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A growing asset class in difficult times. LIUC April 2009. Investing in High Yield and Distressed Debt. AGENDA. Basics of Credit Investing Investing in HY and Distress Strategies and Trading Technicals Current situation Appendix. Basics of Credit Investing. A Focus on

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a growing asset class in difficult times

A growing asset class in difficult times

LIUC

April 2009

Investing in High Yield and

Distressed Debt

agenda
AGENDA
  • Basics of Credit Investing
  • Investing in HY and Distress
  • Strategies and Trading Technicals
  • Current situation
  • Appendix
basics of credit investing

Basics of Credit Investing

A Focus on

High Yield Bonds and

Leverage Loans

credit investing
Credit Investing
  • Lending to corporations
    • a direct private financing contract (loan)
    • underwriting newly issued corporate bonds
      • private placement vs. public offerings
    • Secondary market investing in corporate bond
      • Publicly listed debt vs. OTC transactions
  • Return on credit investments
    • periodic interest payments until maturity
      • in cash vs. payment-in-kind (PIK loans)
    • Repayment of the principal (end of the game)
      • entirely at maturity (bonds, bullet loans)
      • according to a scheduled amortization (most loans)
    • Capped return on the investment
example of a pik the kdg case
Example of a PIK The KDG Case
  • Euro 400m Floating Rate Senior PIK Notes due 2014 of Kabel Deutschland Holding GmbH & Co. KG, issued on December 2004
  • Issue price: 99%
  • Book runners: GS and DB
  • “Interest will be payable of additional notes, or cash if we so elect…”  in case the company elects to pay-in-kind (PIK), all the cash will be received at maturity by the noteholders
  • “The Notes will be senior obligations of the Issuer and will rank equal with all existing and future debt of the Issuer” (as a matter of fact, the notes are structurally subordinated to the operating assets)”
  • “We might redeem all or part of the Notes on December 2005” – technically called Non-Call 1
  • “If we experience a Change of Control, we will be required to offer to repurchase the Notes at 101%”

“Structurally” subordinated to the operating assets

assets traded
Assets Traded

Type of Assets

Asset Characteristic

Typical Investors

Investor Characteristic

Senior secured, 1st lien and 2nd lien bank debt, DIP facilities, bridge financings, mezzanine debt, LCDS

Greater security, stricter covenants, more rights. Assets are generally less volatile

Commercial banks, CLOs, credit funds, mezzanine funds

Low threshold for losses. As investor base shifts from traditional investors to CLOs and general credit funds, level of workout expertise is decreasing

Bank Debt

Secured bonds, unsecured bonds, subordinated bonds, convertible bonds, CDS

Commonly traded instruments with high market correlation. Typically little covenant protection and limited rights in a workout

High yield funds, CDOs and credit funds

Higher threshold for losses relative to bank debt investors. Low expertise in workouts. CDOs may be forced sellers in defaulted situations

Bonds

Trade claims, pension deficit claims, vendor notes, intercompany claims, litigation claims

Less liquid. Often possible to create claims at discount to market. Often provides a different or unique angle

Trade suppliers, unions, employee pension trustees, vendors, insolvency practitioners

Generally unsophisticated, or unable to exercise full rights. Look for liquidity

Trade Claims and Other Debt

Public and private equity, impaired equity, post reorganisation equity, convertible preferred or preferred equity, options

Public securities have highest volatility of all assets. Private situations or structured deals are low volatility. Potential for new money deals

Equity funds, special situation funds, private equity, families, governments, other equity investors

More sophisticated, particularly if private equity. Relationships remain key. Event driven or special situation funds focused on opportunistic investing

Special Situation Equity

6

Only Distress / Special Situation funds

high yield bonds and leverage loans
High Yield Bonds and Leverage Loans

High Yield (HY) Bonds

Leverage Loans

Contract form

Arranged by banks and mostly syndicated to the market

Maturity typically 6, 7 and 8 years (1° lien tranche A, B, C, or 2° lien)

Spreads range from 200bps to 400bps

Most of times underwritten in LBOs, as high yield bonds

Security over assets

Can be first lien or second lien on assets

  • Bond / note / other securities
  • Sub-investment grade - Junk (mostly B- through CCC rating)
  • Typically 7-10 year maturity
  • Yield at issuance  8%-12% (Libor + 500/700 bps)
  • Mostly issued in the context of a leverage buyout (LBO) executed by a private equity firm
  • Usually unsecured and subordinated
where do high yield distress bonds loans sit in the capital structure
Where Do High-Yield, Distress Bonds & Loans Sit in the Capital Structure?

