Polygon Convertible Opportunity Fund Up 11% in 2011

Polygon manages approximately $5billion. Their convertible fund had a spectacular 2011, outperforming the US Convert Arbitrage Index by over 1300 bps. The fund has outperformened the index in 2009 and 2010 as well. The fund did this with a sharpe ratio of 3.0!

Below is fund commentary. You can also view OPolygon’s Equity opps funds, which we posted here.

It is an annual tradition that email inboxes are flooded with outlook pieces providing forecasts and predictions for the coming year and we have dutifully sought to craft our own insightful guide for 2012. This is no simple task, as recent years have demonstrated, and the macro picture seems even more uncertain now than it was at the beginning of 2011. Apparently, much of the research community sees things differently and strongly held views and forecasts are as forthcoming as they are varied. As a result of this incongruity, I found myself reflecting on the value of “outlook” pieces rather than effectively documenting my thoughts on the coming year and a considerable portion of the letter is devoted to this topic as a consequence. Unfortunately, the timing of this piece was also affected and is more coincident with the dawning of the Chinese New Year than it is with the first days of 2012.

A good friend forwarded me an interesting article from the New York Times entitled “A World in Denial of What it Knows”1 in which the author argues that many plain truths are evident but we willfully choose to ignore them. More specifically, he references the Euro in this light: “If truth be told (but it so rarely is!), the euro cannot work and could never have worked.”
He describes this “truth” as an unknown known – borrowing from author Fintan O’Toole (who himself clearly owes Donald Rumsfeld). He defines these unknown knowns as things which are: “…easily knowable, or indeed known, but which people chose to “unknow.” The author urges us to “unknow less and know a little more” – arguing we should accept as fact that the Euro is doomed to failure (and to do otherwise is akin to sticking our heads in the sand). Whilst I believe the Euro experiment to be deeply troubled I found his confidence in its demise concerning. I also recognized in it a commonality with many of the outlook pieces I had just read: they also contained a strongly held and articulated opinion about events, many of which I viewed as unpredictable (or unknowable even). The predictions vary from the life expectancy of the Euro and the coming implosion of the Chinese real estate market to the timing of an imminent Greek default or Italian banking crisis. There was only one outlook piece I read which was truly concerned with the “shelf life” of what they had written.
Economic research, like the broader media, appears to have followed a more sensationalist path in recent years. Alongside more spectacular news, we encounter economic predictions that are more dramatic and convictions (in opposing directions) which are more strongly held. It is easier to find an article vociferously supporting one side of a point than to find an agnostic or hesitant publication offering a more balanced perspective. Research houses appear so committed to making specific forecasts that this tendency has led to a proliferation of “surprise” predictions to complement the general outlook. Rather than directly admitting the fallibility of their views, analysts prefer to predict the “surprises” by which their very own forecasts might be undone.

Forecasts and predictions are a fact of life in our business and invaluable to the investment process. It is clearly sensible to handicap issues of importance to the capital markets (and to prepare for even the unlikeliest of outcomes at the same time) but I think one of the greatest mistakes we can make as an investor is to hold too strongly an opinion. Research demonstrates that an observer’s predispositions will become more strongly held when positive reinforcements are encountered, yet, that same observer ignores data at conflict with their thesis. I am now finally coming to my central point which is that an open mind and a great deal of patience were perhaps our greatest assets in 2011.

1”A World in Denial of What It Knows” – Geoffrey Wheatcroft, The New York Times, 31 Dec 2011.

We were (and remain) defensively positioned. Our focus is on catalyst driven opportunities and in maintaining a nimble and reactive book. Our positioning has, in rosy months, guarded against ugly outcomes we had believed unlikely, and in periods when the world cries “the sky is falling” it has provided us the
latitude to adopt a more positive view than pundits deemed sensible. The European sovereign crisis dominated newsflow and risk appetite in 2011 as I am confident it will do again in 2012. I don’t know if the flawed Eurozone experiment will ultimately come to a fatal end, although I suspect a break-up would prove a far more expensive and damaging outcome than to forge onwards with an imperfect union. It is also difficult to gauge the depth and length of a potential European recession with banks expected to de-leverage against a backdrop of near unprecedented austerity. Who will govern France and will it affect European unity? How will the ECB behave with Draghi at the helm of a new six-member board (new in that it will soon include not even a single member who was on the board 24 months ago)? With such uncertainty, it is no surprise we are keen to maintain our nimble positioning.

With that said, there are a number of reasons to be more optimistic about 2012 than 2011, including a credit market which currently prices in a far more dire outlook than it did 12 months previously, a convertible market which is now significantly cheaper than it was at this time last year, and a competitive landscape (particularly in Europe), which remains highly attractive.

