These are risky times for credit investors. With rates at an all-time low, investors are hungry for returns, spawning narrowing spreads and more lenient borrowing standards. In June the U.S. Federal Reserve announced that it will terminate its controversial bond-buying program in October, raising the specter of higher interest rates. Meanwhile, regulatory reforms have created concerns about liquidity and the ability of banks to make markets in times of economic stress. Global banks have also cut back fixed-income, currency and commodities trading desks — historically some of the most profitable operations at firms like Goldman Sachs Group.
And yet opportunities for active credit managers have never been greater. Global banks have been forced to shutter proprietary trading desks and restrain the use of their balance sheets, leaving openings for hedge funds and other nontraditional lenders. As the global economy, particularly the euro zone, seeks to kick-start economic growth, it needs capital providers. Meanwhile, volatility, currently quite low, seems certain to return in credit instruments, from corporate bonds and sovereign debt to asset-backed securities. This can be a positive for active managers able to take advantage of price fluctuations. In fact, some believe, credit is entering a period the likes of which we haven’t seen since the 1990s and one that could transform how investors think about fixed-income and credit investment portfolios.
Michael Barnes co-founded Tricadia Capital Management in 2003 after more than two decades in structured credit and trading at Bear Stearns, PaineWebber and UBS. New York–based Tricadia has $3.5 billion under management, specializes in credit and is known for its market knowledge and analytics. Recently Barnes, the co–chief investment officer, sat down with Institutional Investor Senior Writer Imogen Rose-Smith to talk about risks and reward in credit markets.
Institutional Investor: Banks have smaller balance sheets available for lending, which is creating opportunities for other types of credit providers. Is this something you are taking advantage of?
Barnes: Yes. Specialty finance, nonbank lending, is an area where we see significant opportunities right now. There is strong demand for credit, fueled by renewed growth in the U.S. economy, and nonbank specialty finance companies are filling that gap. These private sector lenders are currently raising capital to provide credit where large banks have pulled back. Areas of particular interest to us are consumer credit lending, such as residential mortgages, auto loans and student lending, as well as corporate credit lending focused on the middle market, commercial mortgage loans and leasing.
Are you seeing similar opportunities in Europe?
Banks have pulled back even more there. That said, the European lending environment is more complex than in the U.S., with different rules covering different jurisdictions and a less-established market for securitization or the public trading of specialty finance companies. Up until the events of 2008, credit creation in Europe was almost wholly driven by banks. That’s now changing.
Are you concerned about the effect a rise in interest rates will have on your portfolio?
Tricadia hedges its positions to rates, so rates going up is not really going to have a material impact on our positions. To the extent that rising rates create opportunity, for a hedged credit fund like ours, volatility creates opportunity to take risk in anticipation of spreads narrowing and stabilizing. We use very little repo [repurchasing agreements]; in our long-short strategy we are using credit default swaps.
What can you do in the current market, with interest rates at an all-time low and investors reaching for yield?
A tight credit market presents the opportunity to source cheap options focused on downside protection for our fund. We are currently very focused on credit hedges that will benefit in periods of increased volatility or credit spreads widening. Also, in this compressed spread and low-rate environment, we have seen a significant amount of new corporate debt come to market. The corporate new-issue market presents the opportunity of buying good credits at attractive spreads; very often you’ll see spreads tighten up as new issues start to trade more actively in the secondary market.
Credit market participants have suggested that the current regulatory and commercial environment has dampened the ability and willingness of banks to make markets, particularly at times of stress. Does this worry you?
We certainly see liquidity in the credit markets as something to be concerned about. As you move toward less liquid products, you have to expect liquidity gaps. In Europe we are particularly concerned about lack of liquidity in periods of stress. When the markets become more volatile, you will see gaps in liquidity, with bid-ask spreads widening quickly. The less liquid the product, the more significant the gap. However, being nimble and opportunistic, Tricadia may also benefit from these periods of spread displacement.
Is the mortgage trade, specifically the post-2008 run-up in residential and commercial mortgage-backed securities [RMBS, CMBS], over?
For the last three years, RMBS and CMBS have contributed significantly to our returns. The beta play for mortgage investments is much reduced — spreads have tightened significantly these past three years as fundamentals improved and significant capital flowed toward this opportunity. But the good news is that we have recently lost competition as large macro funds have begun to curtail their focus on the mortgage market. It has returned to a bond picker’s environment. For those with experience and good analytic capabilities, there are still opportunities. When sourcing mortgage-backed securities, the focus is now on more nuanced fundamentals and shifting deeper in the capital structure. Outside of government debt, the mortgage market is the largest credit market in the world — I’m not sure the mortgage trade will ever be over.
What effect is the halting of the Fed buyback program likely to have on the bond market?
So far, we’ve seen little change in rates or spreads as a result of the Fed’s tapering. However, with improved employment, signs of growth and inflation in the economy, we would expect that further tapering may have a more significant impact. What is almost certain is that there will be greater volatility in the markets as the Fed progresses on tapering. Although fixed-income funds may be hurt in a rising rate environment, we would expect that increased volatility will produce opportunities for credit hedge funds. We welcome volatility if it comes against a backdrop of sustained economic growth in the overall economy.
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