Opportunistic Fixed Income

Transcription

1 III. Opportunistic Fixed Income 1

2 Overview of Current Market Conditions Fixed income markets over recent periods are best defined by a flight to quality in the face of economic uncertainty and an associated aversion to taking risk. Treasury yields are down substantially. Risk premiums have expanded for corporate, mortgage backed, and high yield bonds. Inflation could arguably threaten real returns for most fixed income investments, as CPI is now as high as nominal yields for most fixed income investments. Fortunately though, it appears now may be an opportune time for investors to embrace credit risk. Inflation should likely trend lower from current levels, but not necessarily as low as current market expectations. Source: Lehman Brothers Current 1 Year CPI (July 2008) The spike in total CPI is clearly driven by food and energy over recent periods. Note the obvious aversion to risk as evidenced by increasing credit spreads. Source: Bureau of Labor Statistics; Freelunch.com Source: Lehman Brothers 2

3 Risk Free Bonds: Nominal vs. Inflation Protected One of the most puzzling aspects of fixed income markets is the implied inflation expectation, which is derived by subtracting real TIPs yields from nominal Treasury yields. This is interesting because while inflation has been spiking over recent periods, inflationary expectations have been falling. Given current bond prices, the market expects inflation to be around, or slightly above, 2% over the next 10 years. This has implications for the attractiveness of TIPs relative to nominal Treasuries. If an investor purchased a 10 year TIP at current rates, inflation would only have to exceed 2.2% over the next ten years for the TIP to outperform a nominal Treasury. On the other hand, if inflation were less than 2.2%, the TIP would underperform the nominal Treasury. Implied Inflation Comparison of Nominal vs. Real US Treasury Yields (August 15, 2008) 5 Years 10 Years 20 Years Treasury Yield Treasury Inflation Protected (TIP) Yield Implied Inflation Breakeven Rate Source: US Federal Reserve; Wurts & Associates A snapshot of Treasury markets reveals very low expectations for future inflation, ranging from only 2.0%-2.2% over the next 5 to 10 years. Interestingly, if you examine historic CPI measures, these rates of inflation have seldom been seen over rolling 5 & 10 year periods. Historic Inflation Data (July 2008) Average Rolling Value % of Rolling Periods < 2.2% % of Rolling Periods > 2.2% Rolling 10 Year Periods CPI (since 1947) % 82% CPI x-f&e (since 1957) 4.5 7% 93% Average Rolling Value % of Rolling Periods < 2.0% % of Rolling Periods > 2.0% Rolling 5 Year Periods CPI (since 1947) % 80% CPI x-f&e (since 1957) 4.3 8% 92% Source: Bureau of Labor Statistic; Freelunch.com; Wurts & Associates Source: Lehman Brothers; Wurts & Associates 3

4 Risk Free Bonds: Nominal vs. Inflation Protected (Cont d) Economic theory tells us that growth in money supply and inflation go hand in hand; evidence supports this. Economic theory also tells us that worker productivity will offset inflation; i.e., as workers become more productive, wage pressures are lowered. Evidence supports this as well. Therefore, we can see over recent years that money supply has grown substantially without the associated rise in inflation. This is because worker productivity rose, offsetting inflationary pressures. Given declining worker productivity and huge influxes of liquidity to stimulate the economy, a resurgence in inflation seems a logical conclusion. The Federal Reserve Bank of Cleveland developed an equation to more accurately predict inflation. This model tells us the actual implied inflation rate over the next ten years is 3.0%. If this turns out to be true, TIPs outperform nominal Treasuries. Source: Federal Reserve Bank of Cleveland Inflation seemed unaffected by growth in money supply over recent years. Note how rising productivity served to offset inflation. Source: Bureau of Labor Statistics; Freelunch.com; Wurts & Associates Source: Bureau of Labor Statistics; Freelunch.com; Wurts & Associates 4

