Macaskill on markets: Credit investors talk a good fight
Blackstone and Pimco are talking a good fight when it comes to possible credit market dislocation. The widening in high-yield debt spreads that accompanied a bout of panic in global equity markets in mid October prompted displays of bravado from the investment firms.
Blackstone CEO Stephen Schwartzman said that his firm’s $70 billion credit unit was ready to “feast” on high-yield credit, especially in Europe, where it had supposedly been waiting patiently for something bad to happen.
Mark Kiesel, one of three portfolio managers who took over the $200 billion Pimco Total Return Fund from deposed bond king Bill Gross, said: “Credit is a buy here, specifically high-yield.”
They were certainly right to downplay the more melodramatic predictions of an imminent apocalypse in the credit markets. Some commentators confuse any correction in the spread tightening of recent years, or reversals of flows into debt funds, as signs of the approaching end times.
Instead, as long as default rates remain low there is no reason to expect big realized losses on high-yield debt. A renewed economic downturn might well crimp the market for new issuance of debt, but it would effectively guarantee low rates for an even longer period and help to keep default rates down.
Yet there are reasons to be concerned about the insouciant tone of big investors in credit, and even more potential for problems with other aspects of the “shadow banking” attempt by investors to displace traditional banks.
Concerns for the newly dominant investors in credit chiefly revolve around liquidity. The discussion about credit market liquidity has focused on the effect of the withdrawal by major banks from principal based trading of debt, and the resulting fall in their own bond inventories.
There is no doubt about the scale of this shift – bank holdings of bonds are down by around 80% from their pre-2008 crisis peaks, according to regulators – though there is room for debate about whether dealers ever provided meaningful liquidity in periods of genuine market stress.
In a phone-based trading market it is easy not to answer the phone, and discretion over bid/offer spreads in both voice and electronic markets for bonds has always allowed dealers to effectively take a time out from providing liquidity.
Big buyers of bonds such as BlackRock (a one time unit of Blackstone that outgrew its parent) and Pimco have been working diligently in recent years to foster liquidity by promoting use of new systems and trading venues. But there are some under-appreciated risks to the newly proactive role they play in the debt markets.
One is that they will be caught up in the allegations of misconduct that have so far been the preserve of the big bank dealers, who were the moustached villains of the 2008 credit crisis and kept themselves in the headlines with subsequent accusations of price manipulation across an impressive range of markets.
The mechanics of allocation of newly issued corporate bonds represent one potential trap for investors. The abrupt departure of Bill Gross from Pimco at the end of September prompted articles examining the role played by the firm in certain corners of the debt markets. Mortgage backed securities rallied on speculation that the newly promoted fund managers at Pimco would reverse a decision by Gross to underweight MBS purchases, for example.
Attention was also paid to Pimco’s ability to insist on high allocations of new corporate bond issues, which have been on a multi-year boom as the era of ultra low government bond yields continues.
Secondary corporate bond liquidity is unquestionably poor – even on October 15, a day of sharp market moves across asset classes, there was only $25 billion of secondary US corporate bond trading, compared to around $1 trillion of Treasury dealing. Synthetic trading in the form of corporate single name credit default swap flow is also less active than it was before the 2008 crisis. So access to desirable new corporate bonds is an increasingly important differentiating factor for investors. That has led regulators to examine the process by which dealers decide on new issue allocation. There have so far been no allegations of misconduct leveled at the biggest investors, led by BlackRock and Pimco. But radio silence from regulators in the months since news emerged of an investigation in February does not mean that supervisors have failed to turn up any information indicating that certain investors are given preferential treatment.
A conclusion that market practice should be overhauled would not need to include allegations as dramatic as the Libor manipulation details to have a harmful effect on the reputation of the leading investors in corporate debt.
The lucrative sideline that big investors such as BlackRock and Pimco have developed in advising supervisors on the valuation of debt portfolios could also come under scrutiny if they are found to have benefited from preferential treatment in certain corners of the markets, for example.
And there are other areas of shadow banking where regulatory reforms designed to shift risk away from traditional lenders could backfire.
Private equity investors and hedge fund managers have been complaining for years about the glacial pace at which banks, especially in Europe, have been shedding bad debts – by which the fund managers mean selling the debts at a large discount.
Some of these managers may end up getting more of the disintermediation pie than they bargained for, however. AnaCap, a London-based private equity firm, must be looking at its portfolio of bank exposure with a nervous eye after the recent bout of market jitters. The fund is a big investor in UK challenger bank Aldermore, which had planned an IPO for October, only to be forced to pull the deal as the FTSE deteriorated.
That will leave AnaCap sitting on its exposure for longer than planned, at a minimum. And news of its deal to buy a nominal €1.9 billion of bad debt from Italian bank UniCredit emerged just as the dismal state of the European economy helped to drive a global dip in equity markets and the European Central Bank prepared for the delicate task of grading the region’s banks without pushing too many of them back into distress.
Firms such as AnaCap, along with bigger investors including BlackRock and Pimco, may well end up on the right side of a historic shift in the capital markets. Individual investors such as J Christopher Flowers and Blackstone’s Schwartzman have made billions for themselves based on past banking cycle bets, after all.
But the investors currently whistling as prices wobble may not be quite as sanguine about the risks in the global credit markets as they would like us to think.