Hedge fund strategy outlook: October 2020

Foreword

What a difference a few months (and a massive amount of government intervention) can make! The first quarter of 2020 saw markets collapse as the coronavirus pandemic ravaged the globe. Panic, uncertainty and headlines about “unprecedented times” abounded.

In response, the central banks around the globe introduced additional quantitative easing and cuts in interest rates. As these and other stimulus measures have kicked in and pandemic-induced lockdown and social-distancing measures have eased, markets have begun to recover. Risk assets, for example, posted a strong recovery in the second quarter of the year.

The first half of the year demonstrated the resilience of hedge funds — limiting the losses in the first quarter and participating in the subsequent recovery in risk assets in the second quarter. Many strategies are now in positive territory for the year (unlike traditional asset classes). In our view, the current market environment provides a great backdrop for hedge funds to demonstrate how they can offer differentiated returns.

The beginning of the second half of the year has seen markets near new highs. So, the question allocators need to ask themselves now is: Where are the returns necessary to meet long-term return objectives? This question is especially important because the current recovery appears fragile.

We explore this question in our second half outlook. We also highlight areas, such as global macro and relative value strategies, that continue to show compelling forward-looking return opportunities. While 2020 has been anything but predictable, opportunities for investors to pursue returns and mitigate risks exist. Though difficult, this year has served as a good reminder that, in markets, what goes up can in fact come down, and thus a prudent approach to investing is a holistic one.

Market overview

Looking ahead over the coming quarters, the ASI Global Strategy team forecasts a strong recovery in the global economy from the depressed levels of the first half of the year. However, the recovery is not expected to be large enough to recover all of the previously lost output and get the economy back to its previous trend of growth. As a consequence of the Covid-19 pandemic, there will be some long-term economic scarring and a widening of the gap between potential growth and actual growth. This “output gap” is expected to put sustained downward pressure on inflation over the coming quarters.

On the positive side, policymakers across governments and central banks have responded quickly to provide support to the economy. Nonetheless, with interest rates everywhere either at or increasingly close to their lower bounds, there is a growing reliance on unconventional monetary policy and expansive fiscal policy to address the current economic challenges. Despite the extraordinary levels of stimulus authorities across the globe have enacted, it remains the ASI house view that inflation is most likely to remain low, and that Covid-19 will prove to be another disinflationary shock to the economy, similar to 2008. As a consequence, monetary policy is expected to remain highly accommodative for the foreseeable future.

Looking now at the three-year ASI asset class return forecasts (below), one can see — unsurprisingly — that developed market government bonds are priced to deliver very unattractive returns from current levels. In the context of a global economy that is still growing, albeit weakly, and where interest rates are expected to stay low, developed market equities and credit are still the favored asset classes from a top-down perspective. The recommended strategic asset allocation is “risk-on,” but with an emphasis on yield and quality, anticipating that corporate earnings will return to growth over the coming quarters and the policy backdrop will remain favorable for risk assets. In terms of regional preferences for equities, ASI currently favors the U.S. and Asia over Europe. While European equities are attractively priced, the downside “tail risks” in Europe from renewed deflationary pressure are greater than in other regions.

 

Chart 1: ASI three-year asset-class return forecasts (USD hedged)

Baseline scenario: Highest returns for equities ex-U.S., but also great downside risk

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Source: ASI, September 2020. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially. All data is calculated gross of fees. Assets classes refer to the indices listed in the Important Information section at the end of this article.

IMPORTANT: The projections or other information generated for the above analysis regarding the likelihood of various investment outcomes utilize Monte Carlo simulations.  These outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. No projection or forecast can offer a precise estimate of future returns or volatility in global asset classes or markets. Forecasts are inherently uncertain, subject to change at any time based on a variety of factors and can be inaccurate.

 

So what does this mean for our hedge fund strategy outlooks? We are positive on equity long/short  in the U.S., but neutral in Europe, Asia, and emerging markets (EMs). We also have a positive outlook on equity long/short fundamental conservative. We continue to view the current environment as attractive for long/short stock picking, as correlation between stocks has fallen since the peak of the crisis and volumes driven by retail traders have surged, creating inefficiencies in market pricing. We are also positive on discretionary global macro, an area in which we expect opportunities to arise as the policy response to Covid-19 varies across different countries. Finally, we have also become increasingly positive on convertible arbitrage, where bond valuations have become materially less expensive at the same time as the outlook for volatility trading has also improved.

