by Richard Phillips, Chief Investment Officer and Kevin Muir, CFA, Market Strategist
Central bank financial repression has forced investors to come up with innovative ways to earn yield. Into this hunt for safe yield was born the modern credit fund.
The modern credit fund attempts to generate alpha by exploiting a chronic mispricing of investment-grade corporate bonds.
The strategy is based on strong logic, but the dangers of leverage, combined with the late stage of the economic cycle offer cause for concern.
The past decade has been hard on savers. Brutal in fact. In the aftermath of the Great Financial Crisis of 2008, central banks throughout the world lowered interest rates to previously unheard of levels. Most brought rates down to zero and left them pinned there for years, and a few even pushed below zero. Negative interest rates were supposed to be a theoretical exercise for LSE PHDs, yet here we are in 2018 with the German 2-year Schatz yielding negative 57 basis points.
This has created a peculiar situation for Canadian investors, but it can also apply more globally. With baby-boomers set to retire in increasing amounts in the coming years, never has saving been so important, yet never has generating a safe return been more difficult.
Faced with the prospect of minuscule yields from traditional fixed-income, investors have clamoured for innovative solutions.
The birth of the modern credit fund
One type of fund that has recently gained popularity is the credit fund. Credit funds are by no means novel. They have been around for ages, but the thirst for yield in the post-GFC (Great Financial Crisis) age has created an almost insatiable demand for a fund that can offer yield without taking undue amounts of risk.
Into this unique situation was born the modern credit fund. The main strategy of these funds involves leveraging (several times) investment grade corporate bonds, usually lower investment grade (or “speculative grade”) corporate bonds. These bonds often have a credit rating of BBB+, BBB, or BBB- from Standard & Poors, or Baa1, Baa2 or Baa3 from Moody’s. The funds focus on earning returns from the credit spreads of these bonds by hedging out the (risk-free) interest rate risk.
Many of these funds started after the Great Financial Crisis as market participants realized that central bank financial repression would not disappear as quickly as might have been previously hoped. This also coincided with a period when bank-owned securities dealers were dramatically cutting back the risk on their trading books. It is uncertain whether this paring down resulted from the increasingly stringent Volcker rules that prohibited proprietary trading, or whether bank managements decided they never wanted to go through another financial crisis that threatened their solvency again, but either way, global banks laid off risk.
Sensing the opportunity, many seasoned bond traders created hedge funds catering to the yield demand from investors. They did so by offering a strategy that the banks were abandoning. It was a perfect fit. Banks were leaving the business, and investors were keen to pick up the risk in return for some yield.
The basis for the strategy
This report examines this strategy in more depth, explaining the basis for its popularity and why it works while highlighting the risks.
This report acknowledges that an individual fund might have enough trading acumen to overcome the macro obstacles that might present themselves in the coming years. This report is not to be viewed as a reflection of any one fund, but rather a commentary about the general style of this strategy.
The modern credit fund’s main source of alpha is created by exploiting a mispricing that exists in the bond market as it relates to investment grade (IG) credits. When comparing investment grade corporate bonds to government bonds, there is the same interest rate risk that any fixed-income investor is exposed to. But there is the added risk the corporation will be unable to pay back the debt. This risk is virtually zero for sovereign debt as the government is the issuer of the currency and can repay bonds with “printed” money. Corporates cannot. Therefore an investor in corporate bonds demands an increased return to compensate for this risk.
This portion is labelled “credit risk.”
Obviously, companies have varying degrees of risk, so the bond market demands more of a premium over government yields for less fiscally sound companies. And the opposite is true. As a company’s financial health approaches AAA (the highest quality), the spread versus government bonds decreases.
The graph above demonstrates the yield for Canadian government bonds (at various maturities) versus AA rated corporate bonds and the BBB rated corporate curve. As the investment becomes riskier, the yield becomes greater.
Safer rated corporate bonds are considered “investment grade”. Within this category, there are varying degrees of safety. The highest rated bonds are AAA and the lowest rated investment grade bonds are BBB. Below investment grade is considered “high-yield” or “junk”.
These credit spreads are not static. They move around depending on investors’ preferences, the stage of the business cycle and other idiosyncratic factors. The question is whether the market is correct in determining how much extra yield the different investments require.
Investment grade’s chronic cheapness
At the heart of many credit funds’ strategy is the belief that the market consistently overestimates the chance of default for higher rated companies. An investor currently receives a little less than 1.25% for a 3-month Canadian government t-bill. For that same term, AA-rated corporate bonds yield around 1.95% for 70 basis points of pickup. Theoretically, the extra yield for the corporate bond should be compensation for the eventual default that will happen at some point. In a perfect market, over time these two returns (government yields versus AA-rated corporate bond yield minus defaulted notional) would be equal. Yet, we all know markets are far from perfect.
A study by U of T professors John Hull, Mirela Predescu, and Alan White titled “Bond Prices, Default Probabilities and Risk Premiums“ concluded markets have chronically overestimated the extra return required for investment grade credits due to defaults. From the paper:
Why are the two estimates of the probability of default so different? The answer is that bond traders do not base their prices for bonds only on the actuarial probability of default. They build in an extra return to compensate for the risks they are bearing. The default probabilities calculated from historical data are referred to as real-world (or physical) default probabilities; those backed out from bond prices are known as risk-neutral default probabilities. Real-world default probabilities are usually less than risk-neutral default probabilities. This means that bond traders earn more than the risk-free rate on average from holding corporate bonds.
