BlueBay: "ever higher" market dislocation, mispricing of risk

But bank deleveraging problem loans creates opportunities

anthony-robertson-bluebay-asset-management

Event driven credit strategies seek to extract value from the leveraged finance markets across a diverse set of market outcomes by investing in special situations. Given the idiosyncratic nature of situational investing, the event driven approach can generate attractive returns at any point in the credit cycle, with low correlation to credit and equity market indexes. More recently, an acceleration in the rate at which European banks are selling down their non-core and problem loans has added significantly to the number and quality of investment opportunities. We believe this trend is set to continue in 2015 and 2016, with banks adopting a staged approach to full implementation of regulatory capital requirements.

Event driven and distressed credit investing is a complex and challenging exercise, but successful navigation of the opportunity set allows for outsized returns. Below we aim to give investors a roadmap to understanding the current opportunity set and the outlook for returns in 2015.

What is event driven credit and why now?

The event driven credit investor aims to exploit inefficiencies in the market that can arise during a period of corporate stress or at the time of a specific corporate event such as a restructuring, acquisition/divestiture or a refinancing. The primary source of event driven credit opportunities has been the leveraged finance markets. These have grown dramatically in both Europe and the US over the past decade and, as at October 31, 2014, represent a combined total of $4.4 trillion of outstanding high-yield bonds and loans.

During the third quarter of 2014, the divergence between the US and European economic recoveries came into sharp focus, with price action in the lower-rated segments of the European market reflecting a potential divergence in default cycles. This was compounded by the dramatic re-emergence of idiosyncratic risk, with failures in the Portuguese banking sector and UK retail sector temporarily fracturing confidence in European high-yield markets. Heightened sensitivity to single-name ‘story’ credits gave way to far more indiscriminate selling of lower-rated European paper, creating opportunities for investors who are able to identify fundamentally mispriced securities within the broader market.

Market fissures in Europe were swiftly superseded by violent price action in the US high-yield energy sector during the fourth quarter, as the sharp decline in the oil price raises the prospect of a new default cycle in the US. While we currently see further downside for issuers leveraged to oil, we expect the US energy sector to provide a host of situational and distressed investment opportunities over the next two years.

The weaker European macro environment, rising idiosyncratic risk and a new, albeit uncertain, oil price regime all contribute to an enhanced opportunity set for event driven credit in 2015. Moreover, these issues are playing out against a backdrop of structural illiquidity in fixed income. With dealer balance sheets constrained on a global basis, the propensity for market dislocation and mispricing of risk is ever higher, presenting opportunities to generate incrementally attractive returns. Coupled with an accelerated sell-down in European bank portfolios, there has been a substantial increase in the number of attractive opportunities in stressed and situational investing. There are several facets to the current opportunity set that are poorly understood and merit further discussion.

Opportunistic strategies: reduced provision of liquidity by dealer banks has led to exacerbated volatility and credit dislocation

The reduced provision of market liquidity to financial markets by banks is well documented. Bank proprietary trading desks have been decimated and dealer inventories have fallen by 70% since 2008, even as global bond markets have more than doubled in size. Regulatory constraints on leverage have profoundly impacted the behaviour of dealer banks and their capacity to be a direct provider of liquidity as market makers. With bank dealers acting largely in an agency capacity with limited appetite to warehouse risk, short-term sell-offs now result in significant price dislocation. This presents compelling investment opportunities for a value-based, event driven manager who is able to identify and exploit these temporary mispricings.

Stressed situation opportunities: structural changes in the European banking system

In stark contrast to their US-based counterparts, European banks account for the majority – about 60% – of all debt financing in Europe. Following the financial crisis, it was broadly anticipated that new capital adequacy requirements would necessitate systemic selling of corporate credit assets off European bank balance sheets. However, this did not materialise, as banks assigned priority to managing down sub-prime, asset-backed and structured product portfolios. The intervening period has seen European banks return to profitability, allowing them to adequately provision and mark down non-performing and stressed corporate loans to market clearing levels. With the spectre of Basel III compliance, banks are now visibly reducing the size of their corporate debt portfolios to focus on core relationship lending. This is increasingly apparent in both the growth of the private debt market and the sale of non-core and problem or ‘special’ loans.

Traditional restructuring/distressed opportunities: default rates do not dictate the timing of the opportunity

While we do not expect a material rise in global default rates in the near term, we are seeing a significant increase in the number of restructuring opportunities, reflecting both the substantial growth in bond and loan new issuance in recent years as well as rising idiosyncratic risk. Following the financial crisis, the banks’ reduced appetite for credit led both large companies and new entrants to issue in the public debt markets, doubling the number of bonds outstanding. As such, the current default rate represents double the volume of restructuring opportunities versus the prior cycle. In addition, there remain a number of pre-crisis leveraged buyouts that have yet to undertake a balance sheet restructuring and will need to do so as they approach 2015 and 2016 amortisations.

Selecting an event driven credit manager: multiple jurisdictions create high barriers to entry

Investing in multiple European jurisdictions creates a high barrier to entry. To maximise outcomes for stressed and distressed investments, the investment manager must have the resources and expertise to lead or participate in a corporate restructuring process. Jurisdictional differences play a significant role in value recovery, as some countries are more creditor-friendly than others. A manager with specialisation across Europe is able to identify the opportunities in single-name impaired corporate debt with a clear path to exit and subsequently use local knowledge to drive a consensual restructuring.

Conclusion

The legacy of the financial crisis and subsequent increased regulatory environment has led to bank deleveraging on a global basis. This has resulted in an increasing supply of event driven and stressed investment opportunities, as the unwillingness of dealers to extend balance sheet has created a greater propensity for market dislocation and mispricing of risk in the leveraged credit markets. Moreover, with European banks accelerating the sell-down of non-core and ‘troubled’ loans, the landscape for investors in this part of the cycle has become increasingly attractive. However, in the context of rising idiosyncratic risk and a weaker European macro outlook, opportunities in this market are not uniformly attractive. We therefore believe that success in navigating the opportunity set requires a credit-intensive, fundamental approach to asset selection. An asset manager with significant analytic bandwidth and deep jurisdictional expertise will be best placed to identify mispricings within the market and thereby generate the best returns for their clients.

Anthony Robertson is partner, chief investment officer and head of global leveraged finance group at BlueBay Asset Management.

 

BlueBay Event Driven Credit – at a glance

  • The BlueBay Event Driven Credit strategy seeks to capitalise on the temporary mispricing of risk by investing in a combination of opportunistic and stressed/situational strategies as well as select restructuring/distressed opportunities with a clear path to exit.
  • BlueBay has managed event driven credit as a dedicated strategy since December 2009.
  • Concomitant with a meaningful acceleration in the number and quality of investment opportunities, BlueBay has opened the fund to new capital.
  • BlueBay Event Driven Credit benefits from the broader analytic resources and sourcing capability of the global leveraged finance team, comprising 36 investment professionals across research, portfolio management and trading and offering deep investment expertise in both public and private debt markets.
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