Junk Debt Saving Pensions and Hedge Funds?
So what's this all about? Allow me to explain in simple terms. The 2008 financial crisis altered credit markets in a profound way. At the height of the crisis, large and small companies couldn't get bank loans as banks preferred focusing on their capital market operations, trading risk assets, profiting off money for nothing and risk for free.
U.S. pension-plan managers are pouring cash into debt from the smallest speculative-grade borrowers, seeking to meet targeted 8 percent returns at a time when average yields are at about record lows.
California’s San Bernardino County Employees’ Retirement Association, which oversees $6.1 billion, is poised to recommend investing in a fund from Tennenbaum Capital Partners LLC that exclusively focuses on lending to smaller companies. The New York State Common Retirement Fund, with about $150.3 billion of assets, committed money to funds from Brightwood Capital Advisors LLC and Monroe Capital Partners LP this year.
Fund managers that oversee retirees’ health and pension benefits are seeking the debt of smaller junk-rated borrowers, pushed toward riskier investments as the Federal Reserve pledges to hold interest rates near zero through 2014. Borrowers with $500 million or less in annual revenue are paying disproportionately higher yields as U.S. banks reduce commercial and industrial lending by 12 percent from the 2008 peak.
“We like this space,” Donald Pierce, chief investment officer of the San Bernardino County pension plan, said yesterday in a telephone interview. “This segment of the marketplace is having a tough time accessing capital,” he said.
Middle-market loans have average yields of 7.8 percent compared with 6.6 percent on large corporate obligations, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data. S&P LCD defines middle market as issuers with earnings before interest, taxes, depreciation and amortization of $50 million or less.
Loans to smaller companies had a 12-month trailing default rate of 1.25 percent in May, compared with 1.05 percent for bigger companies, according to S&P LCD.
Pension plans are poised to play a bigger role in financing the smallest companies after banks reduced commercial and industrial loans and leases to $1.4 trillion as of May 30, from $1.6 trillion on Oct. 22, 2008, according to Fed data.
“The strategy is definitely getting traction,” said Frank Barbarino, a consultant with NEPC LLC, an investment adviser. “It’s that magic 7 to 8 percent number that institutions are shooting for at the plan level. Many are willing to lock up their capital for a few years in order to add strategies that help them get there.”
Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbing by 0.9 basis point to a mid-price of 124.3 basis points as of 11:24 a.m. in New York, according to prices compiled by Bloomberg.
The index typically rises as investor confidence deteriorates and falls as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of bond market stress, declined 0.03 basis point to 30.18 basis points as of 11:24 a.m. in New York. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of Brazil’s Embraer SA (EMBR3) are the most actively traded dollar-denominated corporate securities by dealers today, with 60 trades of $1 million or more as of 11:26 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The world’s fourth- biggest planemaker sold $500 million of 5.15 percent, 10-year bonds yesterday.
San Bernardino’s pension plan, attracted by bigger yields and more favorable covenants, is setting its sights on the smallest borrowers as it faces an actuarial rate of 7.75 percent, Pierce said. Pensions for public employees typically trail the 8 percent average yearly gains that officials set as their benchmark to cover rising costs.
The New York State Common Retirement Fund allotted money for the first time this year to funds from Chicago-based Monroe and New York-based Brightwood Capital, which is led by Damien Dwin and Sengal Selassie. Both firms focus on investing in smaller companies.
Pennsylvania’s Public School Employees’ Retirement Board, which oversaw $50.8 billion as of March 31, 2011, agreed in March to invest as much as $200 million in Cerberus Institutional Partners V LP.
The fund will buy “distressed assets on a global basis” and invest in “private-equity turnarounds focused on the middle market,” according to a Feb. 16 letter to the pension plan’s trustees from Portfolio Advisors LLC, recommending the investment.
“All these pension funds have a huge issue right now: they need to hit a 7 to 8 percent annual return in order to hit their actuarial needs,” said Theodore Koenig, Monroe Capital’s chief executive officer. “The market isn’t giving them that.”
Demand for the debt comes as smaller companies seek a place to borrow. Issuance of loans to the smallest companies has declined to $3.77 billion for the first five months of the year, compared with $7.59 billion during the comparable period in 2011, the S&P LCD data show. In the first five months of 2007, the borrowers sold $15.3 billion of loans.
“In the large-cap market, the maturity wall has been pushed out with the ability to issue high-yield debt in 2011 and 2012,” Monroe Capital’s Koenig said. “In the middle market, that has not been the case.”
About $130 billion of loans that are less than $100 million each are coming due in the next five years, according to Newstar Financial Inc.
“The banks have pulled away in fairly significant ways over the past several years although they’re returning to the market in some capacity,” Barbarino said. “Middle-market loan volumes are down, and banks are focused on larger companies.”
Corporate bonds and loans set to mature through 2014 tumbled 66 percent to $413 billion as of last September from $1.2 trillion at the end of 2008, according to JPMorgan Chase & Co. research.
U.S. leveraged loan issuance has totaled $257.7 billion this year and $603.6 billion in 2011, Bloomberg data show. U.S. junk bond sales have totaled $138.5 billion this year.
