Investing in distressed assets has plenty of appeal in a low interest-rate environment, and yet interest is outpacing activity levels, particularly in what many investors had hoped would be an active European market. Veteran banker Robert Willoughby explains to Alpha Now why that might be the case, and lays out the real risks associated with this investment strategy.

In an investment universe characterized by ultra-low interest rates and rock-bottom yields on the safest of fixed income securities, investors are succumbing to the temptation to push the envelope and set out in search of ever-higher yields. At its most basic level, this has been reflected by the strong and sustained interest in high-yield mutual funds on the part of both retail and institutional investors; among more sophisticated institutions, it has also led to a growing interest in putting money to work in the distressed debt markets. The latter trend may have been sparked by the high yields available to savvy investors, but it has been further fueled by the returns that some have been able to capture.

According to data from Eurekahedge, distressed debt was the top-performing hedge fund strategy in 2012, generating an average return of 13.67% for the year and an additional advance of nearly 4% in the first two months of 2013. (Data for March were not available at the time of writing.) Despite what Robert Willoughby, the former chairman of the Leveraged Finance Origination and estructuring Group at Credit Suisse, describes as growing interest in distressed investing as an asset class — especially on the part of insurance companies, pension funds and others trying to reconcile the need to meet fixed payout obligations to their clients with the low-yield investment environment — inflows and investment activity in this space has yet to take off. Indeed, data from Eurekahedge show that while assets under management in distressed strategies totaled 6% of all assets under management in strategic mandates as of December 2007, that had declined to 5% as of December 2009 and a mere 3% as of December 2012. Indeed, net flows were negative to the extent that for every dollar of performance gain, they witnessed $2 of net outflows on a relative basis.

It was in the context of this data that a group of distressed investing specialists gathered at the global headquarters of Thomson Reuters in New York in mid-April to discuss this conundrum and other issues related to the emerging asset class. The audience was treated to an overview of the macroeconomic trends driving interest in distressed investing as well as insight into some of the specific opportunities that may be emerging, in the defense industry and cyclical businesses such as shipping here in the United States, for example, as well as those arising from Europe’s twin banking and fiscal crises.

The latter issue is of particular interest to Willoughby, whose own views have been shaped through his work in the banking universe, which has included posts overseeing high-yield bond issuance and working on corporate recapitalizations and restructurings. Having just returned to the United States after 19 years spent based in Europe, most recently with Credit Suisse, Willoughby, who in his previous role rarely discussed these topics publicly but who now is making an exception for Alpha Now, says he has watched as the interest in distressed debt has increased along with the difficulty in investing in the asset class. One hedge fund CEO Willoughby said he has spoken to recently confirmed his interest in the asset class, and in particular the opportunities that the European crisis might create. But, as the CEO told Willoughby, “we haven’t figured out how to crack the Euro market” yet.

It isn’t just the European market that offers challenges to potential investors in distressed securities, however, as Willoughby pointed out in a far-ranging conversation with Alpha Now only days before the panel discussion. “As a distressed investor you are buying something someone else created; you have to be a forensic financial analyst to understand what the instrument is really worth, and to understand the appropriate discount,” he explained. “A lot of the debt instruments that people are chasing, are discounted because they should be, because the borrower can’t pay or because the current owner needs to sell and there isn’t a demand” for the assets in question, so the prices plunge.

As an investor moves further along the risk spectrum — from analyzing investment-grade corporate bonds, to seeking out opportunities in high yield securities and ultimately trying to understand the nuances of distressed investing — the complexity and magnitude of the due diligence challenge increases. The further along that continuum an investor moves, Willoughby says, the more due diligence he or she must be prepared to undertake, and the more aspects of the transaction must be scrutinized. For instance, investors in investment-grade corporate debt and the better quality of high-yield issues can “borrow confidence” from analysts who publish research on the company or who apply a credit rating to the specific security. That kind of guidance is absent from the distressed investing arena, where potential investors don’t just have to understand the asset they are buying, or the motivations of the seller and of other potential buyers. For instance, Willoughby points out, “the value of leveraged loans in Europe in 2007 and 2008 fell off a cliff; prices went from 96 to 76 (per $100) without hard evidence of impairment (of the credit quality) just because demand fell off a cliff.”