5 Corporate Credit Risk The combination of the US economic slowdown and credit crisis has led investors to shy away from all types of credit risk. Corporate investment grade bonds are no exception to this trend. Over time we know that beginning yields for the Lehman Credit index strongly predict subsequent 10 year returns, and that default rates for these types of bonds is very low. Although the economy is likely to weaken, potentially causing defaults, we expect investment grade corporate bonds to outperform Treasuries by at least 2%, annualized, over the next ten years. Average Default Rate 0.07 Standard Deviation of Defaults 0.13 Default rates for investment grade corporate debt are extremely low. Source: Moody s Yields are a very good predictor of subsequent returns. The premium for taking corporate credit risk has spiked. Average Difference (Yield & Returns) 0.13 Standard Deviation of Difference 1.02 Source: Ibbotson; Wurts & Associates Source: Lehman Brothers; Wurts & Associates 5

6 Mortgage Bonds The subprime lending crisis began a broad trend amongst investors to avoid mortgage credit risk. Recent concerns over the potential failure of government sponsored mortgage agencies (i.e., Freddie Mac) only served to bolster investors risk aversion to mortgage securities. The Lehman Mortgage Backed Securities (MBS) index consists of government agency debt: GNMA, FNMA, FHLMC. The likelihood of these institutions being allowed to fail is extremely small due to the potential long term impact on the US economy. Equity shareholders will likely bear the brunt of any insolvency, as opposed to bond holders. This is because the government needs to ensure ample access to mortgages while keeping rates as low as possible. Therefore it seems an opportune time to invest in mortgage backed securities given the implicit government support, especially considering the yield premium over Treasuries. Given current yields, we expect the Lehman MBS index to outperform Treasuries by about 2%, annualized, over the next ten years. Yields are a very good predictor of subsequent returns. Average Difference (Yield & Returns) 0.08 Standard Deviation of Difference 1.30 Source: Ibbotson; Wurts & Associates Source: Lehman Brothers; Wurts & Associates 6

7 High Yield Bonds The current environment for high yield bonds is less clear than other credit markets. This is because of the heavy impact of defaults on returns. Credit spreads indicate a resurgence in defaults is expected. Some simple math illustrates the potential long term return premium over Treasuries from this point going forward. Average Default Rate 4.40 Standard Deviation of Defaults 2.62 Projected 10 Average Year Default Rates Projected 10 Year Annual Excess Return Over Treasuries Defaults below Average (3%) 4.7% Defaults at Average (4.4%) 3.3% Defaults above Average (6%) 1.7% Defaults at Peak Rates (8%) -0.3% Source: Moody s Defaults are a material factor in prospective returns for high yield debt; note expansion between yields and subsequent returns during times of high defaults. The market appears to be pricing a substantial increase in default rates, which could very well be the case given the history of these bonds. Average Difference (Yield & Returns) 3.65 Standard Deviation of Difference 1.68 Source: Lehman Brothers; Wurts & Associates Source: Lehman Brothers; Wurts & Associates 7

8 Conclusions & Prospective Returns US Treasuries appear to be the most expensive of all domestic fixed income opportunities. This is expected during times of economic uncertainty as investors flock to safety. US TIPs appear for more attractive than nominal Treasuries over the next ten years. This is because inflation will likely be higher than currently expected by market participants. Presumably near term CPI expectations are being carried too far into the future as a result of falling energy prices. Corporate and mortgage credit risk seem appropriately compensated given current valuations. High yield spreads could very well expand as the economy weakens, but still offer a modest premium over Treasuries. Real interest rates should increase slightly from current levels as the economy strengthens. Conclusions based on a ten year investment horizon: Shift to TIPs over Treasuries for risk free bond exposures (asset only ignores actuarial/liability considerations) Overweight corporate credit and mortgage exposures Consider high yield debt down the road; not too compelling at current rates. 10 Year Expectations - Based on July Index Yields (assumes slight increase in interest rates) Annualized Real Return (no fees) Annualized Nominal Return (no fees) Lehman US Treasury Index Lehman US TIPs Index Lehman Aggregate Index Lehman M BS Index Lehman Credit Index Lehman High Yield Index Inflation 3.0-8