 

Global macro

Most macro strategies generated strong positive performance in the second quarter, with only commodity-trading advisers (CTAs)/managed futures and tail-risk managers having negative performance.


Discretionary global macro managers were by far the best performers in the sector, as they captured a number of profitable market-trading opportunities. Still, there was a large dispersion in performance between the developed-market and EM managers, with EM-focused managers significantly outperforming. The EM-focused managers saw good performance from long biases in interest rates and credit positions, in addition to tactical currency trading.

 

In developed markets, there were notable gains in currencies, with the weakening U.S. dollar a common theme. The most common expression of this view was via long positions in the euro, as the currency rallied strongly against the U.S. dollar from early May. The next-largest gains came from fixed-income and volatility relative-value strategies. In fixed income, strong gains came from a massive compression in volatility and spreads after very poor performance in March. Bond basis trading in the U.S. was also a major driver of returns. Volatility relative value delivered consistent gains as volatility levels were elevated throughout the quarter, despite sharply compressing from their March highs. Systematic macro funds generated positive performance too, although a number of managers still remain in significant drawdowns.

 

Sector performance in CTAs was negative, particularly in June, as these strategies continued to be whipsawed by markets. Underperformance typically came from commodity and equity positions, although sector performance was also negatively affected by currency trading. The commodity losses were the largest. These were driven by net short biases in the energy and metals sectors. In equities, net short biases were negatively affected by the continued recovery in prices. The common factor driving negative currency performance was a long U.S. dollar bias, particularly when expressed against the Australian dollar and euro. Given the massive decline in volatility across asset classes, tail-risk managers performed poorly too.

 


Discretionary Macro
Forward-looking rating: Positive

 

Looking ahead, we expect countries’ depths of recession, abilities to exit lockdown and speeds of recovery to be highly divergent and dependent on the timing and sequence of policy initiatives. This should cause dispersion in price moves across regions and asset classes, providing a breadth of trading opportunities for discretionary macro managers.

 

Besides the virus and vaccine developments, there are several “known unknowns.” These include the U.S.-China trade war and Brexit trade tensions, as well as the upcoming U.S. election. Given these factors, we remain more positive on managers with tactical trading styles than on those that express large thematic views, with certain managers largely waiting on the sidelines for greater clarity before expressing those themes. We have turned more bearish on directional trading opportunities in fixed income given the extent of the monetary policy easing implemented over the recent period. However, managers are more positive on opportunities for trading the interest-rate curve given that yield curves steepened notably in the first half of 2020. The market is pricing in the start of interest-rate normalization within the next year, but several managers view this as unlikely, which would provide opportunities related to the flattening of the yield curve.

 

As short-term yields are anchored by central-bank policy, we believe that currencies will more accurately reflect changing policy, growth and inflation dynamics. This would provide strong opportunities for currency trading regardless of regional focus.

 

Despite substantial outflows in the first half of the year, EMs remain attractive from a technical perspective. We also see opportunities for commodity-focused discretionary macro managers, particularly those that engage in relative-value inter- and intra-commodity-sector trading.

 


CTA/Managed futures
Forward-looking rating: Neutral

 

Given the heightened levels of global economic dispersion we expect, we are concerned that asset prices may not sustain significant trends over the medium to longer term. Therefore, we favor strategies with a short-term time horizon, as these strategies can ebb and flow with the whipsawing markets. For those with a longer-term or medium-term time horizon, we expect a challenging backdrop without sustained market trends.

 

When examining the current positioning across our CTA/managed-futures funds, we find a risk profile that somewhat deviates from our expectations and views. The CTA/managed-futures funds are currently expressing a long bias towards global bonds, but there is limited upside in fixed income, as central banks have doubled down on monetary policy over the recent period. Fixed income has historically been the greatest driver of returns from CTAs/managed futures, and so we are neutral on the strategy.

 

Currencies are likely to provide short-term tactical trading opportunities, but this may prove difficult for CTA strategies. In equities, meanwhile, net-long positioning has started to increase, but remains susceptible to any further market sell-offs. If long-term trends in equities or currencies were to emerge, however, we could become more bullish on the outlook.