Willoughby believes that similar issues are constraining growth in today’s European market, which logic suggests should be full of opportunities for eager investors in distressed assets. Certainly, those investors have been anticipating a big influx of supply, he says, in which they could go “trawling” for deals. Theoretically, Willoughby adds, that would create a pool of bargains made up of assets that are cheap because of the volume of supply rather than the poor or deteriorating credit quality. In practice, he says, what has happened is that European banks, in particular, have been slow to dispose of assets. “The slow pace of selling has forced the creation of a much more rational and rational market price,” he says. “If something trades at 65 (cents on the dollar), either that is what it is worth or the unknowns justify the price.”

How does Willoughby explain the mismatch between the degree of interest in European distressed debt and the level of activity? Part of the answer, in his opinion, has to do with banks’ accounting treatment of their loan portfolios and other assets that could end up in the distressed market — but only if the banks are willing to write down those assets and then accept the need to raise more capital to compensate, at a time when regulatory requirements for bank capital are rising.

The difficulties associated with cross-border investing in distressed assets is another reason that activity in the European market has been constrained, Willoughby suggests. Moving offshore simply magnifies the existing challenges associated with distressed assets. “When you have multiple assets, each of which has a legal claim whose validity you have to investigate” the level of complexity increases, he says. “And when you are in the Spanish market, where a secured interest isn’t understood the same way, you really don’t understand what the net value of the claim will be because don’t know when or how much you will be repaid.”

The end result is a tug-of-war of sorts between highly-motivated investors, eager to capture a few extra percentage points of yield and the kind of upside return that this corner of the financial market already has demonstrated its ability to generate. The questions that have weighed on Europe’s potential to become a hub for distressed investors are simply some of the more obvious ones that came up for review during the panel discussion, but they capture some of the broad issues of valuation, liquidity and risk that any investor in this space must take into consideration, those panelists agreed.

See more at alphanow.thomsonreuters.com. Follow Alpha Now on Twitter at @Alpha_Now.

Bankers and investors were getting a sense of deja vu last week as news from Cyprus reminded them of the Grexit jitters almost three years earlier. “We can be grateful we have seen three years of very benign markets, but I’m not sure what would happen if the market sees some serious volatility,” said one syndicate banker in Hong Kong.

Some real-money accounts and even private bankers echoed his concern because they saw the possibility of a correction in the market, while uncertainty about the future of the eurozone returns to the fore.

“We have seen this before. First, you see volatility pick up just after a wave of supply and, then, there is a correction,” said a high-yield fund manager.

He was referring to the active primary market, which saw almost US$6.5bn in new dollar issues from Asia ex-Japan in the first three days of the week, topping a very active March. The region reached the quarter-end having printed close to US$42bn in dollar bonds, an absolute record for the period.

Amid so much issuance, it is surprising that the market is holding up as well as it is. “The credit market has been very resilient,” said another real money investor.

Still, that strength started to be tested last week with the volatility from a potential banking crisis in Cyprus finally spilling over to the rest of the world. The Asia ex-Japan iTraxx IG Index closed 7bp wider Thursday, at 123bp and JP Morgan Asia Credit Index finished the short week 21bp wider in yield terms.

The steeper drop on the cash side was evidence of one of the reasons for investor concerns. Asian markets remain illiquid and, although they have matured and grown of late, they still suffer sharp swings whenever there is a correction. Furthermore, institutional investors have become increasingly concerned about the build-up of leverage in the system as private banks and hedge funds buy bonds on margins of up to 90% at times.

Both factors together can exacerbate any correction something that was last seen after the downgrade of the US caused a selloff in the high-yield market. Investors admit that, if there is a correction, the high-yield side will take a bigger hit.

However, at the same time, the asset class is also the only one for which they still see some upside because of the looming rise in benchmark rates. “For the time being, people want yield and junk bonds still provide a better cushion against rising Treasuries,” said one real-money investor.

That dynamic, in fact, was seen in secondary markets last week, as the high-yield bonds ended the week above reoffer even as the rest of the market sold off.

The new five-year bonds of Tower Bersama Infrastructure, for example, closed the week at 100.25, 25 cents above the reoffer. Sunac’s deal, which was priced on Thursday, ahead of a wider market selloff, held the reoffer price on the break.

