Opportunities in “off-the-run,” less-liquid, storied credits


Capitalize for Kids – Opportunities in “off-the-run,” less-liquid, storied credits, Michael Apfel (Midocean Credit Partners), October 12, 2017

“This is a market characterized by low yields, high valuations and lack of volatility. The overall lack of volatility has been breathtaking and at times unnerving. Our tactical response is to anticipate that a spike in volatility is coming but avoid overreliance on it happening in the near-term. Until market confidence is shaken by a catalyst we will likely stay in this low volatility-low yield paradigm”

  • Chasing returns in this low volatility-low yield environment is unwise unless you stay extremely disciplined, targeted and maintain strong underwriting standards
  • Total return and yield-oriented investors have struggled with a paucity of product particularly in the traditionally higher yielding sectors
    • LBO volume remains muted and is well off the pre-2008 peaks and dividend deals; CCC issuance is also quite subdued
    • On the secondary side, distressed and stressed product is harder to source
  • Have been focusing on the less liquid segment of the corporate debt markets, primarily “off-the-run” high yield and leveraged loans where significant discount to underlying credit risk exist
    • Opportunities persist in these “off-the-run” North American corporate credit issues as a result of ongoing regulatory, structural, and technical/liquidity factors that continue to cause market prices to decouple from fundamental value
    • Increased price dislocation especially in risk-off market episodes further supports the opportunity set
  • There is limited competition in these names as larger managers tend to focus on more scalable investment opportunities
    • “Off-the-run” names are typically smaller sized issues from private companies with limited financial disclosure and little-to-no sell-side research coverage which further reduces competition
    • Extensive due diligence is required given the complexity of these names as they are often businesses in transition
  • Feel this investment universe is sustainable and attractive as a byproduct of regulatory challenges, the aforementioned barriers to scale for larger managers and significant crowding in on-the-run names
    • Gap risk is an ongoing phenomenon in credit markets that suffer from bouts of illiquidity and technical pressures as a result of downgrades, fund redemptions, and regulatory pressure acutely experienced in “off-the-run” names
    • Banks have become increasingly focused on balance sheet efficiency which has led them to abandon their proprietary trading businesses and reduce holdings of leveraged loans and high yield bonds within their “held-for-sale” trading positions that are infrequently traded
  • Witnessing dealers becoming less willing to act as “shock absorbers” for credit markets, especially with less frequently traded issues. Believe this creates “noneconomic” sellers who are forced to sell at discounted prices
  • Credit markets are increasingly susceptible to market dislocations since the 2008 financial crisis. Shocks have been sudden and not dependent on an economic recessionary environment developing
    • Smaller, less liquid and more storied credits tend to be more exposed to “gap” risk for longer, deeper periods during these dislocations and shocks
  • Witnessing dramatic changes in fund flows which has been exacerbated by the growth in retail oriented funds such as ETFs
    • Many of these funds offer daily liquidity which can cause a mismatch between the underlying liquidity of the assets held with the daily redemption features of the fund
  • While most investors bemoan the low yields, high valuations and lack of volatility, we are continuing to find a series of technical breakdowns and perceived mispricing’s in loans and bonds that are wildly opaque and complex enough stories to create a significant underfollowing

Michael Apfel is the Co-CIO of MidOcean Credit Partners. MidOcean Credit Partners focuses on structurally inefficient segments of non-investment grade credit markets. Launched in February 2009, the Firm now manages approximately $6.4bn across a wide range of alternative credit strategies including Hedge Funds, Drawdown Funds, Tax Advantaged Fund, CLOs and customized strategies/separate accounts as of 8/31/17.

Image Source: Capitalize for Kids, MidOcean Credit Partners, BAML