 


Systematic macro 
Forward-looking rating: Neutral

 

We believe that fundamentally driven systematic macro strategies may struggle in an environment in which asset prices are driven by coronavirus risks and policy stimulus, rather than idiosyncratic factors. Managers with a pure fundamental approach can often be slower to shift positioning than models with more price-based inputs, given the slower and often lagged nature of economic data releases.

 

We are more positive on multi-strategy systematic macro funds, which include models driven by both price and fundamental data, such as trend, mean reversion, seasonality, market activity and machine learning. We expect multi-strategy systematic macro managers to outperform their peer group slightly over the near term. This is because price-based inputs will be the first to reflect changing headlines, not only on the Covid-19 pandemic, but also on the upcoming U.S. election and global trade.

 

Although we remain neutral on systematic macro strategies, we do believe that the opportunity set is expanding here. But we are cautious because the markets are running well ahead of fundamental datain response to increased global stimulus from policymakers.

 


Fixed income — relative value
Forward-looking rating: Positive


We remain positive on the outlook for fixed-income relative-value (FIRV) strategies given an above-average opportunity set for bond-basis trading, particularly in the U.S. However, we are becoming more cautious here as spreads have begun to compress and levels have slightly lowered our expectations for returns. This slightly less attractive, but still positive, opportunity set for bond-basis trading is offset by a more attractive opportunity set for other trading activities, such as trading around auctions. We also believe that the recently approved European Recovery bonds could present new trading opportunities, particularly if these become a perpetual instrument with tradable futures contracts. Additionally, the backdrop for the other non-traditional FIRV strategies, such as macro relative value, discretionary macro and mortgage trading, remains attractive.

 

Volatility — relative value
Forward-looking rating: Positive


Forceful global fiscal and monetary policy has created a huge divergence between financial markets and fundamentals. We believe that the opportunity set remains attractive as the risk of another market sell-off is priced out. This causes volatility compression and pent-up pressure, resulting in frequent and meaningful dislocations in markets.

We are anticipating high levels of global economic dispersion, which will provide another potential profit source across regions and asset classes. But regardless of the path for volatility, relative-value managers will be able to take advantage because of their agnostic approach to the direction of volatility.

In addition, with the forward volatility curve (VIX) now flat or in slight contango (having been in steep backwardation at the end of the first quarter), we expect additional trading opportunities as the forward curve could move into steeper contango if volatility were to fall, or into backwardation should volatility increase again.

Lastly, over the first half of 2020, several volatility-arbitrage players who were involved in the selling of convexity and skew (which compressed these parameters indiscriminately) exited the market because of poor performance. This creates greater dispersion and more relative-value opportunities in certain areas of the volatility relative-value market, such as long/short trading in skew and convexity.

 

Niche tail risk
Forward-looking rating: Neutral


From their peaks in March to the end of July, the VIX Index (representing S&P volatility), MOVE Index (representing U.S. Treasury volatility) and CVIX Index (representing developed-market currency volatility) have fallen by -69.5%, -74.8% and -53.3%, respectively. Volatility markets have priced in an elimination of the worst tail risks because of the strong support from central banks and policymakers. However, we believe that the markets remain vulnerable.

Although we are not necessarily predicting a return to the extreme levels of volatility markets saw in March (VIX Index at 86), a move from sub-30 VIX Index to levels greater than 50 is a possible scenario. The probability of exit strategies failing has increased significantly in recent weeks, and the U.S. election, trade tensions and a second wave through fall and winter are all factors that could herald further volatility. Currency volatility, which is at historically low levels and is attractive from a valuation perspective, provides a strong opportunity for managers. In addition, with interest rates anchored by monetary policy, fiscally driven policy, which is typically more uncertain and sporadic, will start to have a much bigger impact on foreign-exchange volatility. Against this backdrop of maintained or increased volatility levels in most asset classes, there are several factors that keep us neutral on tail-risk strategies. These include vaccine developments and further highly accommodative policy measures.

 

Event driven

It was a strong quarter across the board for event-driven strategies, particularly for higher-beta activist strategies, which rebounded following the March dislocation in markets. However, for the year to date, all sub-strategies remain underwater, per our internal indices, although value-with-a-catalyst strategies were only marginally in the red as we entered the second half of the year.