Citic Pacific’s new seven-year bonds ended their first trading session Thursday at 100.50, having priced at par. Even Greentown China saw its 2018s return to 103.00 Thursday after they were reopened at 102.50.

On the flip-side, investment-grade issues all widened. The five-year bonds of split-rated Bharti Airtel dropped to 100.25, below the tap reoffer of 100.625. SmarTone, which, in spite of being unrated, trades on spread and is, as such, an investment-grade credit, ended its first session 10bp wider than reoffer at 225bp over Treasuries. As for Suzlon’s bonds, with a backing of a standby letter of credit from State Bank of India, they never recovered the 20bp they widened on the break earlier in the week.

Clearly, investors do not seem to be positioning for a pickup in volatility, which would prompt an investment-grade rally. If anything, they seem more concerned about additional supply than headline risk.

One hedge fund manager was of the opinion that credit investors in Asia were in a conundrum right now. “If conditions improve, there will be a supply wall and that caps the outside; if volatility increases then we lose anyway,” he said.

However, their bet on high-yield, ultimately, points to strong faith in the ability of central banks to keep pumping money into the system. “You cannot fight the Fed, especially when it is acting in tandem with the Bank of Japan and the ECB,” said one private banker.

A credit analyst in Singapore said that data in the US was looking better and that, if the world’s largest economy started picking up the pace, Asia would benefit. He added that, if Europe saw more volatility, investors were even more likely to park their money into Asian assets. “Asia and EM will both benefit from continued monetary easing,” said the high-yield manager.

As long as the Fed continues to ease, it seems, any volatility will merely be a hiccup.

By Christopher Langner

400 Capital’s Chris Hentemann says he still sees investment opportunities in residential mortgage debt despite the housing recovery, and is increasing his exposure to commercial real estate debt.

You can tune in to all of Reuters Insider’s exclusive GAIM 2013 coverage by clicking here.

Dan Zwirn, who delivered the keynote address at HedgeWorld New York 2012, discusses getting back into business with investment opportunities in the United States and Europe after deciding to wind down his $6 billion hedge fund in 2008.

You can tune in to all of Reuters Insider’s exclusive GAIM 2013 coverage by clicking here.

Here we take a look at December 2012 absolute performance for the top 5 equity market neutral funds in two categories - all funds and U.S.-only funds - as tracked by Lipper’s hedge fund database. To see more analysis, including assets under management and domicile information for the top 10 funds in each category, click here for all funds and here for U.S.-only funds. To be truly connected to all the Lipper analytics available on HedgeWorld, become a HedgeWorld Premium Plus member. To find out more about how to do that, visit hedgeworld.com/membership/.

The latest twist in the legal battle between Argentina and hedge fund holdouts of its 2005 and 2010 bond exchanges has cast doubt on whether credit default swaps referencing the country’s debt may trigger.

U.S. District Court Judge Thomas Griesa ruled on Nov. 21 that Argentina must pay holdouts when it comes to make regular payments to exchanged bondholders in December.

This will not apply to a $42 million coupon payment on new 2017 bonds on Dec. 2, but a $3 billion payment due on Dec. 15 to holders of GDP warrants and a $200 million coupon payment to discount bondholders on Dec. 31 will not be able to proceed without also paying the holdouts.

GDP warrants do not count as a debt obligation as far as CDS are concerned, said Ian Harvey-Samuel, a partner with Shearman & Sterling, so a missed payment on the warrants would not be relevant for protection holders. The question of whether CDS could still be triggered following a bond coupon payment made to the trustee, but not passed on to investors, is more of a grey area.

“There are different ways that Argentina might discharge the liabilities on their bonds that don’t necessarily result in payment to the bondholders. That’s not a particularly clear issue in the way that the trust indentures are drafted,” said Harvey-Samuel, speaking on Nov. 21 before the latest court ruling was made public.

In particular, the fact that Argentina is making payments to bondholders in December via a trustee (BNY Mellon) complicates matters. If Argentina made the payments to BNY Mellon, which opted against immediately passing the cash on to bondholders for fear of incurring the wrath of the court, it is not clear whether CDS would trigger as a result of a failure-to-pay credit event.