9 Opportunistic Fixed Income vs. Core Plus Bond Management Opportunistic Fixed Income managers will Focus on a firm s best ideas Make larger allocations to plus sectors Allow for sector allocations to vary widely over time Generally ignore benchmark sector allocations Allow for lower overall portfolio quality Take more aggressive yield curve and duration positions 9

10 Support for Single-Manager Opportunistic Bond Portfolio Performance of individual fixed income sectors has varied widely Opportunity set for opportunistic sector rotation is very large Dedicated sector portfolios would hinder opportunistic rotation Relative Annual Return Comparison for Selected Fixed Income Sectors Highest Return Lowest Return Return Spread LEGEND Bank Loans Core Emerging Global High Yield CSFB Leveraged Loan Index Long Duration Lehman Long Gov't/Credit Lehman Aggregate Low Duration ML Domestic Master 1-3 Year JP Morgan Emerging Markets Bond MBS/ABS Lehman Mortgage Lehman Global Aggregate - Hedged TIPS Lehman U.S. TIPS Lehman High Yield Core Plus Median ea Core Plus Fixed Universe Source: Lehman Brothers, JP Morgan, Merrill Lynch, Credit Suisse, evestment Alliance 10

11 Differences in Opportunistic F.I. Strategies The numerous Opportunistic Fixed Income strategies vary in many ways, including: Sector allocation Benchmarks Hedging Vehicle/Liquidity (Separate Account/Mutual Fund/Commingled Pool) Leverage/Shorting Sector Allocations as of December 31, /31/07 Allocations US Govts/ US Inv. US High US MBS/ Dev. Mkt Emr g. Mkt Agencies Grade Corps Yield ABS Convertibles Debt Debt Bank Loans Other Brandyw ine Global Opportunistic FI 6% 11% --- 2% % 11% --- 8% Loomis, Sayles Multisector Full Discretion 4% 32% 25% 0% 4% 29% 2% 3% 1% Loomis, Sayles Multisector Absolute Return 2% 29% 25% 0% 3% 21% 2% 18% 1% MetWest Strategic Income % 18% 68% PIMCO Diversified Income 1% 20% 24% 18% % Principal Mult-Sector Plus 7% 23% 11% 48% --- 6% 2% 3% --- WAMCO US Absolute Return Strategy 5% 8% 10% 61% --- 2% 3% 11% --- '*"Other" includes cash, hedges, and municipal bonds. Source: evestment Alliance 11

12 Performance has Varied Widely Trailing Performance as of December 31, /31/2007 Performance 1 Year 2 Years 3 Years 5 Years 7 Years 10 Years BlackRock Fixed Income Global Opportunities Brandyw ine Global Opportunistic FI Loomis, Sayles Multisector Full Discretion Loomis, Sayles Multisector Absolute Return MetWest Strategic Income PIMCO Diversified Income Principal Mult-Sector Plus WAMCO US Absolute Return Strategy Lehman Aggregate Index Trailing Standard Deviation as of December 31, /31/2007 Standard Deviation 3 Years 5 Years 7 Years 10 Years BlackRock Fixed Income Global Opportunities Brandyw ine Global Opportunistic FI Loomis, Sayles Multisector Full Discretion Loomis, Sayles Multisector Absolute Return MetWest Strategic Income PIMCO Diversified Income Principal Mult-Sector Plus WAMCO US Absolute Return Strategy Lehman Aggregate Index Source: evestment Alliance 12

13 Opportunistic F.I. Management Additional Risks Additional risk factors of Opportunistic Fixed Income strategies include: Concentration risk leads to higher volatility Increased liquidity risk Shorter track records makes it difficult to evaluate strategies Very difficult to model using standard mean-variance optimization methods 13

