By Charlie Henneman, CFA
As a conference organizer, I have put together and witnessed dozens of sessions since the 2008 global financial crisis. Nine years after the collapse of Lehman Brothers, it is still remarkable how often conference sessions arrive at a "Doomsday Moment" - the point when a presenter acknowledges that the spectrum of possible outcomes still includes financial Armageddon.
The Doomsday Moment in Jochen Felsenheimer's presentation at the 2017 CFA Institute European Investment Conference came during the question-and-answer session, but if you're new to this game and weren't in attendance, you're forgiven for thinking it came earlier.
Felsenheimer, a high-yield and distressed portfolio manager with XAIA Investments, began by warning that his presentation, "The Devil in Disguise," would be pessimistic. Then he made a strong case that risk in high-yield markets is as high as it has ever been.
As Felsenheimer sees it, years of excessive liquidity from central banks have completely warped the market, forcing investors to move farther out along the risk curve in search of yield. In his opinion, current market yields do not adequately reflect the actual risks that investors are exposed to.
"We do not live in a world of competitive markets," Felsenheimer said, pointing to negative interest rates as Exhibit A in his manipulation argument. He explained that money pouring into the high-yield sector, largely via exchange-traded funds ((ETFs)), was another source of market distortion, contributing to a massive misallocation of capital that sustains unsustainable enterprises.
The growing concentration of high-yield products in the ETF market is particularly worrisome to Felsenheimer. "There are many worthless companies accessing the credit markets," he said. "I understand these companies have no way to survive. The only reason is the search for yield forces investors to fund them."
The search for yield has also driven many new investors to the sector who do not understand the risk in the asset class. "I've never seen so many investors in high yield who don't understand high yield," he said. "The younger generation of traders didn't experience 2007."
Felsenheimer shared his concerns that idiosyncratic risks in the high-yield sector could become systemic, which means the next turn of the credit cycle would devastate the market. "I think the dumbest slogan in financial history is 'ETFs: Making illiquid markets liquid again,'" he said. "ETFs will add volatility in times of stress. Some bonds are 40%-60% owned by ETFs."
Felsenheimer fears that unprecedented levels of global leverage could bring a systemic increase in default rates, and that they would also result in lower recovery rates for high-yield investors. "Credit pickers will get hammered," he said.
If that weren't pessimistic enough, Felsenheimer then explained why post-default high-yield recovery rates could be even worse than his grim credit outlook might predict.
"Recovery rates depend on the insolvency process, which can be changed," Felsenheimer said. He cited the debt restructurings of Hypo Alpe Adria, Caesars Entertainment, and Novo Banco as examples where the recovery rates for investors were affected by the insolvency process. The prevalence of deteriorating covenant protection in high-yield issuance and a bias to fraud in times of distress were among the other ways that investors faced increasing losses.
Finally, Felsenheimer suggested that the asset management industry, not the banking system, held the largest exposure to high-yield credit. "Asset managers are the fragile part of the system right now," he said. "Big multi-asset funds and ETFs have huge liquidity risk." This is a significant change from prior credit cycles.
Because of these reasons, Felsenheimer concluded that high yield was no place for long-only buy-and-hold investors. He recommended creating exposure to the sector through market-neutral strategies based on carefully executed arbitrage, using bonds and credit default swaps (CDS), which helps investors generate a stable carry income while mitigating interest rate risk and default risk.
"It's better to put leverage on a relatively safe trade than buying over-leveraged European high-yield unhedged," Felsenheimer said. He preferred to use an arbitrage strategy in the high-yield market to generate relative value while avoiding directional risk.
That's when the Doomsday Moment arrived in the form of a question from the audience: "With these strategies, aren't you simply replacing investment credit risk with counterparty risk?"
Well, sure. Felsenheimer's arbitrage strategies assume that CDS counterparties will be able to honor their contract commitments. To support that assumption, he noted that central counterparty clearinghouses in Europe have gone a long way toward reducing counterparty risks, and financial authorities have shown that they will go to great lengths to avoid another Lehman Brothers moment.
The questioner pressed further, suggesting that counterparty risk could not be assumed away so easily. "There's no free lunch," he said.
Felsenheimer conceded the point. "You're right that there is no free lunch," he said, "but there is good lunch and bad lunch. In a nuclear war, you will also lose your investment, but who cares at that point?"
It doesn't get more Doomsday than that.
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