“The mere fact that the noteholders don’t receive payment doesn’t necessarily mean that there’s been a failure-to-pay on the bond; it would very much depend on the terms and conditions of the bond itself,” explained Harvey-Samuel. “Until we know what Argentina does and until it asserts its position with regard to the legal effect on its proper bonds, we don’t know whether or not CDS would trigger.”

Trading the trigger

Argentina CDS—which has a net notional outstanding of $1.8 billion, according to the DTCC—has become a major focus for emerging markets traders ever since the New York appeal court on Oct. 26 upheld the view of Judge Griesa that old bondholders should be treated equally to those that had agreed to the restructuring.

Five-year CDS ballooned from 974 basis points on Oct. 25 to a record wide of 2,589 basis points (or around 50 points upfront) on Nov. 16, according to Markit. It then re-traced slightly early last week, before rocketing wider to 3,594 basis points during Nov. 23 trading as the market absorbed the latest news.

“When it was known that BNY Mellon was going to be implicated in this, there was a concern that Argentina may make payment to bondholders in a way that could technically trigger CDS, which caused the CDS to gap wider,” said Sean Kelly, an EM credit trader at Credit Suisse, also speaking before the latest ruling was made public. “Some of those reservations over CDS have since disappeared, but we don’t see accounts adding new risk positions here. We mostly see hedge funds taking profits on long protection positions on the back of the CDS widening.”

Some of the activity Kelly saw in the earlier part of last week related to some accounts selling one-month credit protection, taking the view that the court would not lift its stay and Argentina would be free to make its December payments to exchanged bondholders. Now, such bets could well turn sour, given the latest announcement.

Read more from IFR here

By Mark Shore
mshore@shorecapmgmt.com

Since the economic decline in 2008, there has been a growing demand of individual and institutional investors to consider various choices of non-correlated investments to reduce tail risk (downside deviation)(i) and correlation risk, often known as alternative investments.

There is a good chance an investor will have stocks and bonds in their portfolio via a 401k, IRA, pension fund or directly into mutual funds. Perhaps they have some real estate either as an investment or the home they live in and maybe some private equity.

In 2008 and 2009, most stocks both domestically and foreign became highly correlated as they headed south and everyone was seeking the exit door simultaneously, thus causing losses to extend as panic selling and the need to liquidate increased.

One of the increasing areas of non-correlation investment is the currency market or sometimes called forex or FX (foreign exchange). In August, 1971 President Nixon removed the U.S. dollar from the gold standard, ending the Bretton Woods agreement and causing currencies to float at market rates. In December 1971, Professor Milton Friedman wrote “The Need for Futures Markets in Currencies”.(ii) May, 1972, the Chicago Mercantile Exchange introduced currency futures.(iii)

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Copyright ©2012 Mark Shore. Contact the author for permission for republication at mshore@shorecapmgmt.com Mark Shore publishes research, consults on alternative investments and conducts educational workshops. www.shorecapmgmt.com Mark Shore is also an Adjunct Professor at DePaul University’s Kellstadt Graduate School of Business in Chicago where he teaches a managed futures/ global macro course.

Past performance is not necessarily indicative of future results. There is risk of loss when investing in futures and options. Always review a complete CTA disclosure document before investing in any Managed Futures program. Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone. The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.

Reuters’ Jennifer Ablan and Breakingviews’ Antony Currie say that, after Moody’s downgraded ratings for several banks, the debt is still a more attractive investment than the stock. (more…)

Are we really heading towards Armageddon or is everything being a bit overdone? There was certainly a sense of barely-contained panic in the air on Thursday and Friday as we headed into the make-or-break Greek election.

With Greece undoubtedly the focus event, the state of the Franco-German axis is also weighing on minds.

It’s getting more and more fractious as Angela Merkel and Francois Hollande trade increasingly barbed comments on a range of issues, from moves towards fiscal union with centralized budgetary control, and the policies and policy mix required to turn the EU economy around, to the knotty issue of euro bonds, euro bills, the debt redemption fund and a banking license for the ESM that will enable the rescue fund to up its firepower by borrowing from the ECB.

