Structured credit is back on the radar
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26 April 2010, Newspaper: Issue 700
Hedge funds found themselves under an uncomfortable spotlight last week. Embroiled in the US Securities and Exchange Commission’s action against Goldman Sachs, US hedge fund Paulson & Co reassured investors that it had done nothing improper.
Similarly, Magnetar Capital. another US hedge fund which profited from shorting the US housing market, faced criticism over the construction of its portfolio. It told investors the strategy was based on a mathematical statistical model and the firm did not control the asset selection of the portfolio.
But the very markets in which Paulson & Co and others made profits by predicting their declines could now be making a slow comeback.
Structured credit, which includes complex packages of bonds, loans and derivatives, is unlikely to grow to its pre-crisis heights. In January, however, the first collateralised loan obligations since early 2009 emerged and others have followed. Even more telling is the emergence this month of two collateralised synthetic obligations which reference pools of derivatives an d are the first such deals since 2008.
Some in the hedge fund industry believe increasingly benign conditions in credit markets could lead some managers back into more complex products in search of yield. While managers including Paulson & Co made money betting on the short side of structured credit trades, other hedge funds lost large sums. Most notably, two hedge funds at Bear Stearns collapsed in June 2007.
Since then credit markets have normalised. A portfolio manager from a large London hedge fund said: This time last year, investors could take exposure to vanilla products and get outstanding returns. Now that markets have normalised, people may start to look at more esoteric products.
Another consultant added: Credit hedge funds are struggling to make returns as credit markets are priced virtually to perfection. There are no easy pickings out there any longer.
The Markit iTraxx index linked to 125 companies with investment-grade ratings in Europe shows that spreads have tightened from 138 basis points 12 months ago to 82 basis points last week. Its equivalent US index shows spreads have almost halved to 87 basis points from 12 months ago.
Default rates have also slowed. Last week, accountancy firm Deloitte put out a report saying that 46% fewer UK companies fell into bankruptcy in the first quarter of the year compared with the same period last year. In the six months from October to March, 1,154 companies went into administration, which Deloitte says is the lowest for any six-month period in the last four years.
A chief executive at a London fund of funds said: To the extent that some of the new structured credit is attractively structured and priced, it would not be surprising if some funds with a deep understanding of the area were again involved.
Loc Fery, managing partner at London hedge fund Chenavari Investment Managers, said that while the bulk of capital raised for credit funds had been deployed in simple vanilla opportunities, hedge funds were also seeking opportunities in structured credit, including CDOs and CSOs.
He said: It can be existing tranches or newly issued ones. We do not need a rating. CSOs have gone from being a default-based play to a market value play. Chenavari acquired $1bn in synthetic CDO funds from Socit Gnrales Lyxor Asset Management last December.
Citigroup raised the first collateralised loan obligation in a year last month for investment manager Fraser Sullivan. This was followed by a $300m (224m) CLO managed by Apollo Management and arranged by Citigroup. Citigroup has two more CLOs under way, according to two people familiar with the situation. Citigroup declined to comment.
Jonathan Laredo. chief investment officer Europe at Aladdin Capital. a credit specialist, said: By and large, the CLO new issuance market will recover in some form because companies need to keep borrowing money. CLOs play a vital role in providing a source of loan finance to companies with lower credit ratings and taking the strain off bank balance sheets.
CSOs will be slower to make a comeback because, unlike CLOs, they arent integral to markets. Laredo believes the CDO and CSO markets wont exist in the same form again because they are arbitrage markets and a space where investors suffered such large losses.
He said: By definition, arbitrage markets tend to come and go, according to market cycles and risk appetite. The large losses have switched off a large percentage of the investor community from these types of deals.
That said, the first deals since 2008 are emerging. JP Morgan is bringing to market a new collateralised synthetic obligation, which is managed by AXA Investment Managers, according to people familiar with the situation.
The firms are in the process of gauging demand for the deal, called Aria IV. Aria I, the first CSO in the Axa series, was sold in June 2004 and referenced a portfolio of more than 140 corporate names, according to a Standard & Poors rating note at the time of its sale. JP Morgan declined to comment.
UBS is marketing another CSO, called Ocelot III, where Prudentials M&G is the manager, according to bankers.
These deals are appealing to investors who do not have access to leverage, such as insurance companies and pension funds, according to bankers.
In the hedge fund community, parts of which remain wounded by the crisis, any steps encouraging managers to embrace structured credit are likely to be slow.
Fery said: Simplicity first. The ability to seek fundamental value is really what matters most for hedge fund investors at the moment. However, they also value fund managers who master the complex dimensions of credit markets, such as correlation and volatility: given the technicalities of the corporate credit market, it is now a necessary condition to perform.
The regulatory backdrop will also play a part. As the SEC investigates whether other deals arranged by large investment banks may have misled investors, it is unlikely that the alphabet soup of acronyms, which became synonymous with the credit crunch, will ever become as widespread as in the boom years.