Senior Secured Loans:

  • private instrument / contract (typically negotiated by banks and then syndicated to the credit investors)
  • first priority in reimbursement in case of liquidation
  • rights typically protected by security over hard assets

Senior Unsecured Bonds:

  • publicly listed instrument / note or bonds (typically underwritten by banks and then syndicated to the credit investors)

Subordinated debt

  • subordinated to senior credit loans or bonds, but senior to equity, in reimbursement in case of liquidation
  • rights typically protected by a general guarantee of the issuer (no direct claim on the assets)

CAPITAL STRUCTURE “WATERFALL”

8

credit investing risk reward profile
Credit Investing Risk-Reward Profile

REWARD / IRR

Indicative spreads to Risk-free rate:

Alitalia

15%-25%

Geox

IT Holding

Equities and

Distressed Debt

4%-15%

Seat

TI

1%-4%

Corporate Debt

High Yield / Junk

Enel

Italy

0%-1%

Corporate Debt

Investment Grade

US

Risk-free rate

Government Debt

RISK

[Risk can be defined as VAR, volatility, illiquidity, tail risk, gap risk,...]

  • High yield debt becomes distressed when it trades in the secondary market below 70-80% of face value
  • This is the main focus of today‘s lecture !
risk reward cutting to the core
Risk / Reward: Cutting To The Core

Risk premium line

REWARD / IRR

Attractive Risk / Reward

Unattractive Risk / Reward

riskfree

RISK

default rates
Default Rates

Historical Max

Previous peak

points

Long-term Avg

corporate credit spreads indexes
Corporate Credit Spreads’ Indexes
  • The latest release of the HY index is the Itraxx S9 Xover (maturity March 2013)
  • The Itraxx Europe index is a reference for investment grade companies

The Itraxx Finl Sen and Sub represent senior and subordinated credit risk of financial institutions

  • Itraxx Generic represents a blend of the various series’ releases (indexes roll every 6 months into a new release with new constituents)
liquid vs illiquid investments trades
Liquid vs Illiquid Investments / Trades

LIQUID

ILLIQUID

  • Typically “forgotten” bonds or loans by brokers, small sized deals, whose syndication went to just a few market participants, or directly sourced investments (where there isn’t a standard process by which banks first underwrite the deals)
  • No market making by brokers
  • Trading might happen based on individual negotiations
  • Impossibility to “exit”, to “trade around”, etc
  • Typically only funds which have a lock-up period and who target a return premium for the illiquidity
  • Typically a bond or a loan which is traded by brokers
  • Bid / Ask spread ranging from 0.25% to 2%
  • Broker willing to trade a size of at least Euro 2mln to Euro 10mln
  • Many market participants focus on liquid investments due to:
    • mandate they have from their investors
    • Capability to “exit”
    • Lower gap risk
    • Capability to improve returns by “trading around positions”, hence benefitting from volatility

25

the extra premium for illiquidity
The Extra Premium for Illiquidity

Extra spread demanded by deals smaller than $500 million (proxy of definition of illiquidity)

26

importance of derivatives for the asset class
Importance of Derivatives for the Asset Class
  • Hedging
    • If you are “long” a single name credit risk, you can hedge the trade without going through the process of selling the underlying cash asset buying a CDS on that name
    • If you are “long” market credit risk, you may buy credit index protection to hedge the exposure to the market (i.e. Itraxx)
  • Capability to have additional liquidity in the market
  • Capability to deploy curve and basis trades
    • relative value
    • market neutral

