Pre-Lehman, credit guys were plucky guys facing the financial universe with a spreadsheet and an R module. Soon enough, it looked like they had it cowering in fear. Post-Lehman, the same universe treats them with a cold irony, their own meagre devices rather helpless given forces beyond their control.
Then central banks came in and tamed the wild curves. Flooded with liquidity, the markets benefited from this windfall. Yet the massive influx of additional liquidity makes markets behave even more strangely: by crowding out investors, the very high price of “risk-free” bonds gradually spreads to all asset classes. The swollen risk premium (difference between the returns on equities and government bonds) that results from tumbling bond yields is seen as justifying equity markets’ high valuations.
It is no surprise that in this financial world there is a raging battle between the deflationary pressures of deleveraging and central bank intervention. The reality of economic cycles in China and elsewhere is fuelling chaos on financial markets yet again. It will take a deeper integration of the tools of the credit guys and the tools of the bond guys.
So we see big movements in the markets with lots of correlation. Equities markets (EuroStoxx -20%, S&P -10% for the same period) and implied volatilities (VDAX & VIX doubled in the last two months). Commodity prices cratered and as a consequence EM countries in particular the commodity weakness assumed meaningful possibility of default. 5Y CDS spreads of Brazil, Malaysia and South Africa widened by between 50% and 100% in the 3rd quarter.
The high volatility that investors had to put up with on equity markets in August owes much to the weight of passive, algorithmic management, as well as the hedging of huge open option positions, which mechanically triggered buy and sell orders, amplifying market movements.
The index movements in the CDS market are now mostly systematically driven on both sides of the Atlantic and in Asia and therefore highly correlated.
The way to beat the dominance of algorithmic trading is to exploit the market price anomalies they generate. These anomalies being the trending or mean reverting tendencies of relative prices. The price anomalies could also reflect a premium for a hidden risk. Shifts in the asset allocation of global investors could lead to inefficiencies. These shifts typically occur over a longer period of time and could thus be exploited with a dynamic investment strategy. The trick is to identify the hidden risks and idiosyncracies embedded in the dynamic tendencies between different instruments and asset classes.
The current market environment is very favorable from a capital structure perspective. In September, a lot of money sold positions in a state of near panic, which meant opportunities arose. Especially in the stressed segments (e.g. US basic resources), equities/bonds performed very differently. In late October, inflows started moving back into high yield.
Despite the shift in risk appetite, in a weakened world it is vital to be in a position where one can very quickly adjust equity, interest rate and currency risks. This is in the credit guy wheel-house. And investments must be in flexible companies themselves, i.e. generating cash and having little debt. This is a bond guy skill.
Trading will use procedures that are simple in nature, but technical in their implementation. For example:
optimal management of long/short positions to generate alpha with little market risk. Bond portfolios balanced to generate the maximum return that can be made from little directional positioning on yields
barbell positions (balanced between strong but volatile conviction picks and dull, but very stable assets)
highly de-correlated assets
relative strategies on different segments of the yield curve (currently assuming a flatter US yield curve)
Risk management is both essential and also very tricky. It requires distinguishing between actual risk, i.e. the possibility of suffering “permanent” losses, and volatility, i.e. the series of fluctuations that test a fund manager’s nerve but are ultimately just froth. Investment grade credit is and always will be a good tail hedge because the cost of borrowing for even the best companies is highly sensitive to broader financial market volatility. The future will require a tolerance of more volatility while being more disciplined than ever in risk management in order to realize real long term potential.