Credit hedge funds – brighter opportunities for a cloudier second half

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Investors in traditional credit markets face a more challenging and complex second half. We expect growth to slow for the remainder of 2023. Lending standards are tightening in many developed markets, a trend intensified by banking turbulence in the US and Europe. And riskier credit segments like high yield and leveraged loans are most at risk of spread widening and negative total returns, as borrower distress and default rates likely climb. Default volumes totaled USD 7.2bn in bonds and USD 6bn in loans in May, while US corporate bankruptcies stood at 236 between January and April this year (double the same period in 2022) based on Bank of America data.

Overall, we are most preferred on fixed income over equities, with a preference for high grade and investment grade bonds over riskier traditional credit segments. But the challenging environment for traditional credit investors may prove fruitful hunting ground for alternative credit managers, in our view. We see growing opportunities for credit hedge funds to provide investors that can bear their risks with attractive carry, lower sensitivity to interest rate and credit risk, and potential for greater gains than losses thanks to “convexity.”

Credit long/short funds may benefit from higher dispersion among the riskiest issuers. Fundamental credit long/short hedge funds posted annualized returns of 2.8% in 2023, with less than half of the volatility of traditional credit (based on HFRI RV Corporate Index data). We see further value in this strategy for the second half, as it seeks to generate returns from exploiting differences between issuers and using hedges to limit exposure to overall credit market movements.

Spread dispersion between high-yield issuers stands at a year-to-date high, suggesting larger return potential from long/short credit hedge funds. These strategies may also benefit from market volatility, as they historically outperformed traditional credit investments two-thirds of the time after a market sell-off (based on HFRI RV: Fixed Income Corporate and Bloomberg US Corporate IG index data back to 1993).

In today’s uncertain economic environment, we see most merit in seeking exposure to managers with low net exposure and with the ability to go net-short in credit markets should economic worries prove worse than expected.

Convertible arbitrage strategies may offer bigger opportunities for gains than losses. Historically, convertible arbitrage funds (represented by the HFRI RV: FI-Convertible Arbitrage Index) generated comparable average annualized performance to equities at less than half the volatility. And low positive correlations of 0.24 and 0.59, respectively, to global bonds and global equities suggest potential portfolio diversification benefits for long-term investors (based on data since 1993).

We see scope for convertible arbitrage to extend its 2.7% year-to-date gain, as last year’s equity market sell off means many US instruments offer appealing yields and would gain more in price from an equity rally than they would fall should stocks sell off (the so-called “convexity” effect). Rising default rates, however, underscore the need for issuer selectivity and for investors to seek managers with conservative approaches and good hedging capabilities.

Distressed corporate debt managers may be able to add value as defaults rise. On balance, we expect mid-single-digit default rates for both high yield and loans over the next 12 to 18 months. The growth in size for lower-rated credit markets over recent years may provide additional opportunities for distressed managers to generate returns. For now, we favor opportunistic funds as well as other alternative managers in private credit with extensive experience through multiple cycles and robust risk management processes, as opposed to investing in traditional distressed funds. Banking sector struggles this year might also benefit private asset-backed finance (ABF), as subdued bank lending and a potential economic slowdown can create opportunities for non-bank lenders. With increased demand, resilient private balance sheets and low defaults, ABF presents diverse investment opportunities across sectors and themes, in our view.

Investors in alternative credit strategies should be aware that these assets are long-term focused, illiquid, and require longer lockup periods. Investors need to be comfortable with those risks, as well as those around transparency of underlying holdings, leverage, and volatility. Above all, investments should be made within the context of a financial plan and a well-diversified portfolio.