28

invest in hy and distress

Invest in HY and Distress

Evolving Asset Class by the Day

29

the difference between a trade and an investment
The Difference Between a Trade and an Investment

TRADE

INVESTMENT

  • Medium-Long Term
  • Take a view on market/sector/company
  • Investment based mostly on analysis and macro view
  • Short Term
  • Potentially look at arbitrage opportunities
  • Trade based on trading technicals

31

investment process overview
Investment Process Overview

MANAGING POSITIONS

IDEA GENERATION

SCREENING ANALYSIS

STRUCTURING

  • Identify investment opportunities internally and from other sources
  • Monitor “stressed credits”, industry sector trends, news and research reports
  • Monitor market trends and review deals in the credit and equity markets
  • Active dialogue with desks, investment management community, restructuring professionals, industry experts and other relationships
  • Maintain key relationships with funds, desks and professionals and industrial players
  • Identify the edge
  • Conduct full financial analysis, including valuation, debt capacity and liquidity analysis
  • Evaluate process risk by analysing legal issues, jurisdiction, capital structure, indentures, legal agreements, stakeholder interests, etc
  • talk to key players – management, existing investors, professional advisors, and interested investors and buyers
  • Conduct industry and sector analysis
  • Perform scenario analysis to determine upside/downside cases
  • Identify events and timing to events
  • Focus on capital preservation and low volatility
  • Identify opportunities with down side of debt and upside of equity
  • Assess and understand liquidity of the investment and exit
  • Review the entire capital structure to determine where to invest and identify intra capital structure plays
  • Determine opportunities to create / offer a new security
  • Understand which security has negotiating leverage, and assess stakeholder interests
  • Determine size, liquidity and overall fit with portfolio
  • Monitor all positions for news, data and events in real time
  • Mark positions monthly based on bid-ask market
  • Sell discipline focused on exit: sell when event happens; sell on price appreciation; sell if situation or event changes negatively
  • Talk continuously to key players and contacts to keep ahead of the information flow
  • Review all positions weekly
  • Revisit scenarios constantly
  • Advisory panel input during portfolio review process
  • Structure hedges

32

managing the process special situations
Managing the Process (Special Situations)

From identifying an opportunity to executing on it, we closely manage the process every step

INITIAL ASSESSMENT

REACHING AGREEMENT

EXECUTION

  • Opportunity assessed against our investment criteria
  • Immediate feedback – we will only work on deals we believe we can execute
  • Experienced analyst allocated to complete financial analysis
  • Founding partners involved from the outset to make an assessment of the risk/reward dynamics
  • Information request provided focusing on the key facts we need to make an investment decision
  • Key commercial issues identified and put on the table
  • Meet and develop relationship with management
  • Initial terms proposed and negotiated
  • Flexible and pragmatic approach to other stakeholders
  • Ongoing honest feedback provided throughout
  • Upside/downside scenario analysis
  • Timeline to completion established
  • Experienced structuring team dedicated delivering the agreed deal
  • Creative deal structuring using both financial, legal and industry angles
  • Streamlined documentation requirements, borne out of years of experience of what is key in distressed and special situations
  • Founding Partners involved throughout – leveraging their relationships to bring other stakeholders on board

24/48 hours

2-5 days

5+ days

33

managing the trade
Managing the Trade

Distressed and special situations require early identification, efficient trading and quick, decisive decision making. For this reason, our founding partners are involved in every stage of the investment process to ensure we can take full advantage of the different stages of a company’s restructuring and turnaround

Price

(% of Par)

Efficiently trade throughout the restructuring period, have the best information, look to create the trade in other ways

Refine understanding of the investment rationale, build the position, drive the process

100

Constantly reassess investment rationale, valuation parameters, and trading flows throughout the restructuring process

75

Early identification of potential opportunities. Identify capital structure weak points and likely outcome of inter-creditor negotiations

