US 10-year Treasury yields rose to 2.25% in the past few days, the highest level since April last year, after Fed chairman Ben Bernanke told Congress at the end of May that the central bank could slow the programme of asset purchases, which has fuelled a boom across asset markets. Credit investors have felt the pain, and the iTraxx Crossover index of high-yield credit default swaps (CDS) has widened almost 100 basis points during the past month to around 470bp, as investors bet that spreads will widen further.
The speed and scale of the turnaround in market sentiment has left fund managers in a bind, and asking how to avoid the ignominy of selling into cash while holding the gains made.
A number of choices present themselves, from investing in short strategies to reducing duration exposure, buying protection in the default swap market or turning to hedging strategies such as the use of options.
“One of the key questions fund managers are asking themselves is do I sell or do I hedge,” says a UK-based credit strategist. “There comes a point where hedging is not going to be sufficient and you need to start taking risk off the table.”
Many hedge fund and real-money investors have turned to the credit options market as a source of protection against tail risk, or the chance of a large-scale sell-off.
Options traditionally provide a low-cost safety net against extreme events, but such has been demand for credit index payer options in the recent period that implied volatility – used to price option contracts – has risen sharply, from as low as 48% for at-the-money September iTraxx Main contracts a month to 65% in recent sessions, the highest level for a year.
Rising credit market volatility shows that sentiment around credit markets is deteriorating in line with expectations for rising interest rates. However, despite a recovering US economy, there are additional fundamental reasons for credit investors to be concerned, and a recent report from Moody’s Investors Service showed that credit quality among new European issuers in the high-yield space continues to decline.
“Our analysis of the financial projections of 175 first-time rated corporate issuers in the EMEA region shows average leverage at rating assignment has increased considerably since 2010 and that this trend, judging from the first quarter, is likely to continue in 2013,” Moody’s says in a note published on June 5.
“These issuers, which are dominated by LBOs, have less room to underperform on financial forecasts and will be more vulnerable to external shocks, including weaker economic growth or changes in the interest rate environment.”
One simple way for fund managers to protect against credit market losses is to buy protection in the CDS market. However, many managers have shied away from that space, amid concern over liquidity, particularly in single names, and taking counterparty risk against swap counterparties, which leads to a heavy burden of regulatory responsibilities in respect of trading, margining and reporting.
For the majority of fund managers, the best way to reduce risk exposure in credit is to try to decrease the average maturity of bonds in portfolios, and this has the additional bonus of dampening the sensitivity of fixed-income securities to interest-rate fluctuations.
“Reducing duration is the best way to mitigate damage,” says Georg Grodzki, head of credit research at Legal & General Investment Management in London. “You will still see market values decline but at least you are doing something.”
For fund managers holding the appropriate mandates, the best way to play a spread-widening environment is to try to profit by actively shorting corporate bonds.
Many credit hedge funds made a killing in 2009 hedging peripheral corporates as spreads widened from less than 200bp to more than a 1,000bp, and many are now revisiting that strategy, looking to identify specific names where there is sufficient cash liquidity available.
New York-based hedge fund manager Troob Capital Management is among those in recent months to launch a short-bias credit fund, which co-founder Peter Troob says could generate substantial returns.
“We are targeting companies rated single-B where we see companies in weak industries and where there are well-financed competitors,” says Troob. “We are still in a market where the majority of investors are long, which means it’s fairly easy to sell bonds.”
Troob launched the fund in February and saw $100 million of inflows by the beginning of May.
“Our targets are companies where the yield on the bond pays too little against the level of secured loans on its balance sheet,” he says. “Where there is too much leverage, a short position makes sense.”