14 Opportunistic F.I. Implementation Considerations Total Allocation - Due to higher volatility, Opportunistic Fixed Income strategies should make up no more than 33% of total fixed income allocation. Benchmark Selection Strategies are often benchmarked by both standard market benchmarks (Lehman Aggregate, Lehman Universal, Citigroup World Gov t Bond) and absolute return benchmarks (LIBOR + 2.5%, CPI + 5%). This should be reviewed on a case-bycase basis. 14

15 Supplement Distressed Debt 15

16 Recent Events: Expansion in Buyout Activity Private equity buyout markets serve as a wonderful example of the recent credit bubble. As capital markets were flooded with liquidity, the availability of credit served to fuel massive increases in buyout activity. Investor commitments to these strategies grew by several multiples Loan volume increased by nearly 20 fold from The logical result of these activities given current conditions is too much outstanding corporate debt given the current weak economic environment. Commitments to US Corporate Finance Private Equity Partnerships US Buyout Leveraged Loan Volumes 16

17 Recent Events: Diminution Of Credit Quality Not only did ample credit fuel an expansion in corporate debt, it also fueled an ever diminishing quality thereof. From : The percent of low quality bonds issued more than doubled The debt multiple for leveraged buyouts (LBO) loans went up 50%. Interest coverage ratios were nearly cut in half From a strategic standpoint, one must believe low quality debt will likely suffer in a weak economic environment. New Issues Rated B- or Below as a % of All New Issues Average Debt Multiples of Large Corporate LBO Loans Interest Coverage Ratios: (EBITDA-CAPEX)/Cash Interest 17

18 Market Response: Credit Risk is Being Re-Priced Aversion to credit risk is more than apparent in capital markets over recent periods. Although the sub-prime mortgage market is the only credit sector where substantial defaults are taking place, the emotional implications of this crisis have affected all credit markets. Investment managers are now commonly avoiding credit risk in order to appease perceptions and avoid near term losses. The good news is that investors are being far better compensated for taking credit risk. Opportunities in both public and private markets are the logical manifestation of this aversion to risk. 30% Subprime Delinquency Rate and BBB Spreads % 20% 15% 10% 5% 0% Jun-98 Delinquency Rate Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun Spread to Libor 0 Subprime Delinquencies Sources: Lehman Brothers, Goldman Sachs, Intex; ING Clarion BBB Subprime RMBS Spreads Source: Lehman Brothers 18

19 Market Response: Not All Re-Pricing is Necessarily Rational Opportunity exists in the current market environment because broad re-pricing of risk is not necessarily rational in nature. A very good example of this is the widening of credit spreads in the commercial real estate market. Research indicates that commercial debt defaults are strongly correlated to periods of excess capacity as seen in the mid 1980 s. Over recent periods there is no reason to believe there is significant excess capacity in commercial real estate. As such investor aversion to risk in these credit markets seems irrational in nature, which opens opportunities for disciplined investors. Construction or Absorption as a % of Stock 8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% Office Supply and Absorption Construction as % of Stock Absorption as % of Stock Data as of 12/31/07. Source: PPR Forecast 30% Commercial Mortgage Delinquency Rate and BBB Spreads % Actual Cumulative 10 Year Defaults 25% % Delinquency Rate 20% 15% 10% Spread to Swaps 25% 20% 15% 10% 5% 500 5% 0% Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Commercial Mortgage Delinquencies Jun-05 Jun-06 Jun-07 Jun-08 BBB CMBS Spreads 0 0% Vintage Years Source: PPR, Morgan Stanley, ING Clarion Capital Sources: JP Morgan, Trepp; ING Clarion 19