50

Maximise value through recovery and turnaround phase

25

0

Time

34

risk return profile for an hy manager
Risk return profile for an HY manager
  • Target return: 15%-20% IRR
  • 10%-15% volatility
  • Key risk measures:
    • DIV01 = change of the underlying security value to a change of 1bps in credit curve; also indicative of the duration of a security.
      • Example: For a bond with 5y duration, if the credit curve widens by 20bps, its value decreases by 1% (20bps * duration of 5).
    • Leverage
    • VAR
making an investment recommendation
Making an Investment Recommendation
  • Market screening
  • Building an investment idea
    • Sector analysis
    • Company analysis
    • Equity and credit comps
  • Assessing risk-reward profile
  • Degree of conviction
  • The investment recommendation
market screening
Market Screening
  • Scouting for companies with traded debt securities
    • Take a look at sectors we deem to be attractive
    • Take a look at bonds/loans deeply discounted to par value
  • A HY investor restrict himself to names offering a potential levered return of at least Libor+600 bps
  • Brokers or research analysts might suggest ideas, companies and situations to look at
  • Who is focused on distressed looks at firms with an important credit event (imminently due or just past)
    • bankruptcy process, like Alitalia or Lehman Brothers
    • downgrades
building an investment idea
Building an Investment Idea
  • Choose the right sector
  • Choose a company with a very good management team in that sector
  • Pick cheap debt securities of that company in relative value terms
1 sector analysis
(1) Sector Analysis
  • Most of our actual return on capital depends on the sector we invest in
  • A deep understanding of all the challenges faced by the companies in the sector are facing is then of paramount importance
    • e.g. raw material price increases, price pressure, intense competition,…
  • To gain an educated view on the company sector condition and outlook
    • look at the competitors/peers in terms of their operating and financial stats (sales growth, EBITDA margin, leverage, cashflow conversion, etc)
    • when a listed competitor / peer reports its quarterly numbers, we might find a lot of information from its reports and subsequent brokers’ analysis
  • In the current context (recession) we
    • favor sectors like utilities, telecom, healthcare, aerospace, niche technologies (“defensive” sectors, uncorrelated with economic cycles)
    • avoid retail, fashion and luxury, financials, automotive and related, airlines, consumer goods (“cyclical” sector, highly correlated with the economic environment)
2 company analysis
(2) Company Analysis
  • Review of
    • Financial accounts (annual reports, quarterly financials statements)
    • Sell side research (equity and credit analyst research)
  • Interviews to suppliers, customers, peers, etc.
  • Aim to gain a deep knowledge of:
    • firm’s business model and business plan
    • firm’s financial structure
    • firm’s traded debt securities or loans
  • The end product is an excel-based output, including a granular operating and financial model of the company
3 equity and credit comps
(3) Equity and Credit Comps
  • Need to understand if the debt securities we are considering investing in are “cheap” or “expensive” - compared to the securities of other companies in the same sector or with similar leverage
  • Especially true if we are trying to deploy a relative value investment strategy to isolate the “ALFA”
    • One of the key features to make money over time is to invest in cheap securities
  • Often we find better investment opportunities (better risk/reward and better companies) in comps/peers we look at
    • By analyzing comps’ securities as well, we might find a better way to express our views by combining together various trades
equity and credit comps example 1
Equity and Credit Comps: Example #1

Selected equity automotive components trading multiples

Looking at equity comps is the most immediate - and frequently the most effective - way to form a view on the Enterprise Value of our target company

example yes no
Example (yes / no)

KAMPS: NO – too much leverage due to operating underperformance

GROHE: YES – quite leveraged, but high potential for cost savings and plenty of liquidity

assessing risk reward
Assessing Risk-Reward
  • To measure the risk/reward we need to look at the unit of reward we are getting for a unit of risk we are undertaking
  • One possible risk-reward measure can be spread / leverage turns
  • Example:
    • An investment in a senior secured loan purchased at discount (80-85 cents) where there is a likely event of refinancing in 1-2 years and an almost nil probability of default potentially represents a good risk/reward investment (low default risk of senior secured loans and 15-20% equity-like potential return over the investment horizon)