After the unprecedented widening of merger spreads in March, arbitrage managers experienced continued challenges in the second quarter: M&A activity dried up, and several of the remaining deals face uncertain outcomes as some buyers struggle with liquidity and deal terms agreed upon pre-pandemic. Arbitrage managers’ exposure levels declined as completed deals rolled off with insufficient new transactions into which to redeploy this capital. However, spreads continued to tighten from the extremely wide levels of March, enabling managers to generate positive returns.

In the absence of catalysts, value-with-a catalyst managers rotated into compounding stocks and tended to benefit from behavioral shifts emerging in the post-Covid-19 world. Activist managers generally put a pause on traditional activism, especially deal-driven campaigns, at the beginning of the period. However, by quarter-end, managers had begun to adapt, focusing on strengthening company balance sheets and initiating new positions where they believed they could create value in the “new normal.”

A couple of notable themes emerged across the sub-strategies. First, we saw a record amount of special-purpose acquisition company (SPAC) issuance, with managers across the event-driven landscape allocating to the asset class, especially those that traditionally have a heavy merger-arbitrage component and are sitting on larger-than-desired cash piles. Second, we saw several managers launching credit-focused funds/vehicles. While investment-grade opportunities quickly came and went following the unprecedented levels of central-bank support, managers have positioned their portfolios for the much-anticipated next leg of the cycle and opportunities in distressed/restructuring credit that may emerge as a result of the Covid-19 pandemic.


Activist
Forward-looking rating: Positive

Despite the uncertainty in markets, improved shareholder engagement remains an important topic for global policymakers. Companies are in the spotlight regarding how they respond to a challenged economic environment. Additionally, as passive investing continues to grow in popularity, we expect the engagement of traditional investment managers to continue to affect the balance of shareholder power. Index funds managed by firms such as Vanguard have large ownership stakes and voting influence, and therefore a greater voice on governance and stewardship principles.

 

In the near term, we expect a slowdown in new activist campaigns as uncertainty across markets remains high. M&A-related activist campaigns and capital return-related campaigns (i.e., share buybacks and dividends) appear to be on hold. However, market dislocations create opportunity, including opportunities to double-down on existing positions and initiate positions in new target companies. The sharks are swimming, and activist investors remain on the hunt for companies trading at levels below their fundamental value. Activist managers with cash on hand are in a position of strength because it allows them to allocate capital to companies that experienced steep price declines and, at the same time, increase their stake and influence. Many companies find themselves in a vulnerable state as buyer appetite should return sooner than seller appetite, which could also create an uptick in hostile activity.

 

Risk Arbitrage
Forward-looking rating: Neutral

Following March’s dislocation, managers capitalized on the short-term opportunity to generate strong returns on pending deals, but we maintain caution because of heightened re-investment risk. Global M&A activity is down, and given the larger level of uncertainty over future deal activity, managers will struggle to reallocate capital quickly. As a result, they are currently running with high cash balances. This said, we continue to like the defensiveness of risk arbitrage.

 

Short bouts of volatility that cause spreads in announced deals to widen create opportunities for arbitrageurs. We witnessed this in March, when deal spreads reached their widest levels since the 2008 global financial crisis, generating opportunity for very high returns in a short period of time when these transactions closed and the spreads collapsed. Longer term, a high level of uncertainty can lead to acquirers walking away from deals and curtail new M&A activity. We have witnessed a significant decrease in new M&A activity because of the Covid-19 crisis. Collapsing chief-executive and consumer confidence, increased global policy uncertainty and a sustained period of volatility challenge the drivers for M&A activity. Sustained high volatility and deal breaks are the biggest risks to the strategy. Managers certainly don’t rely on high M&A volumes to generate strong performance, but persistent deal flow can be a tailwind to the strategy.

 

Ultimately, we do expect M&A activity to return as uncertainty recedes. Activity is emerging in industries primed for consolidation or growth, such as healthcare, tech and consumer-led businesses that need to adjust the post-Covid-19 world.

