“Inflation is the crabgrass in your savings.” -Robert Orben (author)
The more I think about this quote, the more I’m impressed by Mr. Orben’s analogy. Today, we’re continuing to examine how higher rates and inflation have impacted alternative investment strategies. Last time, we looked at private credit, and today we’ll move into some other credit strategies that tend to be more tactical undertakings.
Before we get started, here’s a brief anecdote about private credit: Yesterday, I heard from a team that specializes in solar financing, and they conveyed the reality that borrowers are willing (and happy) to pay higher interest rates in exchange for lenders with greater certainty of execution, ability to underwrite unique situations, and flexibility in working with them throughout the life of a given project. Banks often fall short on the other fronts even if they can offer cheaper financing, so private lenders have built entire businesses via differentiation – NOT necessarily competing directly on rates. Remember, for the borrower, expensive debt is still far cheaper than selling equity to raise money.
Now onto today’s topic. Here we go!
Structured credit
After the painful experience that was the 2008 Financial Crisis, residential mortgage-backed securities (RMBS) became well known, as they were at the epicenter of the meltdown. As a brief refresher, these securities were created by packaging individual mortgages together (aka “securitizing” them) into something more easily tradeable. It’s not easy for investors to purchase private mortgages, but trading an RMBS representing many underlying mortgages can be much more convenient.
[As an additional reminder, back in February of 2021, we briefly discussed securitized structures, including CMBS (commercial mortgage-backed securities) and, more broadly, asset-backed securities (ABS), when contemplating what types of investments may help to replace traditional fixed-income.]
Securitization originally dates back to the early 1700s, so it’s not a new idea, but the application to mortgages emerged in the 1970s. The space has evolved significantly ever since and – with some imagination – has grown to include areas like aircraft leases and consumer receivables (part of the general “ABS” category). I could do an entire Alt Blend series on the topic, but since this whitepaper (which I encourage you to read) from Axonic Capital is an overview that I can’t possibly contend with, there’s no need to reinvent the wheel.
It is worth quickly noting the concepts of tranching and credit enhancement, which can alter the level of credit risk, cashflows, and potential return/loss EVEN within the same underlying pool of loans; those features allow securitized structures to fulfill a variety of investment objectives. Considering all the debts that can be securitized and the broad spectrum of risk/reward that securitization offers, there are virtually an infinite number of trades that can be structured around these investments. Hence, the structured credit investment universe.
Don’t blame the messenger
The above is not to imply that securitization was at fault for the 2008 Financial Crisis, even if it played a significant role. Instead, the implosion was caused by several factors, including:
- a) the belief that pooling together horrendously underwritten mortgages resulted in a high-quality investment (spoiler alert: it didn’t, as that’s not how diversification works), and
- b) incredibly poor risk management and unethical behavior of consumers and the financial industry.
In fact, one might call it a Crisis of Responsibility (a great read if you haven’t already). Thus, I hope your reaction to structured credit isn’t, “Yikes – I’m never touching that stuff!
Back to the lecture at hand
I’d summarize the structured credit space for 2022 as thus far “treading water” (i.e., it’s “flat-ish” – to be very technical) from a return standpoint. That’s because the high yields available have done a good job of offsetting the price declines. Also, many trades involve some degree of price hedging in the first place, which can help mitigate volatility vs. long-only bonds.
A flat return for 2022 is a relatively attractive outcome, given that high-quality bonds (Bloomberg US Corp Investment Grade Index) are down over -16% and high-yield bonds (Bloomberg US High Yield Composite Index) are down nearly 12% for the year (source: Tamarac Advisor View, data through 11/17/22). At least on the surface (over this short timeframe), then, it makes the case that a) structured credit can introduce different risk/reward characteristics vs. owning traditional bonds, and b) it can be a potentially viable alternative investment strategy.
The recent rally of both equity and fixed-income markets should help reduce hedging costs, so we expect that managers are taking advantage of this to adjust their trades based on short-term (tactical) views of the ongoing bounce in the context of longer-term (strategic) allocations. In other words, if I’m a manager with a long-term trade in place, the current situation may offer attractive entry points for mitigating the downside risk of that trade via (now cheaper) options or derivatives.
