest rate risk. Similarly, we seek teams whose portfolios incorporate tail hedges or other systematic credit hedging to limit the outright credit exposure. Similar to loan pools, this strategy presents an asymmetrical return opportunity, especially when compared with liquid credit. Hedged returns of percent are available using punitive assumptions, such as a 1 15 percent house price decline, 7 8 percent default rates, and 7 8 percent severity rates. As with the other asset classes, a supply demand imbalance exists. It is particularly evident in the Fed s attempt to sell the Maiden Lane portfolio. Buyers are not interested in transacting at the prices at which people are trying to sell these assets today. Price recovery in the credit sensitive ABS market remains behind the corporate credit markets; the residential mortgage market has a long way to go to catch up to corporate markets in terms of spreads and prices. In fact, the non-agency RMBS market was primarily rated AAA before the crisis and has now become a primarily below-investmentgrade market. Many institutions have regulatory, capital, or other restrictions on how much, if any, non-investment-grade assets that they can actually own, which distorts the buyer and seller balance for these types of assets. Private Lending. The private lending strategy involves directly originating loans to small- and mid-sized companies globally. This portion of the market cannot access the high-yield market, and banks generally have not stepped up to provide sufficient financing to these types of companies. Typically, private lending involves floating-rate loans, so it has limited interest rate risk. It is a longbiased credit strategy, but the options that investors are short are deeper out of the money than they were before the crisis. For example, lenders are financing against depressed earnings before interest, taxes, depreciation, and amortization (EBITDA) and collateral values, and at lower leverage levels, as companies come out of the economic recession. At the same time, lenders earn higher returns in terms of yields and fees than before the crisis. Overall, the risk-adjusted return is quite interesting. This opportunity exists for many of the same reasons as the other opportunities in complex credit: (1) supply demand imbalance resulting from the reduced presence of capital providers, such as banks, CDOs, business development companies, and specialty finance companies, and (2) high barriers to entry given the infrastructure required to support origination and monitoring. Using China as an example, Figure 6 compares the producer price index (PPI) in China with the amount of net direct lending to nonfinancial institutions. Following the crisis, China s government increased lending to support the economy. As the recovery has progressed and China has entered more of a growth phase, the government has decreased that support. The result has been the creation of opportunities for private lending. Opportunities are also emerging in the United States, although not quite at the spread level available in China. Risks and Portfolio Construction The obvious risks embedded in a portfolio of complex credit assets are liquidity and complexity, but investors are being paid to assume these risks. The other risks in these strategies are more idiosyncratic than systematic for example, prepayment risk in mortgage derivatives, servicing risk in loan pools and private lending, regulatory risk, and weakening fundamentals versus conservative assumptions, to name some key risks. Proper manager selection is also critical. From a portfolio construction perspective, a portfolio of complex credit assets can and should be customized to reflect the objectives and constraints of the underlying investor. Generically, we would recommend a portfolio of 5 1 managers. We also recommend using some of the premium to purchase 44 DECEMBER 211 cfapubs.org

8 Opportunities in Complex Credit Figure 6. PPI vs. Net Direct Lending to Nonfinancial Institutions in China, 1Q22 1Q211 Renminbi (billions) 5, 4,5 4, 3,5 3, 2,5 2, 1,5 1, 5 PPI (right scale) Net Lending (left scale) PPI (%) Q2 1Q3 1Q4 1Q5 1Q6 1Q7 1Q8 1Q9 1Q1 1Q11 1 Source: Based on data from Bloomberg. out-of-the-money protection against left tail events; this approach has always been an integral part of how we build portfolios. Finally, this type of portfolio should not be viewed as a quarterly liquidity investment. Rather, the most appropriate structure would incorporate a short drawdown period (one to two years) with a flow-through return of capital. Conclusion Complex credit investments offer a compelling return profile in comparison with traditional liquid credit assets. Complex credit assets continue to be undercapitalized for a variety of reasons, including investor preferences for liquidity and simplicity, macro uncertainty, the reduction in the shadow banking system, and continued asset sales by banks. As a result, the opportunity to earn attractive riskadjusted returns should persist in this asset class. Diversified Global Asset Management is an institutional fund-ofhedge-fund manager. In the normal course of business, our funds own complex credit assets for existing investors and we market complex credit opportunities to potential investors. This article qualifies for.5 CE credits. cfapubs.org DECEMBER