20 Prospectively: Another Wave of Defaults? Speculative grade debt tends to default cyclically in response to economic conditions. Generally speaking, speculative debt investments are best made during times of economic stress and underweighted during times of economic prosperity. The current and prospective economic environment bodes well for distressed investing due to many reasons. Consensus expectations for GDP growth are low; 1.6% for 2008 & 1.3% for 2009 (source: The Economist). This will make it more difficult for speculative borrowers to service debt Credit costs for borrowers have increased significantly as a result of investor aversion to risk. Borrowers may not be able to afford issuing or refinancing debt. Most intuitively, default rates are at historic lows and it is very reasonable to expect higher rates going forward. Given all these factors, it seems an opportune time to allocate to distressed debt strategies. Source: Moody s Source: Drum Capital 20

21 What are the Primary Areas for Distressed Debt? Mortgages Most distressed opportunities exist in the lowest credit quality portion of the approximately $10 trillion mortgage-backed security universe. However, as is evidenced by the failures and potential failures of many of the nation s leading financial institutions, the market conditions for mortgage instruments continues to be significantly depressed. Corporate Albeit US corporations are yet to experience increasing default rates, it seems reasonable to expect this to change. More importantly though, we are coming off a period of excessive activity in corporate buyouts and an associated decrease in the quality of debt used to finance these activities. Private market investors should be able to take advantage of recent excesses. Real Estate Commercial real estate and residential real estate are not highly correlated with one another. There appears to be ample opportunities in commercial real estate as credit spreads have widened in spite of what appears to be somewhat solid fundamentals in this industry. Of course the implicit expectations of credit spreads could ultimately be proven true (i.e., a large negative impact from a slowing economy). However this is good for distressed investment strategies. 21

22 What are the Basic Venues for Accessing Distressed Credit? Trading Strategies Hedge funds offer the best venue for accessing trading strategies centered around distressed debt investing. The drawback of this approach is its implicit focus on short term market trends in that managers are attempting to garner short term trading profits. This approach is potentially lucrative in any market environment, but there should be more opportunities prospectively. Unfortunately though, the potential effects of being wrong in the near term makes this venue for distressed debt the most risky. Illiquid (Non-control) This strategy involves taking longer term debt positions; trading is not the primary means to add value. Generally speaking target companies are expected to go into bankruptcy and managers will participate in this legal process to maximize the benefits of being a debtor. Positions tend to be somewhat concentrated and large in nature, as investment managers must not only be able to strongly influence bankruptcy proceedings but also be able to focus their efforts on a modest number of opportunities. Illiquid (control & restructuring) This approach is based on the fundamental concept of taking control of a company by being its primary debtor. In a distressed situation a company can be effectively purchased through acquisition of debt more cheaply than through an equity stake. Managers will seek to add value by actively controlling, restructuring, and turning around a given firm. This is another long term approach to investing, and probably has the highest potential for value added. 22

23 Private Equity Segments: Special Situations Distressed Distressed investing can include investments across the capital structure (debt/equity) in either private or public securities experiencing distress*. Types of strategies include short to intermediate term trading strategies as well as more active restructuring and debt-for-control transactions. Types: Distressed Investment Spectrum Trading Strategies Trading Strategies Impact the Reorganization Control Class of Securities Acquire Issuer Rescue Financing / Direct Lending Restructuring / Workouts Hedge Fund Oriented Private Equity Oriented Debt-for-Control / Loan-to-Own Passive Involvement Active Involvement * Distressed securities can include those already in default, under bankruptcy protection or in distress and heading toward such a condition. A common definition of distress in fixed income instruments include securities trading at or above 1,000 basis points over comparable Treasuries. 23

24 Distressed Fund-of-Funds Distressed Fund-of-Funds Candidates Fund Target Raise Description Investment Period Term Mgmt Fee Carry Preferred Minimum Comments Drum Capital SSP Fund III $500 mm Allocates across the distressed spectrum. Focus on private market strategies. Up to 20% co-investments (10% carry). 4 years 9-years 0.8% 3.0% 8.0% $5 mm Final closing before year end Siguler Guff Distressed Fund III $1.5 billion Allocates across the distressed spectrum. Focus on private market strategies. Up to 30% co-investments (15% carry). 3 years 10-years 1.0% 5.0% 8.0% $5 mm Final closing end of November