 

Chart 2: Weekly Average U.S. Deal Spreads

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Source: Bloomberg, September 2020

 

Equity long/short

The second quarter proved to be a great period for many equity long/short managers. The HFRI Equity Hedge Index (+13.4%) posted its largest quarterly return since the fourth quarter of 1999. The majority of strategies recovered their first-quarter losses and closed the second quarter with positive returns on the year. The combination of easing Covid-19 lockdowns, indications of improving economic data and large-scale monetary and fiscal stimulus packages contributed to the rallies across many equity markets. Volatility abated over the quarter overall, but there were episodes of volatility as further Covid-19 outbreaks and escalating U.S.-China tensions caused nervousness among market participants.

 

Factor exposures played a large part in determining returns, particularly in the U.S. strategies with an overweight exposure to growth and/or an underweight to value tended to outperform. Although year-to-date alpha generation is positive across all regions, in the U.S. this has largely been driven by factor contributions, rather than stock selection. From a sector perspective, strategies with overweight exposure to technology, energy and consumer discretionary were among the top performers, while those that were overweight in utilities or consumer staples lagged. From a regional perspective, there was little difference in performance as developed markets and emerging markets performed broadly in line. There was a positive correlation between net exposure and performance, with the top-performing strategies running with high nets and capturing the market rally.

 

The performance of systematic quantitative strategies was marginally positive for the second quarter, beginning with the reversal of weak performance for shorter-term models from the end of the first quarter. In particular, positive performance came from faster-moving models based on contrarian and sentiment insights, as well as from those based on the liquidating activities of market players.

Positive strategy performance then continued throughout the quarter, particularly for managers who were able to construct models and use alternative data to capture Covid-19-related themes, such as technology firms that provide work-from-home solutions, e-commerce capabilities and healthcare stocks focused on vaccine research. Longer-term models were not able to navigate the volatile markets or the shorter-term time horizons, which led to underperformance for those with slower trading programs.

 

North America
Forward-looking rating: Positive


We remain bullish on the opportunity set for North America-focused managers. We believe that the U.S. will continue to outperform and produce superior earnings growth given its position at the forefront of innovation and secular growth.

We favor sectors that have historically exhibited the widest dispersion regardless of the outlook for economic growth. These include technology, healthcare and industrials.. Certain trends and themes in technology will continue to provide opportunities, such as the growth in “software as a service” and the emergence of 5G, but the sector has become increasingly attractive as a whole, as people who have begun to work from home in light of pandemic concerns have increasingly dependent on cloud technology. In the same theme, cable-broadband companies will continue to benefit from more people needing high-speed internet access.

Within healthcare, product innovation, regulatory complexity, supportive demographic trends and protection of intellectual property continue to create a dynamic environment for long/short investing. Certain areas remain attractive as they suffer only minimal impact on earnings from Covid-19. These include managed care and pharmaceuticals. Life-saving drugs and novel treatments are considered recession-proof, so certain biotechnology companies are also viewed as attractive opportunities. Another bright spot has been in diagnostics companies, given the demand for Covid-19 testing. Additionally, there have been impressive spikes in the valuations of companies developing Covid-19 treatments, regardless of fundamentals.

At the broader market level, we continue to see supportive dynamics as behavioral, monetary, and valuation signals point to a favorable opportunity set for managers. In the long term, there may be pent-up demand for goods and services as and when restrictions are more widely eased, which will boost economic activity.

 

Europe

Forward-looking rating: Neutral


In Europe, we favor managers with variable net exposures who can capture market-rally beta without being excessively exposed to a fragile economic recovery. We favor those focused on identifying quality and secular growth and value-with-catalyst opportunities, and are less keen on those with pure value doctrines.

Despite strong second-quarter performance, European equity markets remain fraught with risks to the downside. Investors were both surprised and impressed by the swiftness and magnitude of the European Union’s €750 billion recovery strategy. But while the strategy itself has been lauded for mitigating serious tail risks and providing much-needed comfort to the market, it alone won’t stimulate the entire European economy to a sustainably high growth rate. The EU recognized the need for an atypically coordinated and impactful response in this unique situation, which is encouraging, but fault lines remain, and the bloc’s unity and resilience will continue to be tested.

We’ve observed managers in the region adding more style balance to their portfolios. While quality growth remains a core focus for many active managers in Europe, such stocks have been strong outperformers in a market beset with uncertainty. Managers feel it prudent to take profits in these areas and selectively to add cyclicals and value stocks that have lagged in the market recovery (and reduce them in their short books). Many managers we’ve communicated with have made it clear that they’re not advocating a structural shift to more cyclical areas of the European market. A sustained preference for such stocks would require signs of a sustainably strong economy and, typically, higher bond yields, which have eluded the European market for many years. But tactically adding style balance to the portfolio should make it more resilient in a market marked by extremely high factor volatility and correlations. Managers want to help protect portfolios in such a sharp rotation.