A debt security which yields 1000bps over Euribor and “sits” at 5x EBITDA leverage, has a ratio of “spread per turn of leverage” equal to 200bps – the higher the ratio, the higher their are paying us for a unit of risk, where the proxy for the unit of risk is the EBITDA leverage

risk reward moving up and down the capital structure
Risk / Reward Moving Up and Down the Capital Structure

Example Intra Capital Structure: Moving Lower – from Senior to

Subordinated – Risk is More and More Rewarded with Extra Spreads

Spread / Leverage (Sub Debt)

Incremental Spread / Leverage per additional leverage to go from Senior to Sub

Spread / Leverage (Senior Debt)

A

B

C

D

A/C

B/D

(B-A) / (D-C)

degree of conviction
Degree of Conviction
  • The degree of conviction represents how comfortable we are in the numbers and in the judgment calls at the basis of our analysis
  • Having a high degree of conviction in high yield and distress investing is of paramount importance since
    • the loss can be huge
    • Exit may be difficult
degree of conviction examples
Degree of Conviction: Examples
  • Situations where we might have a high degree of conviction:
    • We have been studying the company for a long time and we have had the chance to verify that our financial model works well in terms of forecasting
    • We have a good relationship with the CEO or CFO of the target company and we feel we have a better understanding of their body language
    • We know the sector well because we have been investing in it for a long time
    • We have already invested in the company
  • Situations where we might NOT have a high degree of conviction:
    • It is the first time we are looking at the sector of our target company
    • We have little historical financial information on the target company
    • Earnings have historically proven to be very volatile
    • The sector is going through a transformational period
a crucial pair risk reward measure degree of conviction
A Crucial Pair: Risk/Reward Measure & Degree of Conviction

REWARD / RISK

Attractive Investments

Unattractive Investments

DEGREE OF CONVICTION

the investment recommendation
The Investment Recommendation
  • Following the investment analysis, an investment idea (if reached) must be proposed in a one-pager
    • “Buy/Sell the security X at the price Y in this size”.
  • Additional recommendation detail: “trading on a scale”
    • “If the price goes up by Z amount, unwind the trade, while buy K more if the price goes down by a W amount, assuming the investment thesis l holds true”
  • Additional recommendation detail: “stop loss”
    • “If the price goes down by Z amount, unwind the trade, while buy K more if the price goes up by a W amount
trading on a scale example
Trading on a Scale: Example
  • It averages down the purchase price of our investment if market conditions worsen
  • It secures the profits if market conditions improve
  • Since each bond price implies a Yield to Maturity -YTM, if the investment thesis holds true, you invest more in that debt security whenever returns become more attractive (prices go down only due to market conditions)
trading on a scale mean reverting high conviction trades
“Trading on a Scale” – Mean Reverting, High Conviction Trades

The importance of trading on a scale in credit investing is due to the “mean reverting” aspect of the strategy

While in equities a stock can be cheap but it can get cheaper and stay there forever, in credit there is an event (the repayment at par value) which allow to verify if the initial investment thesis was correct (assuming you go long a credit at discount)

Assuming the company will be able to repay at par the debt security we have invested in, then a scenario of high volatility allows a good trader to make more profits throughout the way

TOTAL P&L: CARRY INTEREST + CAPITAL GAIN

sell

sell

Par value: 100

price

buy

buy

buy

54

54

strategies and trading technicals

Strategies and Trading Technicals

The Devil is in the Detail

55

detailed company fundamentals
Detailed Company Fundamentals
  • Having a bottom-up granular operating and financial model allows to forecast quarterly developments of the financials of the company,
  • You can potentially understand if covenants will be triggered or other events will unfold and act immediately on this expectations
    • should prices of raw materials price increase, you may immediately run your model to assess changes in the profitability (i.e. EBITDA) of the company without the need to wait for the next quarterly financial release to understand what the numbers are
    • we can act sooner on our investment (exiting or adding more) before the vast majority of investors who lack a precise and detailed operating and financial model
  • Credit investors have a much more sophisticated bottom-up approach than equity investors since forecasting cashflows in detail is their core business
    • in equity investing you will very rarely find people who have detailed operating and financial models on companies under analysis
approach to company fundamentals
Approach to Company Fundamentals

Disciplined approach to analysis and investment decisions.