Issuance of collateralized loan obligations may reach $30 billion this year, JPMorgan said in April. That’s down from $91.1 billion at the peak of the market in 2007, according to Bloomberg and Morgan Stanley data. CLOs buy high-yield, high- risk loans, including those from smaller companies and slices them into securities of varying risk and return.
“We have seen a couple of new entrants in the market, but as you know, the middle-market lender universe has been thinned dramatically over the past few years,” said Timothy Conway, Newstar’s chief executive officer, in a May 2 earnings call.
Pension plans are facing “lackluster” returns in 2011 that weren’t sufficient to offset rising liabilities, causing funding gaps that are poised to widen, according to a Feb. 14 Fitch Ratings report.
The California Public Employees’ Retirement System, the largest U.S. pension, has seen its market value decline 4.8 percent this year after stocks fell amid the brewing fiscal crisis in Europe and slowing of the U.S. economic recovery.
Investment-grade bonds yield 3.49 percent, according to Bank of America Merrill Lynch index data, while U.S. Treasury 10-year notes are at 1.66 percent. Including reinvested dividends, the S&P 500 (SPX) has returned 6.3 percent this year after gaining 2.1 percent in 2011.
“Pension plans are really looking to expand the list of approved investments,” said Mark Oline, Fitch Ratings’ global head of corporate ratings in Chicago. “Secured loans were not very common in the asset list but are gaining favor in portfolios.”
As credit markets 'normalized', large companies were able to issue debt and start lending from big banks, at a higher cost of capital, of course. But small and mid-sized companies were effectively shut out and are still not able to get banks to lend to them.
Here is where credit hedge funds and pension funds that allocate capital to them come in. These funds 'lend' money to small and medium sized businesses starving for capital. If it sounds like legalized loansharking, that's because it is, but the truth is they are serving an economic need, providing credit to companies that aren't able to secure bank loans.
They do this by investing in junk bonds or by lending directly to companies through asset based lending. It's a risky business but the best hedge funds all invest in these strategies. And it can be immensely profitable for hedge funds and their pension fund investors.
In fact, Katya Wachtel of Reuters reports, Credit hedge funds profit despite rocky markets:
In a year of uneven returns for many U.S. hedge funds, managers who invest mainly in bonds have outshone stockpickers.
Over the first five months of the year, credit-focused hedge fund portfolios were up 4.11 percent compared with a 2.4 percent gain for stock-focused ones, according to hedge fund tracking service eVestment|HFN.
Well-known managers such as David Tepper and Daniel Loeb have seen hefty returns in their credit-focused portfolios on bets they made in the second half of 2011.
Some managers are profiting from those shrewd trades, which they made on mortgage-related securities, U.S. corporate debt and beaten-down European sovereign and corporate bonds. Others, meanwhile, benefited from an early move into junk bonds, which have been one of the credit market's better-performing sectors this year.
It is another indication that, in a year of great turbulence in the stock market, bonds have been the place to be despite the yield on the 10-year U.S. Treasury hovering around 1.61 percent.
"At the end of last year, European financials were massively battered down so we went long those corporate credits - they were great investments," said Peter Faulkner, a credit portfolio manager at $2 billion P. Schoenfeld Asset Management.
Similarly, Third Point's Dan Loeb, in a May 4 investor letter, said successful bets on corporate credit during a debt market selloff last October, led to strong gains on those positions in the first quarter.
PSAM's credit fund, which was up 6.6 percent through May according to HFN, also benefited from gains in corporate credits that have exposure to U.S. housing such as iStar Financial Inc (SFI.N) and Residential Capital LLC RESC.UL.
James Malley, who co-manages the PSAM credit fund with Faulkner, likened the fund's gains this year to "harvesting" investments it made last year.
The PSAM fund profited, in part, from the European Central Bank's move to pump more money into the euro zone banking system earlier this year in an attempt to stabilize the economic situation. The effort temporarily boosted liquidity and confidence, which led to a rise in corporate bond prices around the globe.
Also funds that were early to buy high-yield debt benefited from a growing sentiment that corporate defaults were unlikely given signs of a strengthening economy and a search by investors for securities that yield more Treasuries.
But the high-yield market has given back some of this year's gains in the wake of recent weaker jobs data and renewed worries about Europe.
ROUGHER ROAD AHEAD?
This year retail investors have made a similar big move into bond mutual funds, as they flee stocks and seek to avoid risk. Through May, bond mutual funds gained $139.84 billion in net inflows, while equity mutual funds saw $27.21 billion in net outflows, according to estimated data from the Investment Company Institute.
But some analysts wonder whether the big gains for credit funds in the hedge fund universe have already been achieved for the year. These analysts suggest it will be much tougher for debt funds going forward with yields on high-quality corporate debt declining and an uptick in U.S. home foreclosures that could spell trouble for mortgage-backed securities.
"Most of the positive year-to-date performance in credit strategies can be attributed to January through March," said Minkyu Michael Cho, a research analyst at eVestment|HFN.
In May, credit-focused portfolios fell 0.02 percent, according to eVestment|HFN. But that was not as bad as the sharp 3.31 percent decline registered by stock-focused funds in May.
