23/06/2008
Alpha or Beta – take your pick!
Just when credit looked so easy along came the credit crunch. And it’s staying much longer than anyone wants. If you think things are bad – can’t get a mortgage, can’t run the 4X4 any more – then think about the high alpha credit fund manager. For a long time he was able to make easy money trading credit when spreads were low and liquidity in plentiful supply. Then he discovered that his alpha was really beta as spreads rose and the cost of shorting strategies soared. High spreads and high costs of funding change the rules, focusing attention on value rather than volatility, and on long term core positions rather than short term trading.
What have we discovered? Incorporating market beta and dressing it up as alpha is not a long term sustainable investment strategy over the credit cycle. Neither is betting on correlation levels between different asset types remaining within short term historic ranges. However, a true stock picking strategy is sustainable.
A strategy based on successful stock picking – long and short – has to be at the core of any long term higher alpha product. Traditional fundamental investment skills are essential in any manager you select, because current conditions are here for a while.
High credit spreads have emerged as a symptom of the famous “credit crunch” over the last 12 months. The original subprime problem seems so long ago now, as we have moved through IKB, Northern Rock, emergency rate cuts, ABS meltdown, leveraged loan meltdown, Bear Stearns, monoline downgrades, bank rights issues and the emergence of radical Central Bank support systems. Banks remain at the centre of the credit prognosis – progress has been made patching up damaged balance sheets but there is still scope for more writedowns, and they remain vulnerable to a genuine cyclical deterioration in credit quality. Also, how do the Central Banks unwind their vast holdings of Residential Mortgage Backed Securities? In particular, how will the European Central Bank justify on the one hand aggressive bank bailouts and on the other a harsh interest rate stance? Schizophrenics can behave erratically - we are guaranteed more volatility over the summer.
So it looks as if high spreads are here to stay until the banks get sorted, or at least resume a semblance of normal banking activity – lending and allocating capital to support new projects. Capital markets will remain fractured until then. But the good news is that for investors there is a fantastic opportunity to buy credit at bargain levels. Average corporate bond spreads in Sterling are currently at around 160bps, having reached 200bps in March when the credit crunch looked like it was developing into a full blown banking crisis. 160bps is still well above the previous peak of 140bps reached in early 2000 during the tech bubble and the associated issuance frenzy led by telecoms. Even after Worldcom, spreads only rose to 105bps in late 2002. Illiquidity and banking problems have led to a level in spreads which historically looks incredible over a timescale which includes genuine massive investment grade defaults.
Spreads look cheap on a comparison with historical default rates as well – the peak for Moody’s investment grade defaults was just below 2% in the 1930’s. Even I can’t remember that far back, but within living memory the annual default rate for investment grade credit actually hasn’t exceeded 1%. If you factor in a recovery post default of 40%, at 2% pa default rates you would expect to lose 0.6 X 2.0 = 1.2% every year. That’s every year. Another way of looking at the spread is that you are discounting 3% defaults on investment grade corporates - which on average have an A rating like Tesco – every year. This seems unlikely. For Credit Crunch read Credit Opportunity.
So while spreads should remain high for the foreseeable future they are supported by valuation. Until they fall they provide excellent carry and scope for generating much alpha by the adept stockpicker.
Andrew Sutherland, Head of Credit at Standard Life Investments.
This was published in Investment Adviser on 23rd June 2008.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
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