Rates up, prepayments down
An essential factor in assessing the return profile of a mortgage (as one example) is the concept of “prepayment,” which is another way of saying “early repayment.” If a borrower can refinance a mortgage at a lower rate, then the old mortgage is paid off (prepaid) to do so. For a lender, prepayment is a risk since new loans will typically be issued at lower interest rates (otherwise, the borrower wouldn’t have prepaid the loan). On the other hand, in a rising-rate environment (like our current situation), borrowers with low-rate mortgages will want to repay as slowly as possible.
If an investor (or manager) purchases a mortgage bond at a discount, prepayments can boost the total return on the investment. That’s because the bond’s par value is received ahead of schedule due to prepayment (e.g., a mortgage is purchased for 80 cents but repaid at 1 dollar). For mortgage bonds, higher prepayment expectations created higher valuations in the lower-rate environment of the past. Now that rates are up, it logically follows that prepayments are down, and the value of mortgage bonds has fallen commensurately. Thus, there should be an opportunity to buy those investments at (now) lower prices as the interest-rate/housing market finds its footing.
Adapt and succeed
As with any segment of the investment universe, managers need to adapt to the situation. Looking at the CMBS (commercial mortgage-backed securities), perspectives on the direction/sustainability of rental income and where properties will trade (in terms of “cap rates”) are needed to assess the risk/reward of a given CMBS holding. Each manager has a proprietary approach for modeling pricing and risks, either resulting in a trading advantage or bad trades, depending on the quality of said models.
In my experience, securitized credit markets tend to be an area of outsized dislocations during market stress. From time to time, we expect situations where these investments will trade at a fraction of their underlying value (e.g., 30 cents on the dollar) simply because of forced selling by investors with too much leverage. So, the Coast Guard motto, Semper Paratus (“always ready”), is good for structured credit managers to keep in mind. When there’s forced selling, being the manager with ample cash and credit lines to soak up money-good debt at a fraction of the usual cost can allow them to generate years of typical returns over short periods. The better managers will look for reasonable opportunities in less distressed periods while reserving resources for deployment in more volatile times.
Event-driven / Merger Arb
As we’ve covered previously, event-driven investing is one of the few Alts strategies that can be effectively managed in a daily-liquid format (e.g., a standard mutual fund). A large subset of the event-driven space focuses on merger arbitrage (“merger arb”), which structures trades around mergers and acquisitions (e.g., one publicly-traded company acquiring another). The perspective on merger arb is favorable in the current environment, as it inherently tends to mitigate the impact of interest-rate or equity-market movements; that’s because the focus is on whether a deal closes (or not) – NOT on whether the market moves up or down.
By structuring trades with both long and short components (of equity and/or debt), merger arb strategies intentionally try to hedge out the interest rate and market noise. Thus, the success of merger arb trades is based on the spread between two positions (e.g., being long one stock and short another stock) narrowing as the anticipated deal closes. The trade ends when the deal closes (or doesn’t close). And those factors point to two reasons merger arb could benefit from the current environment:
- A higher risk-free rate tends to create wider spreads and higher return potential for these types of trades. Said another way, the low-rate environment since the financial crisis naturally diminished the potential returns of merger arb, and we now find ourselves in a much more favorable construct.
- Since these trades only last until the deal is complete, they are naturally short in duration. Even if, for example, 10-year corporate bonds are used to express a particular merger arb trade, the “lifespan” of the trade is only that of the deal period, and the maturity timeline of the bonds is much less relevant. In a rising-rate environment, like we’ve had thus far in 2022, once a deal closes, proceeds can be reinvested into potentially even more favorable trades (at higher rate spreads).
That’s not to say inflation and rising rates don’t present challenges to the event-driven universe. Higher rates and a more volatile environment can increase the uncertainty of deal outcomes. As we saw with real estate and private equity valuations earlier in this series, interest rates can profoundly impact asset prices. It’s not outside of the realm of possibility, then, that a rapidly changing or deteriorating market situation could result in a buyer walking away from a deal or requiring renegotiation of terms – and those risks may be exacerbated if significant leverage (borrowing) is required to complete a deal. Those factors must be assessed for each situation, and – as we’ve discussed many times – investing with a high-quality manager can make all the difference.
I realize this edition was longer than usual, but thanks to those of you who powered through it. I needed to get this series wrapped up to leave room for the annual Indextravaganza recap as the final installment of 2022. And – who knows – in 2023, maybe we’ll get to do a series on the impact of falling rates and lower inflation.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