 

Asia, Japan and emerging markets

Forward-looking rating: Neutral

Many managers within the China long/short strategy display strong exposure-management skills while delivering attractive alpha. There are still various tailwinds for long/short stock-pickers within Greater China, with the improving quality of the onshore stock-lending market among the most highlighted. We continue to target funds that have both high-quality bottom-up research processes and strong top-down risk management procedures (with macro awareness).

Although the Chinese government was accused of mounting a slow response to the spread of Covid-19 and suppressing information, the scale of its containment plan has dwarfed the measures taken in developed markets. The aggressive monetary and fiscal stimulus packages combined with gradual improvements in the local economy have also contributed to a buoyant market. 

New-economy stocks continue to gain most attention, both from institutional and retail investors. Managers, however, show an increased interest in cyclicals, which are trading at attractive valuations and with good visibility on earnings recovery. In the current environment, stock-pickers are focusing on quality metrics, such as balance-sheet sustainability and management quality. 

In Japan, the uptick in the Bank of Japan’s ETF-purchasing program has created a difficult environment for fundamental stock-pickers. The magnitude of Japan’s fiscal and monetary measures will help support equity markets, but Japan long/short has struggled to deliver alpha and attractive returns in recent years with the expectation that this underperformance could continue. However, the government remains committed to improving corporate governance, and the identification of long/short managers with expertise in identifying opportunities in corporate change is still a preferred route for us.

While various valuation metrics are trading at attractive levels, the economic impact of Covid-19 could prove more severe and longer lasting in EMs than in the developed world. Economic data from Latin America, India, Indonesia and South Africa is lagging emerging Europe and the Middle East. Gross exposures are low, reflecting this nervousness, and managers have commented on reduced liquidity in the market. Our preferred access route is through managers with expertise in allocating across various countries.

 

Systematic quantitative
Forward-looking rating: Neutral

Although performance for quantitative managers in the second quarter was largely positive, our expectations looking forward are neutral given the uncertain backdrop. Those managers with shorter-term time horizons performed well during the second quarter, while those with a more focused approach in terms of the time horizons of their signals and/or the markets in which they invest did not generally perform as well. We maintain the view that sentiment models will be alpha-generative, as will short-term technical models.

 

There is still evidence of accelerating alpha decay, which keeps our Sharpe-ratio expectations for these model categories tempered. But we continue to believe that a key source for alpha generation will be machine-learning techniques that can identify non-linear relationships between disparate variables. Particularly relevant to the current market environment will be the ability of managers to capture data and develop models based on the constantly evolving Covid-19 situation. Consequently, we continue to prefer larger managers who invest globally and have the technological resources to analyze increasingly complex data sets, as well as the ability to develop new models faster than older models decay.

 

Alternative credit

In the second quarter, credit strategies’ performance collectively did a 180-degree turn compared with the first. Across the board, all strategies were positive as the U.S. Federal Reserve and other global central banks pumped liquidity into markets and investors came back searching for yield.

There was, however, a meaningful difference in performance between broad, liquid credit strategies and less liquid, hedge-fund-type strategies. For example, U.S. high-yield and crossover strategies delivered large returns leaving them much closer to breaking even for 2020. Few credit managers, corporate or structured, matched this performance in the second quarter or are as close to being back in the black.

In corporate credit, many issuers were able to tap the capital markets to borrow at attractive levels to help them weather Covid-19-related business disruptions. Notably, energy credits, which are an exposure across many managers, rebounded strongly in the period, but still remain deeply in negative territory for the year to date. Despite the open debt-capital markets and improving investor sentiment, there were still many notable defaults over the quarter, such as Intelsat Jackson ($14.4 billion of bonds and loans), Chesapeake Energy ($6.0 billion), Valaris ($5.7 billion), Neiman Marcus ($4.3 billion), and JC Penney ($3.7 billion).