Convertible Valuations

The convertible market has for the last seven months traded in sympathy with the general appetite for risk, and valuations have risen and fallen broadly alongside moves in the equity and credit markets. The U.S. remains the largest and deepest convertible market and has shown the least sign of strain, both on valuations and with respect to liquidity. European convertible bonds have steadily cheapened in recent months and the performance for European funds (both outright and hedge funds), has been poor, leading to small outflows. The U.S. market is at its cheapest since August 2010 while European bonds have not been this inexpensive since 2008 (see Charts 1 and 2).

 

Liquidity in Europe, particularly in the more esoteric names, has declined, sell side commitment to the product is not as strong as it was a year ago and both
capital and head-count have been reduced, in some cases very significantly. As a result, movements in bond prices and valuations are more dramatic as dealers are uncomfortable carrying inventory (and therefore prices adjust quickly to find the other side of a trade).

Being an appropriately-sized fund is even more critical given the reduction in trading volumes the market has withstood in recent months. One further implication on the markets has been the near total absence of a calendar for new issuance. We think this particularly affects the large arbitrage focused funds in the space as it can be a significant source of cheap paper with new issuance providing the liquidity to build large positions. All of these factors leave the European markets less vibrant than they were but should work to our advantage given our more concentrated approach and nimble size. As the chart below demonstrates, our differentiated approach and thoughtful risk management have provided far less correlated returns than the traditional convertible arbitrage managers who dominate the sector (see Chart 3).

 

Credit Markets and Macro Backdrop

Credit spreads widened significantly over the second half of 2011 and investors were subject to periods of extreme volatility as headlines surrounding the European crisis played out. Unemployment in Europe now stands at post war highs and the economies of the Eurozone are dramatically imbalanced. As BoE Governor King recently commented, recovery in the UK (and globally) is likely to remain “arduous, long and uneven.” This sentiment is reflected in credit spreads which imply default rates for the speculative grade universe of greater than 12% annually, something which has happened only twice in the historical series we have (see Chart 4).

 

Despite an expectation for economic weakness in the coming year, forecast profits remain relatively healthy and corporates are more prepared for an adverse economic outcome than they were going into the Lehman induced bust. Cash levels are high, leverage low, and credit appears to offer value given the dire outcomes currently discounted by spreads.

The Eurozone crisis remains the primary driver of market sentiment and it would be foolish to dwell on markets without an examination of the issue. Austerity measures in Europe stand in stark contrast to the more Keynesian approach taken in the U.S. and I can’t help but think the next five years will provide, with hindsight, abundant empirical evidence to support the soundness of one or the other approach. The debt burdens of Greece, Portugal (and others) and the means by which they are dealt with will provide key inflection points in the path that markets take. Recent action by the ECB has thankfully calmed markets in January and much has been written of the significance of the three year Long-Term Refinancing Operation (“LTRO”) they introduced. The ECB balance sheet has expanded tremendously and through the LTRO they have found a more politically expedient means of easing conditions in Europe. The LTRO has assured the banking sector of funding liquidity and the banks are in turn able to support European sovereign credits. The impact has been dramatic as the significant move in short-dated Italian bond yields clearly illustrates (see Chart 5).

 

Despite this new source of liquidity, many banks face significant regulatory pressure to raise equity capital to meet EBA targets. As a result we will likely see a large number of liability management exercises, rights issues and other corporate actions aimed at improving those ratios to EBA mandated levels. This will be a fertile area of opportunity and we believe the fund is well-positioned to capitalize in a number of shorter dated events and corporate actions.

Given the financial sector’s sharpened focus on bal-ance sheet strength, European banks are expected to significantly de-lever in the coming years and politi-cians will have to work hard to minimize this trend be-cause of the adverse impact it will have on an already fragile economy. With banks reluctant to renew lend-ing commitments, particularly to non-core clients, the bond markets are expected to provide an alternate source of financing. European businesses are signifi-cantly more reliant on the banks for financing than their US counterparts. As a general rule, European compa-nies fund as much as 80% of their borrowing needs through bank loans with US corporates relying on banks for only 20% of debt financing. The trend from loans to public markets is expected to drive new issu-ance and could be a boon for both bond and converti-ble markets.

A heavy calendar of issuance may also contribute to credit spreads remaining wider for longer as new pa-per is digested.
The markets have offered as much certainty to investors in 2011 as a trip to the casino, and counting cards at the blackjack table is perhaps a useful metaphor for a successful investment approach, both at the casino and when facing such uncertainty. In either case you must accept that it will be rare to know anything with reasonable certainty and this will govern the research and investment approach you must take. Follow it dili-gently and there will be periods of lucidity when you can aggressively wager. Most importantly, you will be successful only if you are patient. I think that success-ful strategies in 2012 will again embody this ethos.

Given our focus on maintaining an open-minded ap-proach, I thought it worthwhile to close with one further perspective. I’ve been told that the Year of the Dragon will bring a time of change and adjustments, new strategies, and new directions for a better world…and also that it will be exhausting! It seems to me there could be as much truth in this forecast as in most of what has been written.