Process includes an iterative approach to analysis and structuring

FINANCIAL ANALYSIS

PROCESS ANALYSIS

Industry and Competition

Process Environment

  • Competition, customers, suppliers
  • Comparables (multiples, M&A comps)
  • Jurisdictional and legal issues, including relevant bankruptcy processes
  • Identify various process alternatives

Continuous discussions with analysts, managers, industry experts, advisors, other investors, etc

Valuation

Situation Assessment

  • Business plan and scenario analysis
  • DCF, multiples, sum of parts
  • Liquidation and break-up analysis
  • Capital structure, review of indentures, covenants, security and inter-creditors agreements
  • Shareholders’ and other agreements

Debt Capacity

Scenario Analysis

  • Leverage comparables and ratings
  • Focus on coverage ratios: debt, interest, free cash flow, capex
  • Identify players involved
  • Assess stakeholder interests & negotiating leverage
  • Timing of events and map out possible scenarios
  • Understand upside/downside, risk and reward
  • Identify the edge in a trade
  • Upside/downside scenarios
  • Know events & timing
  • Understand exit in illiquid situations
  • Take process or business risk
  • (not both)

Liquidity Analysis

  • Debt service, capex, w/c impact through restructuring process
  • Cash, borrowing capacity, headroom
company capital structure example ii ii
Company Capital Structure: Example II/II
  • Combining capital structure analysis with the equity and credit comps’ analysis, we are effectively able to “price” the distress securities
  • Previous example of Wind Hellas, the Greek telecom operator:
    • from equity comps’ analysis we have that similar type of assets trade between 6x and 7x
    • a 6.5x value would then “break through” Wind Hellas’ capital structure, allowing to recover par value on the subordinated notes (which sit at 6.5x leverage) and nil on the PIK notes (which sit at 7x leverage)
  • Among Wind Hellas’ securities, subordinated notes currently trade in the 70s while the PIK notes trade in the 50s implying a return of approx 15-20% on the subordinated notes and of approx 35-40% on the PIK notes
    • The market is not pricing the subordinated notes at par while the PIK notes at zero
    • The company in two to three years might or might not improve its profitability, hence the PIK notes might get or do not get value
    • The price of the subordinated notes and the PIK notes tell us that the market on one hand is pricing the possibility that the company might lower its EBITDA/Valuation (that’s why the subordinated notes are trading at discount) and on the other hand is pricing the possibility that the company might improve its EBITDA/Valuation (that’s why the PIK notes have some value)
credit statistics
Credit Statistics
  • There is a set of credit statistics coming out of financial models which are what most credit investors look at in order to form an opinion about the credit soundness of the target company

Lack of deleveraging  distress situation

Pro forma

Year 1

Year 2

Year 3

Year 4

  • The analysis of the credit stats varies according to:
    • the cash-flow conversion of the company, its earnings’ growth, its predictability of earnings, etc
    • new issue or secondary trade;
    • the sector we are looking at
legal and structure analysis
Legal and Structure Analysis
  • Investing in credit offers a variety of legal rights as outlined in legal norms and either loan provisions or bond indenture
    • Basic one: priority be reimbursed vs equity in case of liquidation
    • That’s why credit return is capped
  • Being able to identify our own rights as creditor is an important step of the investment decision process
    • the priority in the capital structure,
    • covenants’ protection,
    • majority clauses to change the contract if loan or the bond indenture if bond, etc
  • The legal and structure analysis becomes more and more important the more distress the situation we are looking at is
    • When investing in high yield, hopefully we will not get to the point where we have to worry about liquidation priorities, etc
    • In distress, instead, the legal and structure analysis is paramount
legal and structure analysis66
Legal and Structure Analysis
  • When investing in debt securities, the legal documentation analysis and the understanding of our own and other creditors’ rights rights is of paramount importance
    • Security / collateral (mainly in case of loans, but also bonds sometimes)
    • Seniority in the capital structure (structural and contractual)
    • Change of control clause
    • Super majority clauses (specifically in case of loans)
    • Covenants and events of default
    • Application of excess cashflow
    • …..
    • ……
    • …..
liquidation analysis
Liquidation Analysis
  • High yield and distress investors must understand:
    • the bankruptcy regime of the country where the default would take place (Center of Main Interest)
      • Privileged creditors
      • Concordato Preventivo vs Fallimento vs Legge Marzano etc
      • …..
    • Understanding of treatment of each class of creditors & waterfall mechanics
trading dynamics and scale
Trading Dynamics and Scale
  • Given the illiquidity of the product, being able to rightly identify which broker to deal with in order to build up a position, which timing to use, etc is a key aspect of investing in high yield and distress bonds/loans
  • While stocks can be cheap/expensive but can always get cheaper/more expansive, credit investing is mean reverting, i.e. the company will pay you back par value unless it defaults
  • This feature makes the trading scale strategy crucial
  • When prices deteriorate because of market conditions, usually high yield and distress investors who have a high degree of conviction would tend to add to their positions (technically called “double down”)
trading analysis
Trading Analysis