With forced selling, margin calls and thin liquidity of a sort last seen in the depths of the 2008 crisis, the first quarter was difficult for structured-credit strategies. But they enjoyed a strong recovery over the second quarter, particularly in June. For many managers, RMBS (residential mortgage-backed securities) led the way as forbearance and fundamental data came in much better than most anticipated. Other sectors also saw a recovery in performance, including mezzanine collateralized loan obligations (CLOs), as spreads tightened on the back of inflows and the Fed’s bond purchases. Despite the well-telegraphed issues in the commercial mortgage-backed securities (CMBS) sector, commercial real estate (CRE) credit also experienced a rebound, predominately in June, on the back of improved technical opportunities.

After posting losses in March, the sector experienced a strong recovery in the second quarter, and most convertible-arbitrage managers performed well. Managers captured high-single/low-double-digit gross returns over the quarter and generally recovered from their year-to-date drawdowns.

 

Convertible arbitrage
Forward-looking rating: Positive

We upgraded our outlook on convertible arbitrage to positive last quarter, in light of the opportunities that opened up from the Covid-19-related market dislocation. Despite the strong second-quarter rally in the equity and credit markets, the pricing of convertibles remains cheap relative to their theoretical fair value. This is the result of both the strong supply pipeline in the second quarter, with issuers keen to offer discounts in order to attract investors, and the elevated longer-dated volatility and tighter credit spreads, which increase the theoretical pricing.

In addition to the attractive valuations, the strategy is further benefiting from two other industry trends. One is the record level of new convertibles issuance, with $92 billion priced in the first half of 2020, a record for the first half of the year. The sectors hit hardest by Covid-19, including cruise liners, airlines, retailers and clothes manufacturers, are issuing convertible bonds to take advantage of their stock volatility and offer participation in a potential rebound. 

Lastly, the impact of Covid-19-related disruptions on business activity and liquidity has meant that single-name volatility remains elevated against high levels of uncertainty about the economic outlook. Higher volatility levels and dispersion create a favorable environment for those managers with strong company-research capabilities and those who can monetize the volatility mispricing, as well as trade between credits and within capital structures.

Chart 3: Convertible Bond Valuation

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Convertible bond valuation 

Source: BofA Global Research, ICE data indices, LLC, September 2020.


Structured Credit
Forward-looking rating: Neutral

Last quarter, we downgraded the outlook from positive in response to the onset of Covid-19. Fast-forward three months and central banks and government policymakers have implemented significant monetary and fiscal programs that have supported the recovery in structured-credit pricing. However, there is considerable uncertainty about the economic fundamentals. Furthermore, the pandemic appears to be accelerating technological adoption and changing fundamental behaviors such that the outlook could have a wide range of outcomes.

 

We continue to favor the RMBS sector. It has benefited from the low-interest-rate environment and the search for yield, leading to demand for new issues and increased trading volumes. Significant resources are likely to be devoted to ensure that home prices remain stable and to keep borrowers in their homes. All of this speaks to continued positive cash flows and collateral backing. However, we are keeping a close eye on several developments in the sector:

  • Increased refinancing trends as mortgage rates dip lower
  • The level and impact of forbearance programs on cash flows
  • The evolution of the unemployment picture
  • The legal uncertainties of investing in parts of the sector.

To date, several other structured-credit asset types have also enjoyed significant spread tightening, but the risks continue to be elevated. For example, while the prices of junior CLO debt tranches increased over the second quarter, and CLO equity tranches have continued to distribute cash to investors, there is potential for further increases in corporate defaults. Within the CRE sector, the amount of delinquent loans has picked up, and these are likely to rise further. In the current environment, CRE valuations carry significant uncertainty, especially for retail and even some office space. Therefore, it may be prudent to remain defensive in these sectors and to await better entry points.

 

Insurance-linked securities
Forward-looking rating: Neutral

Midyear 2020 reinsurance renewals suggest a further firming up of rates (+5% to +20%) and insurance-linked securities (ILS) managers recouping a higher mean return compared with the previous years. However, we maintain a neutral outlook as the low-interest-rate environment is likely to support the supply of capital into the sector and environmental risks appear to be increasing. For example, one interesting area of current debate is the degree to which commercial property-insurance policies cover business-interruption losses caused by the Covid-19 pandemic. While the insurance industry is likely to push back on such claims, this is a matter of current litigation and has led to the creation of side-pockets or holdbacks by some funds, pending further clarity around the legality of such claims. In the second half of the year, all eyes will be on the hurricane season, which started in late July with category-one hurricanes Hanna, Douglas and Isaias making landfall in southern Texas, Hawaii, and North Carolina, respectively.



