As a convention organizer, I’ve put collectively and witnessed dozens of periods because the 2008 world monetary disaster. Nine years after the collapse of Lehman Brothers, it’s nonetheless outstanding how usually convention periods arrive at a “Doomsday Moment” — the purpose when a presenter acknowledges that the spectrum of attainable outcomes nonetheless consists of monetary Armageddon.
The Doomsday Moment in Jochen Felsenheimer’s presentation on the 2017 CFA Institute European Investment Conference got here in the course of the question-and-answer session, however for those who’re new to this sport and weren’t in attendance, you’re forgiven for considering it got here earlier.
Felsenheimer, a high-yield and distressed portfolio supervisor with XAIA Investments, started by warning that his presentation, “The Devil in Disguise,” could be pessimistic. Then he made a powerful case that danger in high-yield markets is as excessive because it has ever been.
As Felsenheimer sees it, years of extreme liquidity from central banks have utterly warped the market, forcing buyers to maneuver farther out alongside the chance curve searching for yield. In his opinion, present market yields don’t adequately replicate the precise dangers that buyers are uncovered to.
“We do not live in a world of competitive markets,” Felsenheimer mentioned, pointing to unfavourable rates of interest as Exhibit A in his manipulation argument. He defined that cash pouring into the high-yield sector, largely through exchange-traded funds (ETFs), was one other supply of market distortion, contributing to an enormous misallocation of capital that sustains unsustainable enterprises.
The rising focus of high-yield merchandise within the ETF market is especially worrisome to Felsenheimer. “There are many worthless companies accessing the credit markets,” he mentioned. “I understand these companies have no way to survive. The only reason is the search for yield forces investors to fund them.”
The search for yield has additionally pushed many new buyers to the sector who don’t perceive the chance within the asset class. “I’ve never seen so many investors in high yield who don’t understand high yield,” he mentioned. “The younger generation of traders didn’t experience 2007.”
Felsenheimer shared his issues that idiosyncratic dangers within the high-yield sector may grow to be systemic, which suggests the subsequent flip of the credit score cycle would devastate the market. “I think the dumbest slogan in financial history is ‘ETFs: Making illiquid markets liquid again,’” he mentioned. “ETFs will add volatility in times of stress. Some bonds are 40%–60% owned by ETFs.”
Felsenheimer fears that unprecedented ranges of worldwide leverage may carry a systemic improve in default charges, and that they’d additionally lead to decrease restoration charges for high-yield buyers. “Credit pickers will get hammered,” he mentioned.
If that weren’t pessimistic sufficient, Felsenheimer then defined why post-default high-yield restoration charges may very well be even worse than his grim credit score outlook may predict.
“Recovery rates depend on the insolvency process, which can be changed,” Felsenheimer mentioned. He cited the debt restructurings of Hypo Alpe Adria, Caesars Entertainment, and Novo Banco as examples the place the restoration charges for buyers had been affected by the insolvency course of. The prevalence of deteriorating covenant safety in high-yield issuance and a bias to fraud in instances of misery had been among the many different ways in which buyers confronted rising losses.
Finally, Felsenheimer steered that the asset administration trade, not the banking system, held the most important publicity to high-yield credit score. “Asset managers are the fragile part of the system right now,” he mentioned. “Big multi-asset funds and ETFs have huge liquidity risk.” This is a big change from prior credit score cycles.
Because of those causes, Felsenheimer concluded that prime yield was no place for long-only buy-and-hold buyers. He really useful creating publicity to the sector by way of market-neutral methods primarily based on fastidiously executed arbitrage, utilizing bonds and credit score default swaps (CDS), which helps buyers generate a steady carry revenue whereas mitigating rate of interest danger and default danger.
“It’s better to put leverage on a relatively safe trade than buying over-leveraged European high-yield unhedged,” Felsenheimer mentioned. He most well-liked to make use of an arbitrage technique within the high-yield market to generate relative worth whereas avoiding directional danger.
That’s when the Doomsday Moment arrived within the type of a query from the viewers: “With these strategies, aren’t you simply replacing investment credit risk with counterparty risk?”
Well, positive. Felsenheimer’s arbitrage methods assume that CDS counterparties will be capable of honor their contract commitments. To help that assumption, he famous that central counterparty clearinghouses in Europe have gone a great distance towards lowering counterparty dangers, and monetary authorities have proven that they may go to nice lengths to keep away from one other Lehman Brothers second.
The questioner pressed additional, suggesting that counterparty danger couldn’t be assumed away so simply. “There’s no free lunch,” he mentioned.
Felsenheimer conceded the purpose. “You’re right that there is no free lunch,” he mentioned, “but there is good lunch and bad lunch. In a nuclear war, you will also lose your investment, but who cares at that point?”
It doesn’t get extra Doomsday than that.
This article initially appeared on the CFA Institute European Investment Conference blog.
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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially replicate the views of CFA Institute or the creator’s employer.
Image credit score: US National Nuclear Security Administration/Nevada Site Office