High yield and distress loans / bonds traded OTC (Over The Counter), can be very illiquid, meaning that bid/offer spreads are high (1 or 2 percentage points):

E.g. WIND PIK 91.5 – 93.5 2X2

Being able to find the broker “who has paper” is key in order not to “spoil” the market.

if you go to a broker who is not “axed” (he doesn’t have the paper you are looking at), he will put out a bid in the inter-dealer broker market, hence pushing the price up before you buy the targeted bond or loan

Inter-dealer 1

Inter-dealer 2

Inter-dealer 3

Broker 1

Broker 2

Broker 3

Broker 4

Broker 5

70

Client 1

Client 2

Client 3

Client 4

Client 5

Client 6

which investments to place in the portfolio
Which Investments to Place in the Portfolio?
  • In a Portfolio Manager’s perspective, it is key to evaluate where an investment opportunity stands compared to others when added to his portfolio
  • Each new investment should fit at the “margin” with the existing portfolio when considering risk/reward, degree of conviction and other diversification profiles
  • This “marginal investment opportunity” needs to be one where the manager think he has a particular edge (competitive advantage)
  • Investments can be:
    • market directional (beta exposure, both positive or negative)
    • market neutral (long/short credit, curve trades, basis trades, market-hedged trades, etc)
directional vs market neutral investments
Directional vs Market Neutral Investments

DIRECTIONAL

MARKET NEUTRAL

  • Strategies mostly built up through liquid investments
  • Inter-company  long/short credit
  • Intra-company  long loans / short bonds or long bonds / short equity
  • Curve trades  long 2y credit risk / short 5y credit risk
    • Possible if credit derivatives exist (CDS)
    • Express a view about the shape of the credit curve (e.g. steepeners and flatteners)
  • Basis trades  buy a cash bond and buy CDS protection, yielding a net interest income (virtually risk free)
  • Most illiquid investments/trades are directional
    • Betting on an individual company or situation
    • Very idiosyncratic, low correlation with the market
  • “Value” investments, based on a deep knowledge of the company or the situation
  • Degree of conviction needs to be very high
  • Most of distress situations are directional (e.g. Alitalia convertible bond)
relative value basis curve trades another way to express investment views
Relative Value, Basis & Curve Trades: Another Way to Express Investment Views

Buy CDS protection X-year and Sell CDS protection Y-year

Trade can be

DIV01 neutral (ratio to neutralize market risk)

Jump to default neutral (ratio to completely neutralize default risk)

Trade can be

Flattener (to “play” the flattening of the curve), generally a bearish trade

Steepener (to “play” the steepening of the curve), generally a bullish trade

Trade need to be rebalanced quarterly, since with time going by the ratios (to make the trade DIV01 neutral or jump-to-default neutral) change

If short term credit risk is attractive but a market exposure is not wanted, then a trade where to go long the short end of the credit curve (i.e. sell CDS protection) and short the long end of the credit curve (buy CDS protection) makes sense - specifically if the trade is carry positive and roll-down positive