Beyond that, French parliamentary elections, and the results of Spain’s government-commissioned bank audit – which will determine the scale of the country’s bail-out lite – are also on the agenda. Who’d be an investor in the face of so many cross-currents?

As luck would have it, leaders of the G20 along with observers from the IMF, ECB et al will at the very least all be together as a Mexican beach in Los Cabos, site of the G20 Summit, becomes the nerve centre of emergency policy response if it’s required.

Back to my opening question. I have a feeling that the panic and disaster scenarios have all been a bit over-engineered. Talk of the Greek bailout agreement being torn up; Greece exiting the euro; restrictions on ATM withdrawals and capital controls introduced; banks being shut; a destructive transmission effect that forces Spain and Italy into bailouts that are beyond the capability of the bailout mechanism to cope with, given the magnitude of the task: it’s pretty scary stuff.

I could be completely wrong, but I have a sneaking suspicion that trading into the start of the coming week and beyond could be a bit of an anti-climax. For a start, central banks worldwide have acted in a quasi co-ordinated way to stop the rot and are standing by to pump liquidity into the system and basically do anything that’s needed.

The Swiss National Bank and the Bank of Japan are poised to intervene heavily in currency markets to prevent their currencies soaring on safe-haven flows, in the process curbing speculative behavior. The Bank of England is kicking off its Extended Collateral Term Repo Facility on June 20 (monthly auctions: minimum ÂŁ5bn at 75bp) and along with the UK Treasury will unleash a ÂŁ100bn scheme to pump medium-term credit into the UK economy.

Meanwhile the European Central Bank will lend liquidity support to EZ banks as required, while ECB president Mario Draghi also implied the bank was willing to cut rates. The Bank of Greece has the facility to inject cash into Greek banks via the Emergency Liquidity Assistance scheme.

The amount of official firepower out there to keep things orderly actually pushed equities, the euro and peripheral government bonds higher on Friday, with Spanish 10-year bonds falling back below that 7% barrier of unsustainability.

Also helping sentiment was talk that even if the Syriza party does come out on top in the Greek elections, the result is more likely to be a negotiated flexibilisation of terms than a redo of the deal’s core requirements. I suspect that Alexis Tsipras’ pledge at his last rally, “The memorandum of bankruptcy will belong to the past on Monday,” is likely to be political rhetoric.

Not surprisingly, there was a lot of position-flattening into the weekend as investors, spooked by all the talk of euro exit firestorms, sensibly took money off the table and covered short positions.

Here’s a thought, though: markets can and often do exhibit perverse and contrarian behavior. The results of the Greek election could well be inconclusive; and there’s going to be a grace period of at least 100 days in any case while the new government is formed and figures out its stance on a whole range of issues.

If, at the same time, the Spanish bank audit shows that capital requirements are at expected levels or even lower, and the €100bn bailout isn’t taken up in full; and if the G20 at least makes some progress towards agreeing goals and a way forward on key issues at its Summit, we could get a rapid if opportunistic about-turn in sentiment and a pop in prices over the course of the next few days.

It’ll be a classic short-run fast-money trade, but on the basis that things are never as bad as they seem or indeed could be, I reckon the overwhelmingly bearish overall sentiment could well be played here for some flighty gains.

And last word on Jamie Dimon. I was shocked by the performance of the JP Morgan boss’s interrogators at the Senate Banking Committee hearing into the credit derivatives losses. But this isn’t about the losses. For a bank the size of JP Morgan, they’re insignificant. The losses destroyed a chunk of shareholder value, but that’s an issue for the bank and its investors.

What the hearing failed to get to the bottom of was the egregious (to use a Dimon word) failure of internal controls at the bank. Dimon was happy enough to explain that the losses were the result of traders not knowing what they were doing, a risk committee that wasn’t independent enough, management that failed in its duty, and a broken chain of command.

That’s the terrifying aspect of this saga. What the Senators failed to ask and Dimon failed to mention was: why?

Keith Mullin is Editor-at-Large of International Financing Review (IFR). You can e-mail him at keith.mullin@thomsonreuters.com. This article originally appeared on ifre.com.

BNP Paribas’ Marty Fridson says high-yield debt is trading at close to extreme spreads relative to fair value and that we won’t see any significant tightening until Europe’s issues are resolved. (more…)