Still, the credit market also has proved to be a bumper crop for Tepper's Palomino fund, which is one of the largest portfolios managed by his Appaloosa Management. The $5 billion credit fund rose 12.94 percent through April 30, according to data collected by HSBC Private Bank.
Another top performer is Andrew Feldstein's Bluemountain Credit Alternatives Fund, which was up 7.85 percent through May 25, according to HSBC data. Another Bluemountain credit fund, a long short credit portfolio run by Derek Smith, was up 3.72 percent through May 25.
The Brevan Howard Credit Catalysts Fund has risen roughly 6.5 percent through May 25, and a CQS ABS Feeder Fund had gains of almost 5 percent through April 30. Meanwhile, the Mariner-Tricadia Credit Strategies fund was up 5.14 percent through May 15.
The stand out performance by credit-focused funds has helped some managers offset sharp losses in their stock funds. One example is John Paulson, whose flagship Paulson Advantage fund is down 6.3 percent this year, while Paulson & Co's Credit Opportunities Fund is up 5.26 percent.
Global credit-focused fund Pamli Capital Management, which earned big gains earlier in the year on trades in mortgage-backed securities, has risen 1.6 percent for the year, according to an investor note.
But eVestment's Cho said with yields coming down on high-grade U.S. corporate debt and Treasuries, the easy money may have been had.
"It seems the move to safer assets may actually have hurt credit strategies over the course of the year," he said. "Yields have come down across the board for U.S. treasuries since highs in March, and yields have also come down for U.S. AAA corporates."
With all these hundreds of billions pouring into credit strategies, one may rightly ask whether there is a bubble in junk bonds. I'm not convinced there is a bubble, partly because of the reasons I cited above. There is a structural disconnect in credit markets and hedge funds are capitalizing on it.
Having said this, there is an awful lot of money being poured into bonds, period. Investors fearing the worst in Europe have seeked refuge in U.S. treasuries while others are taking risk via corporate bonds and junk bonds, making a killing in the process.
And it's true that credit hedge funds have been beating their stockpicker counterparts. Bloomberg reported that hedge fund manager Paul Sinclair is the latest casualty of Europe’s sovereign-debt turmoil, is closing his fund due to poor performance:
Sinclair, who is based in Los Angeles, is liquidating his $458 million health-care equities fund, Expo Capital Management LLC, after more than five years, as political decisions made on the other side of the globe have undermined his stock picks and spurred losses for a second year.
“I don’t have an edge on Greek elections, the Spanish banking system, what the European Central Bank, the International Monetary Fund, the Chinese government, Angela Merkel, or the U.S. Federal Reserve will do,” he said in a telephone interview yesterday.
Sinclair, 41, said that over the past year he’s found it increasingly difficult to make money because of the macroeconomic environment, and that investing in health care since 2004 has left him “physically and mentally exhausted.” He said he chose to return money to investors, which he plans to do by the end of the month, rather than hold cash and charge them fees.
Billionaire energy trader John Arnold, former Morgan Stanley co-president Zoe Cruz, and Duke Buchan III are among managers who have shuttered hedge funds in the past year as Europe’s sovereign-debt crisis has roiled global markets. The industry last month posted its biggest loss since September as stocks slumped on concern Greece may exit the euro and the global economy is weakening.
But other hedge fund managers are making out like bandits this year in credit and stockpicking. David Tepper made a killing in airline stocks:
That is the way the cookie crumbles in the high stakes game of hedge funds. Some win, most lose and it's a constant struggle to make money, especially in these macro news dominated markets.
Warren Buffett has an antipathy toward airlines. He has said that "the net wealth creation in airlines since Orville Wright has been next to zero" and called his own investment in US Airways in the early 1990s one of his biggest mistakes.David Tepper, the master of distressed investing who made billions during the financial crisis, typically enters a scenario when there is a bankruptcy involved and an opportunity to gain after others have lost. This was the case with his two big airline purchases of the first quarter: US Airways Group (LCC 0.00%) and Delta Airlines (DAL 0.00%). His uncanny timing led to an average gain of 82% on them to date this year.
The bigger winner was US Airways, which has gained 135.1% year to date as it has pushed to new 52-week highs. Tepper added 7,419,026 shares of the airline in the first quarter at an average of $7.40. He already held 3,238,217 shares, making a total holding of 10,657,243.
The stock's rally began in late January when the company reported its fourth-quarter results and announced that it had hired M&A advisers to possibly take over AMR, the bankrupt holding company of American Airlines.
In the fourth quarter US Airways made a fourth-quarter net profit of $21 million, compared to a fourth-quarter 2010 net profit of $28 million, mainly due to a 38% increase in consolidated fuel prices and partially offset by an approximately 10% revenue increase.
Below, Bloomberg's Sara Eisen reports on the challenges faced by the European banking system. And former Greek Prime Minister George Papandreou speaks with Bloomberg's Sara Eisen about what's at stake for Greece and for all of Europe if Greece were to exit the euro. He speaks on Bloomberg Television's "Inside Track."