The roll-down is when a 5y CDS becomes a 4y because 1 year has gone by  roll-down is positive when 4y spread is lower than 5y spread, hence your contract is in the money after 1y

75

example of a curve trade the steepener
Example of a Curve Trade: The Steepener
  • Trade/Investment:
  • Sell 5mln protection (go long credit risk) on Grohe 2y CDS at 700bps
  • Buy 2mln protection (go short credit risk) on Grohe 10y CDS at 950bps
  • Carry plus “roll-down”:
  • Positive carry: 700bps * 5mln = +350k
  • Negative carry: 950bps * 2mln = (190k)
  • Net annual carry: +160k
  • Roll-down effect in 1 year: +200k
    • From 2y to 1y  400bps * 5mln * 1d = +200k
    • From 10y to 9y  0bps * 2mln * 5d = 0k
  • Risk of default: 5mln – 2mln = 3mln
liquidating a position
Liquidating a Position
  • Liquidating a position in high yield can be very expensive (in distress is virtually impossible)
    • Bid / Ask spread can be up to 5 points in the less liquid names, and most likely would work in max 2mln size
      • Once you hit a bid of a broker in 2mln, the next “market” the broker might offer you can be 1 or 2 points lower
    • In a market where there is lack of liquidity, e.g. the days after the Lehman bankruptcy, there is literally no bid for the higher yielding products
  • The CDS is much more liquid, however not all the cash bonds do have CDS protection outstanding (only the more traded and liquid names)
monitoring risk
Monitoring Risk
  • Risk monitoring is done through a portfolio management tool
    • Interest rate or currency risk exposure
    • Breakdown of exposure by sector
    • Breakdown of exposure by seniority of securities in the capital structure
    • Analysis of carry interest vs accrual of principal (PIK or capital appreciation when securities purchased at discount)
    • Analysis of liquidity of the instruments
    • Analysis of volatility by instruments
    • Analysis of estimated tail risk (capital at risk in case of financial shocks)
  • Risk management performed daily with update of prices
  • Risk management need to be put into the overall hedge fund context
hedging strategies which risks to hedge
Hedging Strategies: Which Risks to Hedge?
  • Market risk
    • Hedged through shorting the reference index (Itraxx Xover 5y in high yield)
    • Hedged through shorting basket of comps
    • Capital structure trades (long loan, short bond)
    • Curve or basis trades
  • Tail / Shock market risk
    • Buying out of the money put options on the reference index
    • Buying out of the money put options on the listed public equity of the company, assuming the company is listed
  • Operating risks
    • Assuming the company is highly exposed to a raw material, then short the best proxy of such raw material or buy out of the money call options
    • Assuming the company has significant portion of EBITDA in US$, then hedge the currency risk
  • Financial risks
    • Assuming we want to buy a long dated fixed coupon bond, then probably a good idea would be to hedge the interest rate risk
why is information so important
Why is Information so Important?
  • To refine the company fundamentals analysis
    • Better operating and financial modeling
    • Better knowledge of suppliers’ and customers’ opinion of company’s products
  • To forecast events that the market is not aware of
    • M&A or extraordinary finance transactions which might have an impact on bonds and loans
  • From a strictly trading perspective, better execution on buying and selling
    • Knowing who has the paper
    • Knowing how many buyers and sellers there are in the market
current market conditions

Current Market Conditions

Are You Ready for Distress?

where are we in the cycle
Where Are We in the Cycle?

DOES NOT INCLUDE LEHMAN BROTHERS OR ANY RECENT DEVELOPMENT!

[NORTH AMERICAN DATA AS PER END OF AUGUST]

conclusions
Conclusions
  • Distressed debt is already out there
    • Many private equity funds and other institutional funds are setting up more and more dedicated funds to this asset class
  • Spreads are currently on the rise, and there to stay for 12-24 months
    • Carry interest is currently high, looking at historical average, which makes the asset class already attractive
  • Default rates will peak in the next 12-24 months
    • Market prices (hence spreads) anticipate default rates