Relative value - MBS/ABS
Forward-looking rating: Neutral

The mortgage-derivative space suffered a significant dislocation in the first quarter on the back of a technical unwinding of balance sheets. This provided an attractive entry point at spreads of 500–700 bps in conventional assets, and significantly more in niche sectors. However, several risks still remain, and these could drive higher prepayment speeds from here (which is negative for returns). These risks include the following:

  • Higher-than-expected (voluntary) refinancing levels. Despite projections that tightening credit availability and higher unemployment would lead to slower refinancing levels at the start of the quarter, government-sponsored enterprises have provided a number of flexibilities to servicers and originators to facilitate and streamline refinancing, leading to elevated prepayments.
  • Policy risk (namely loan buyout) leading to higher (involuntary) prepayments. This risk is higher for certain securitizations as some servicers have the right to buy out any loan that is 90 days delinquent and to effectively pocket a profit as the loans re-perform. In the second quarter, several more aggressive servicers bought out loans.

Nonetheless, the current complex environment for pricing prepayment risk favors those managers with the fine-tuned bottom-up research capabilities required to select those securities that become oversold because of policy risk or liquidity needs. In addition, a low-interest-rate environment should continue to support the demand for strong carry assets, creating the potential for further spread tightening.

 

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IMPORTANT INFORMATION

Important information regarding the Monte Carlo simulations included in chart 1 : ASI’s forecast modeling incorporates both proprietary and third party tools to derive a risk and return data for each asset class listed. Our forecasts and projections are informed by history while making forward looking assumptions. ASI believes that the benefit of this information is highest in evaluating the potential risk adjusted return of various components of a globally diversified portfolio. We make use of economic forecasts, implied market views and assumptions about historical trends and mean reversion over several time horizons. We use various macroeconomic and asset-class specific variables as inputs. In attempting to forecast expected returns and volatility, we apply a Monte Carlo simulation method to project the estimated volatility. This enables us to create 10,000 scenarios for each asset class listed, from which we derive realistic probability distributions for returns, and from which asset class volatility can be derived. Results produced by the forecasting tool will change with each use and over time. Since past performance and market / economic conditions may not be repeated in the future, information provided should not be viewed as an indication of future results events or results. Further information regarding our forecast modeling can be delivered upon request.

Asset classes referenced in chart 1 are represented by the following indices: UK Equities = MSCI United Kingdom Index; US Equities = MSCI USA Index; Europe ex UK Equities = MSCI Europe Excluding United Kingdom Index; Japan Equities = MSCI Japan Index; Emerging Markets Equities = MSCI Emerging Markets Index; Global Equities = MSCI AC World Index; UK Gilts = ICE BofAML UK Gilt Index; UK Inflation-Linked Gilts = ICE BofAML UK Inflation-Linked Gilt Index; US Treasuries = ICE BofAML US Treasury Index; US Inflation-Linked Treasuries = ICE BofAML US Inflation-Linked Treasury Index; Euro Govt Bonds = ICE BofAML Euro Government Index; Euro Inflation-Linked Govt Bonds = ICE BofAML Euro Inflation-Linked Government Index; UK IG Bonds = ICE BofAML Sterling Corporate Index;  Euro IG Bonds = ICE BofAML Euro Corporate Index;  US High Yield Bonds = ICE BofAML US High Yield Index;  Europe High Yield Bonds = ICE BofAML Euro High Yield Index; Senior Secured Loans = S&P/LSTA Leveraged Loan Index; ABS - Mezzanine = Bloomberg Barclays Euro ABS FRN BBB Index; UK Commercial Property = MSCI UK Monthly Property Index; US Commercial Property = MSCI US Property Index; US REIT = FTSE EPRA/NAREIT United States Index; Europe ex UK REIT = FTSE EPRA/NAREIT Developed Europe ex UK Index; USD Cash 3M LIBOR = ICE BofAML US Dollar 3-Month Deposit Offered Rate Constant Maturity Index

Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.

Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

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RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.