By PutriPascualy, Managing Director, PAAMCO
The changing regulatory landscape impacting banks across the globe has brought dramatic changes to the nature of banking and investing. Credit hedge funds have emerged as an important source of marginal capital in many parts of the leveraged finance market as banks have retrenched and been forced to rationalize their balance sheets. As we continue to see substantial transfers of risk from the global banking system to the hedge fund industry, many investors have asked, what are the opportunities and risks in this brave new world?
Recent developments with trust preferred securities (TruPS) provide an interesting case study onhow credit hedge funds and the banking system can both benefit as risk is transferred from the banking system to investors. TruPS are junior debt typically issued by banks. They are callable, have maturity dates, and, most importantly for the issuing banks, their coupon payments are tax deductible under IRS rules. At the same time, TruPS issued by bank holding companies may also qualify as Tier 1 capital under regulatory rules. These securities were typically placed into a TruPS CDO ( i.e., a structure where a portfolio of TruPS are the underlying assets and the cash flow is paid out in a waterfall structure to different classes of rated notes and an equity tranche). The trust preferred market provided an important source of financing to banks and at the same time, many regional banks were investors in senior and mezzanine tranche of TruPS CDOs. Issuance for these TruPS CDO structure was strong from the early 2000s until right before the financial crisis in 2008.
Recently, many community banks have disposed of their TruPS CDO holdings in the market in expectation of implementation of final rules that are part of the Volcker Rule. Banks benefitted as credit hedge funds came into the market and prices of these instruments rose. Banks were able to bring their portfolios into compliance with the new rules at better than expected proceeds. The credit hedge funds are able to add exposure to an instrument that is yield generating, still offers attractive return, and provides diversification.
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Nonetheless, as a myriad of complex debt instruments become available in the market, investors are best advised to follow the new “rules of the (going to be rather bumpy) road.” First, dealer inventory is much lower than pre-crisis period, which provides opportunity but also removes an important shock absorber in the market as dealers’ ability to make markets is severely reduced. Many investors are aware of this fact, but unless one is actively engaged in the market, it is difficult to truly understand how pockets of the market can go through sudden dry spells. Parts of the non-agency RMBS and junior tranches of the CLO market in 2013 illustrated this point. As such, having an opportunistic mindset and being nimble are more important than ever in capturing buying opportunities in the credit market.Second, as is common in liquidity challenged markets, the bid-ask spread for these instruments is wider than that of the typical corporate bond. This means the cost of a wrong call on the credit fundamentals is higher. Part of the risk premium offered by these instruments is due to the need to understand not only the underlying credit risk behind the instrument, but also the complexity surrounding the structure that “wraps” the instrument. Third, traditional risk methodologies may be insufficient to gauge the risk behind these complex instruments. Most of the risk measures are largely designed to capture the systematic (i.e., non-diversifiable, or market) risks of an instrument. If the very point of investing in these complex instruments is to capture the idiosyncratic risk embedded in them, it makes sense that much of the risk management will need to depend on human knowledge, experience, and sound judgment instead. Furthermore, given the change in regulatory landscape and the resulting behavior of different financial players, a much larger grain of salt is needed when using historical data to predict the future outcome.
The changing landscape will provide fertile hunting ground for the sophisticated players. However, the potentially adverseconsequence of driving forward while looking at the rear view mirror is significant. In order to avoid being paralyzed by fear and/or taking on risks that are of the “unknown unknown” variety, investors should choose the right partner to guide them in navigating the credit environment ahead.
Putri Pascualy is a Managing Director and the senior credit strategist at Pacific Alternative Asset Management Company (PAAMCO). She is responsible for managing investment portfolios on behalf of leading institutional investors. She specializes in evaluating global opportunities in corporate credit and distressed debt. Ms. Pascualy has led the research and structuring of large institutional mandates, where she utilized hedge funds and complex alternative investment strategies as part of innovative portfolio solutions for global investors. She is a frequent speaker in industry panels and at conferences. In addition, her comments and contributions have appeared in The Wall Street Journal, Bloomberg News, Bloomberg TV and Radio, US News and World Report, Thestreet.com, Opalesque and Hedge Fund Intelligence. Ms. Pascualy is the author of “Investing in Credit Hedge Funds” (McGraw-Hill), a practical guide on various aspects of alternative investing in corporate credit.