Friday 6 April 2012

Deleveraging - Bad for equities but good for credit assets

"The degree of leverage now being reversed is staggering, and the underlying global imbalances - notably between the savers and the spenders - will require long and painful adjustment."
Vince Cable

In their latest Scorecard Nomura is wondering if the corporate deleveraging implies a new golden age for credit given that credit has outperformed equities over the last decade:
Credit returns are leveraged to have the same volatility as respective equities over this horizon - Nomura

They make the following interesting points in their note:
-Corporates around the world have been deleveraging for longer than most people realise, starting around the time of the tech bubble in 2000.
-Deleveraging is generally bad for equities, but good for credit assets.
-In the US, Europe and Japan, credit has outperformed equities by any reasonable measure (e.g. volatility, drawdowns, absolute).
-As credit is far less volatile than equities, some leverage is sensible. Even leveraged credit can be less risky than unleveraged equities.
-Among other indicators, corporate leverage is a key focus of the Scorecard.s credit positioning. This has enabled the Scorecards to outperform standard long-only credit.
-Unlike corporates, financials have just started what is likely to be a long deleveraging process, suggesting opportunities in financial credit.
-As dealers, they will carry lower inventories. As investors, they will have less demand for assets. And they will be supplying assets to the market.

Point number 1: Corporates in US, Europe and Japan have been de-leveraging for some time
"Events since 2008 have highlighted the excessive leverage of households, banks and various governments‟ balance sheets in US and Europe. However, less well-recognised is the fact that corporate leverage (ex-financials) in these countries has been on a steady decline since 2000 (Figure 2).
Figure 3 shows the same trend by looking at free cash flow to debt ratios. Free cash flow is the cash available within a company for distribution among its various security holders. An increase in this ratio, therefore, denotes an increased ability to repay debt holders. The decline in company debt may be linked to increased corporate conservatism in the US and EU after the many high profile defaults at the turn of this century. The same behaviour was visible much earlier in Japan. After the leverage bubble of the 1980s, Japanese corporates have spent nearly two decades trying to repair their balance sheets."

Point number 2: Deleveraging is generally bad for equities, but good for credit assets
"Given a certain return on assets, a company can raise its returns on equity by increasing the ratio of debt in its capital structure. This is good for equity holders, but harms debt holders by lowering the threshold for default (when the value of assets is lower than the value of debt). This was the case in US and Europe in the 1990s. Though, notably in Japan, where deleveraging had already started, equity returns were negative in the 1990s. However, when companies turn conservative and start reducing debt, credit holders benefit and equity holders lose out. While good quality credit data did not exist for Japan in the 1990s, if we consider the performance of credit vs. equities in G3 since 1999 (Figure 1 above), we can see evidence of this. Credit in G3 (US, EU, Japan) has had higher risk-adjusted returns than equities since 2002. As volatility of credit is much lower than equities, investors could have taken a suitable amount of leverage on credit to convert this into high absolute returns. Figure 1 shows leveraged credit returns with the same volatility as equities."

Nomura also argues the following in their note:
"Financial credit may be the next big opportunity
The build-up of corporate leverage in the 2000s was confined to financials which, unlike other corporates, had escaped unscarred from the 2001 experience. However, this changed in 2008. Judging by the experience of G3 (US, EU, Japan) non-financial corporates, there should be significant deleveraging in banks going forward. Indeed, regulatory pressures are also pushing in that direction. All else being equal, this should be bullish for financial credit."

There is more evidence on this assertion than meets the eye, as reported by Sam Jones in the Financial Times in his article - Hedge funds exploits eurozone anomalies:
"Across the eurozone, and beyond, hedge fund managers are now pointing to “significant” pricing anomalies on a scale not seen since 2008. A huge rally in credit has seen spreads tighten to pre-Lehman lows. The reason for most hedge funds is clear. For all of its protestations to the contrary, the European Central Bank’s longer-term refinancing operation is having as profound an effect on markets as quantitative easing."

Same Jones in his article points to the following example:
"For example, on January 27th, inflation protected Italian government bonds maturing in 2021 were yielding 5.35 per cent, compared to 5.66 per cent for regular Italian government bonds of an almost exactly equal maturity. An inflation swap could meanwhile be written for 2.31 per cent. In other words, a hedge fund could have bought the inflation protected bond and written the swap for a fixed return of 7.66 per cent, and simultaneously gone short the regular Italian bond, completely hedging out credit risk, for a fixed cost of 5.66 per cent, locking in a gain of 2 per cent. With leverage, such a trade – a classic example of relative value fixed income arbitrage – could have generated huge returns. And for some, it has.
Relative value arbitrageurs have enjoyed outsize returns ever since 2008 precisely because of the “uneconomic” distortions created in markets by central bank liquidity operations. The Barnegat fund, a New Jersey-based hedge which launched after the collapse of LTCM – the world’s most notorious relative value arbitrageur – returned 132.68 per cent in 2009, thanks to “the largest arbitrage ever” – in the US bond market, caused by the Fed’s quantitative easing."

The LTRO effect - also from the same article:
"Even in broader corporate credit arbitrage, meanwhile, the LTRO has flattened risk and is also throwing up big trading opportunities. "
And the article to conclude:
"Look at the pricing in credit between a Caixa and Deutsche Bank,” says one credit fund manager. “Something isn’t right there.
Hedge fund managers are poring over a whole host of such potential trades which offer the kind of attractive risks most missed in 2011: assymetric ones."

Back in January 2011 in our post "A Tale of two Markets - Credit versus Equities" we argued:
"Capital Structure Arbitrage is according to the definition: any of a number of trading strategies designed to arbitrage the relationship between assets issued at different parts of a company's capital structure. Examples include convertible arbitrage (trading convertibles against equity options, for example), trading secured loans versus unsecured bonds of the same issuer and trading senior debt against subordinated debt of the same issuer."

In 2011 according to Christine Idzelis in her Bloomberg article - Hedge Funds Gaining on CLOs Drives Up Volatility (2nd of February 2012):
"Companies sold $231.8 billion of institutional loans last year, 77 percent of which were raised during the first six months, according to S&P LCD.
Hedge, junk bond and distressed funds made up 30 percent of the primary market in 2011, up from just 1 percent in 2002, data from S&P LCD show. Mutual funds represented 18.7 percent of buyers, compared with about 20 percent a decade ago. Finance and insurance companies were 10.5 percent of the market in 2011 and 12 percent in 2002."

Capital Structure Arbitrage has been indeed a key driver in achieving excess returns in the credit space in general and in a deleveraging environment in particular.

For more on Capital Structure Arbitrage please refer to:
Distressed Debt Investing - Capital Structure Arbitrage Part 1.

"Arbitrage proof has since been widely used throughout finance and economics."
Merton Miller

Stay Tuned!

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