Octobre 2015 – Crédit – Beaucoup de bruit pour rien

Volatility not coming from where you expect

6 months ago when asked about their major concerns for the rest of 2015, most European credit market participants would have put the Greek debacle and the European govies volatility at the top of their lists. With hindsight, it happened that exogenous factors such as a slowdown in several non-European economies, a series of dislocations in the EM/commodity complex and the uncertainties around the future path of the US monetary policy were most damaging – as opposed to Europe-centric factors. This analysis of the price action during a tumultuous Q3 led us to maintain our deployment, stay the course on most of our core positions and take advantage of the repricing to incept new trades. This was done at the price of short-term P&L volatility for the Fund in order to protect the embedded performance of our book in the longer term, which would have been damaged should we have decided to unwind many of our positions in a poor liquidity environment.

Where our European credit strategy risk is not

Importantly, we have continuously reviewed our core positions over the summer as a set of various events unfolded. How much of long oil price exposure do we embed in our book? Essentially zero as we stayed away from the handful of European oil and gas names. How many of our positions are directly related to China growth risk? One corporate name in the construction materials sector, which we took flat in the early part of the summer at a profit. How much exposure do we have to the current and upcoming woes of Latin America – and Brazil in particular? Two corporate names, but both are driven by their own idiosyncratic restructuring dynamics which have more to do with a turnaround of their non-EM operations and a comprehensive deleveraging program than with the outlook for GDP growth in Latin America. How long commodity markets is our portfolio? Actually, it is a bit short overall, in particular via a single-name short position on the senior unsecured credit instruments of a global commodities trading company. How long is our portfolio exposure to US rates and increasingly levered US corporates? Zero, as our investment universe is exclusively European and any significant fx and rate risks are hedged.

Stay the course and find new higher-return opportunities

Overall, our portfolio construction and name selection remain very disciplined and consistent with our assessment of the risks on the horizon. Global investor risk aversion was the main transmission mechanism of negative mark to market performance to the Fund, which makes us quite confident that our current positions carry limited credit risk and should continue to deliver positive returns. Arguably, some expected catalysts may take a bit longer to realize than initially thought due to the market volatility, but our investment thesis for all our positions remains highly valid, in our view.
As we shared with you last month, we also took advantage of the market repricing to rebalance some of our investing positions and/or incept new ones at more attractive risk-adjusted expected returns. Interestingly, we believe that the European “credit situational” space is less crowded than before at the moment as several global investors are currently more focused on managing stressed and distressed exposures in the North American energy complex than on researching below-radar European financial and corporate situations.

Watching the spread between US and European HY

Regular readers know that one of our major risk markers is the valuation gap between the US and the European HY markets. Since the summer, the gap in yield ranged between 2.0% and 3.0%, a range that starts to be on the dangerous side, in our view. However, we believe that such reading requires a more in-depth analysis. First, because the gap in credit spreads ranged between 120bps and 160bps – the balance being explained by the difference in USD and € risk-free rates. Second, because aggregate valuations in US HY market are currently skewed by the ca. 20% bucket of energy/commodity-related names which are experiencing a rising pattern of defaults – there is essentially no such exposure to those sectors in the European HY market. Last, because European single-B corporate spreads are now trading more or less flat to where their US peers are trading – in credit spreads – which make several European long opportunities in that segment more attractive than in the US from a risk-return perspective.