9 CFA Institute Conference Proceedings Quarterly Question and Answer Session Lindsay Holtz, CFA Question: What is your expectation of volatility for complex credit returns in the mid-teens range? Holtz: These are not normally distributed assets. For lack of a better metric, however, standard deviation, looking backward, was about 7 percent; looking forward, I would expect it to be similar. As we build a portfolio, we do a forward-looking factor-based buildup, in which each asset is mapped to factors and a residual, and estimate the volatility. On the basis of that work, volatility is expected to be in the 8 percent range. Question: In terms of allocation to complex credit, would it come from the fixed-income allocation or as an allocation to alternatives for a typical institutional plan? Holtz: Taking it from the fixedincome component would be a better use of capital today because fixed income is offering low return expectations. It depends, however, on how the fixedincome portfolio is set up and whether the plan guidelines allow for something less liquid in the fixed-income bucket. If the plan does not allow it, then many investors put complex credit assets in their alternative buckets. The return opportunities for alternatives are higher than they are for traditional fixed income, so it would be better to move capital from fixed income than from the alternatives. Question: What would be your recommended allocation range? Holtz: Investors plans vary in terms of the asset and liability mix, but many investors would not tolerate more than 1 percent. I think it should be more than that, but in many plans, the whole alternative bucket is only 1 percent. Question: Can large pension funds use complex credit strategies in an adequate size to affect returns, or are there capacity constraints? Holtz: Capacity constraints exist not in terms of the opportunity for asset supply but rather in terms of plans actually being willing to allocate to complex credit. The supply of capital is constrained. I think it is unlikely that there will be a flood of capital into this market. Question: What is the historical default and recovery experience in this asset class? Holtz: Different strategies have different default patterns. Mortgage derivatives collateral represents higher credit quality, so prepayment risk, versus credit risk, is the primary concern. In the credit sensitive ABS area, the default rate might be anywhere from 1 to 4 percent, depending on whether it is prime, Alt-A, or sub-prime collateral. I think that the 7 8 percent default rate that has been priced into that market is conservative. The recent past produced a lot of spikes in defaults in these asset classes. Part of the reason the complex credit opportunity exists is that investors do not want to (or cannot) own securities that are not performing or that are below investment grade. The assumptions that have been priced into the return expectations, however, are worse than what has been experienced historically. Question: How big are the teams that are using these strategies? Holtz: It depends on how much they have in assets under management and how many types of assets they are trying to manage. On the private lending side, I have seen teams of 5 75 people, including both sourcing infrastructure and monitoring infrastructure. I have also seen teams of two to three people trying to get into these strategies, but I do not think that is sufficient. On the loan pool side, the teams have about 1 2 people. More of those teams are working in the back office, ensuring that the assets are well managed and monitored after they have been put into the portfolio. Because these are long-term assets, it is important to have that proper infrastructure around the investment. Question: How transparent is the valuation in complex credits? Holtz: One of the reasons it is called complex credit is that some of the asset classes are less transparent than others. The mortgage derivatives and assetbacked securities tend to have reasonable transparency in the market. Loan pools and private lending are similar to how value would be considered in a private equity portfolio. There may be independent valuation firms that are involved in the asset class on a monthly or quarterly basis. In most cases, they test for asset impairment, but in some cases they do try to find comparable transactions in the market and to ask questions, such as, How have yields changed? What are the underlying 46 DECEMBER 211 cfapubs.org

10 Q&A: Holtz characteristics of the particular asset? Have defaults and recoveries changed in such a way that the valuation should change? Valuation and transparency are part of the reason why complex credit assets are not quarterly liquidity assets. If investors traded in and out with that timing, they would probably sacrifice value in one direction or another. cfapubs.org DECEMBER