Thames River manager believes while fever pitch within peer group may be over, an elongated credit cycle means plenty of opportunities remain
Stephen Drew, co-manager of Thames River Capital’s two recently launched bond funds Global Credit and Credit Select, believes one of the best opportunities in corporate bonds at the moment is in unrated debt.
Drew, who employs hedge fund like techniques in his management of the two portfolios, believes while the fever pitch excitement for corporate bonds may be over, there remain plenty of opportunities. With an elongated credit cycle underway, Drew thinks corporate credit markets have a further nine to 12 months before they turn back to a more normal return pattern.
With banks shoring up balance sheets and hoarding cash what is your view on how corporate financing will evolve.
With the bank situation, corporates have had to resort to new ways of raising capital. Their debt levels are such that they will be in hock for three to five years at least. They have very few ways of raising capital so they have had to turn to the public market.
In addition, high-quality companies in emerging markets have been looking for capital and they never had access to public bond markets before.
The market, as a result of high investor demand, has been very receptive to their issuance – even the unrated companies. We have seen some E18bn in unrated debt issuance since September, which is more than in the previous five years.
How have credit markets changed and who is in the driving seat, controlling the flows.
Europe is taking the lead here. It is similar to how the US restructured in 1989-91 after its Savings & Loans crisis made corporates look at alternative ways of financing instead of being dependent on institutions.
The European market has always been relationship- and Libor-driven. Now it has hit the sweet spot of trying to meet what investors are looking for.
In the past in Europe, corporate bonds were no more than five to seven years in duration. Now we are seeing longer-dated issues, and strong demand from investors seeking yield means they are in the driving seat and it is effecting change, such as stronger covenants. Only
banks have had that luxury in the past.
If there is a wider spread of duration options now, what areas look attractive to you?
Within the A-rated bonds, the 15-year issues, BBB the 10 years and for BB the shorter, five- to seven-year area.
But while Europe has come a long way, it does not mean on a global scale they have taken over from the more mature and dominant US market.
Europe is catching up with the US, not only in terms of meeting investor demand but in the types and sizes of the issues. I thought this would happen after the single currency was introduced, but then the TMT bubble happened and it fizzled out. Banks have had a stranglehold on the corporate market.
Is the fear of defaults behind us now?
Back in March, spreads were so wide if half your portfolio defaulted the other half would have compensated. It was an overreaction. I am not sure if defaults have peaked or not, but they may do so next month or shortly thereafter.
Throughout 2008, liquidity has been a serious issue for the corporate debt markets. Has this improved?
Credit derivative liquidity is back to its peak, although what is driving it is different. Index liquidity in this area of the market is amazing, although in single names, liquidity is still patchy.
Within the secondary cash market, the situation has improved but it too has changed, mostly because of all the new issuance.
Liquidity appears abundant until it is no longer there. In this environment, portfolios have to be as liquid as possible.
How has this changed the way you manage assets?
Understanding your portfolio dynamics is more important than ever. Not too long ago we had 10 times as many ideas as we had capital; now it is closer to four to five times as many.
We have to be more selective as there are fewer home runs around, but there are still plenty of opportunities for capital gains. We have more positions than normal and position-sizing is key as sector and asset correlations increase.
What is an example of what you are hedging as a risk at the moment?
I see interest rates as the biggest risk factor to investment grade corporates – more so than credit risk.
We have protection against that as well as some long volatility trades on currencies.
As an example, we are positive on longer-dated dollar calls. Essentially, this helps to hedge some of the tail risks we are taking with our longer-term investments.
If we see a double-dip scenario, the dollar will outperform; if we see a V-shaped recovery, the dollar will outperform.
The dollar only continues to underperform in the middle, where we should be able to outperform through our credit calls.
What do you think of the situation with Dubai?
It was inevitable given what is been going on there for some time. The situation is very muddy, but I think it is more likely there will be an outcome that is positive for bondholders than markets are expecting.
Do you have any exposure to the region?
We have actively traded Dubai, sovereign and corporates, over the past week.
What do you see as the area offering the biggest opportunities?
Finding inefficiencies in the market offers the most opportunity and right now that is in unrated corporate debt. I think this plays to our strengths, with more than 55 years of corporate analyst experience.
We have 17% currently in unrated debt in our High Income fund.
We do not have any at the moment in Global or Select Credit because these funds are so new, not because we will not take positions in unrated.
I would be confident putting 15%-20% in unrated corporate in these funds.