Using the decades of data collected by Hull, he estimates that Aaa-rated bonds averaged 40 basis points of return over the risk-free rate, yet the realized amount of default resulted in an actual loss of only 2 basis points. Therefore investors earned 38 basis points of excess risk premium.
But the interesting part of the puzzle? Look closely at the bond-yield-spread-over-the-risk-free-rate versus the real-world-default rate. As you head down the credit curve, the ratio between the two converges lower. This means that an investor earned more on an absolute basis as the credit quality declined, but given the risk, they were not being compensated as richly.
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Taking this mis-pricing to the next level
There are profound implications to this observation. As an investor, would you rather own $100 of Caa+ rated bonds that, over time, will earn 264 basis points extra over the risk-free rate, or the same amount of A-rated bonds that earn 69 extra basis points? Given a long enough time horizon, along with the ability to withstand the larger risks and volatility of the Caa+ rated bonds, the riskier bonds make more sense. An investor would earn more in an absolute sense.
Yet, what about the taking that same A-rated bond and leveraging it up? After all, there has been only 8 basis points of default risk for that security group. If an investment manager constructs a portfolio which consists of 5-times levered A-rated bonds, the total excess spread earned will be 345 basis points versus 40 basis points of real-world default. This compares to 264 of pickup from Caa+ rated bonds but with 1014 basis points of real-world default.
Exploiting this phenomenon has generated considerable alpha for credit funds specializing in this strategy over the past decade. The use of leverage, along with the neutralization of interest rate risk through hedging, has allowed hedge funds to capture the excess return from IG fixed-income. This strategy has delivered a steady income stream to investors.
Investors won. They found a way to earn a decent yield in an environment that had shrunk to virtually zero through central bank financial repression. The banks that exited the proprietary trading business won. They replaced their volatile revenue stream with more reliable commission dollars. But most notably, the credit hedge fund managers, who became the darlings of this cycle, won. They produced strong returns that attracted significant money from investors who were desperately seeking somewhere safe but that still delivered strong performance.
The strategy almost looks foolproof on paper. Yet like most things in the markets, nothing lasts forever.
Leveraged credit near the end of the economic cycle worries
One of the more difficult parts of examining the relative merits of this strategy is that at first blush, it appears like the perfect all-weather strategy. After all, during good times, the strategy should perform well as credit defaults are low, and then during bad times, the fact that the majority of the portfolio is invested in investment-grade credits should provide a cushion as investors tilt their portfolio towards safer instruments.
According to Cambridge Associates, Senior Debt should be a strategy applicable across the entire economic cycle.
Yet the modern investment grade credit fund differs from past cycles. Whereas it was always easy to see the dangers in levering up Ccc and other junk-rated bonds, this cycle, the excess leverage is being applied to higher-rated securities that appear much less risky.
When looking at global default rates throughout history, it might appear like this strategy has little risk. These charts from Standard & Poor’s illustrate the relative safety of investment grade bonds over the past decades.
There can be no denying default risks are considerably lower in investment-grade securities. Yet it’s not like the total amount of defaults have been stuck at record lows. It’s quite interesting that even with the robust economic environment, default rates have recently been ticking higher:
But the really scary part? For many years after the Great Financial Crisis, the number of downgrades was limited. However, downgrades have been outpacing upgrades even in the face of global economic expansion:
The question investors should be asking themselves is how long they expect the current economic expansion to continue. We are now in the midst of the second longest expansion (106 months) in the recorded history of the US:
Here is a closer look at the most recent history:
Given the rather stretched nature of the economic expansion, it is alarming that investors are not demanding higher spreads vis-a-vis risk-free returns to compensate for the next part of the cycle. And it is important to note that many modern credit funds rely on lower investment grade or speculative grade bonds (BBB) to generate their returns. The next graph pulls these two concepts together:
The dangers lurking ahead
Even if the logic behind the strategy is sound, investors should examine the risks that will develop as the global economy eventually slips into a recession.
Over the past eight years, these credit funds have had a declining credit spread environment tailwind at their back. It’s been much easier to post positive returns when these hedge funds could ride the lift that all corporate bonds received relative to the risk-free rate. Even if credit spreads go sideways, this extra boost will be gone.
As it becomes more difficult to achieve the advertised returns, it will be tempting for these funds to employ greater leverage – this is a danger. Investors should be on guard for funds that do not simply accept the lower rates offered by the market and instead try to soup up yields through borrowing even more.
Yet the real risk is that the recession that the global economy has managed to avoid over the past eight years, finally hits. In this scenario, owning any credit will be challenging. Credit spreads are trading too tight considering the risks that the economic cycle is potentially nearing its end.
Investors are not likely getting paid enough to justify taking this risk. And the answer to the market not offering up enough yield is never to simply lever it up. This is the sort of behaviour traditionally seen towards the end of the cycle. More often than not, it’s these purchases that hurt the most.
Every strategy has its day in the sun. The modern credit fund has enjoyed more sunny days than almost any other class of hedge fund since the Great Financial Crisis. It might be time to think about the possibility of some rainy days in their future.