Stephen Antczak, CFA of Citigroup credit research is out with a new note titled ‘If I Were a Hedge Fund Manager’, we thought the title spoke for itself so we present it here……… If i were a hedge fund manager. Virtually all investors that we have chatted with over the past few weeks have said that they see recent volatility as an opportunity to add risk…but not quite yet. They point out that it’s important to get non-farm payrolls out of the way first (consensus expectation is 169k, report date on July 5th), and it would be good to see some more signs of stability in the Treasury market as well.
And of course the single most important variable that would-be buyers need to get a better handle on before adding risk is outflows. This is because mutual funds and ETFs make up such a large proportion of the credit space now — almost four times the historic norm according to the Fed data — that we really are in unchartered territory. And exacerbating this problem is that the dealers are not particularly enthusiastic about expanding their balance sheets.
These are very valid points, but in our view there are two other factors to keep in mind. First, one lesson that we have learned in recent years is that when the price action reverses valuations tend to move very, very quickly. The reality is that it
probably won’t be possible to “add on weakness” if one waits until Treasuries stabilize, for example.
Second, valuations have already gotten beaten up quite badly, both absolutely and relative to historical norms – perhaps too dramatically. For example, in Figure 2 we present high-grade and high-yield total returns during severe Treasury market selloffs over the past three decades.
On average high-grade annualized total returns were basically flat during these periods (+0.1%), and high-yield returns were meaningfully positive (+11.4%). Comparatively, the unannualized total returns since early May in high-grade and high-yield are -6.0% and -4.2%, respectively.
Citigroup’s Key point: While we are in unchartered territory in the context of sensitivity to Treasury rates, at least some metrics suggest that it may already be priced in.
Citigroup – A simple trading strategy
It may be a bit too soon to add exposure en mass, particularly since the Treasury market seems to be trading in a vacuum and may be vulnerable to gapping in either direction. Figure 4 shows that implied volatility in the rates market is at its highest level since the ’11 sovereign-induced setback, which suggests that if the markets are at least somewhat efficient MTM risk may remain acute in the period ahead.
But that said, we do believe that there are opportunities to selectively add risk right now. In Figure 2, we summarize our simple strategy, but essentially we advocate adding exposure to assets: (1) that are not highly levered to the Treasury market, (2) are not crowded, and (3) that have a fundamental valuation anchor in this environment.
By fundamental valuation anchor we simply mean a link between fundamental risk and valuations that is likely to exist in the period ahead. In credit we believe that default risk will be the anchor for spreads and limit spread widening potential (not prevent it, just limit it). But what is the fundamental anchor for Treasuries at this stage? A real rate of 1%? 3%? Who knows…
With regard to specifics, in Figure 1 (cover page) we present the performance of a variety of assets since May 1st, and split them into two groups. There are exceptions but in general Group 1 represents assets that we are a bit more cautious on at this stage. These assets may very well have gone down too far, too fast, but that said we do not see an obvious valuation anchor that could limit their volatility. In addition, they tend to be heavily levered to Treasuries and crowded as well. Who knows how much higher rates could weigh on EM, or how crowded positioning in that space could impact valuations? Unpredictable risk / reward profiles, in other words.
Conversely, we are more comfortable understanding the risk / reward profile of the assets in Group 2. Many of our potential ADD CANDIDATES are less susceptible to a Treasury sell-off (e.g., short duration), and by and large were not particularly crowded prior to the early May sell-off. And even if valuations are pressured, in the current environment we are fairly confident that investors will step in to take advantage if valuations stray too far from fundamental risk.
To illustrate in detail, note that the best performing asset that we looked at was a broad portfolio of stocks that are pursuing or are likely to pursue shareholderfriendly activities. Why?
- Not levered to Treasuries: In theory stocks and Treasuries are linked (DDM models, for example), but the reality is that the long-term correlation between equity and Treasury prices is low (-23%; Figure 5). For reference, the correlation between the typical IG cash bond and the 10-year Treasury is 65%.
- Not crowded: While investors were adding exposure to the stock market in recent quarters, this was a fairly recent phenomenon and long stocks is not a particularly crowded position.
- Fundamental valuation anchor: What better link between valuations and fundamentals can there be than activist investors specifically focusing on enforcing the linkage?
Citigroup – Positioning within Group 2
While we advocate adding select assets within Group 2 we still encourage being selective within these asset classes. For example, we believe that the buying of CDS in the IG space looks a bit overdone, and for those looking to add exposure we encourage selling protection on the indices or at the single name level.
As for sector preferences, we prefer adding risk in sectors with improving fundamentals (e.g., banks). While spreads may seem attractive in some high beta sectors (e.g., metals / mining), we are more cautious about adding exposure as the economic headwinds could overshadow any technical snap-back.
With regard to Citigroup’s single-name ADD CANDIDATES, in Figure 6, we highlight ten names in the IG space that we like from the fundamentals perspective but for which CDS spreads may have moved too far too fast (32% wider versus May 1st spread levels).