Canyon Capital’s latest commentary explains that the U.S economy is in between the aftermath of financial crisis and the next distressed cycle in corporate debt. Canyon, which is one of the leading credit funds based in the U.S, is managed by Mitchell Julis and Joshua Friedman. According to a quarterly letter reviewed by ValueWalk, Canyon Value Realization Fund netted a gain of 2.6% in the first quarter.

Canyon continues to sell mortgage backed securities

The fund’s net cash balance has increased in this year and is now nearly 14% of the assets. CVRF sold $200 million worth of RMBS in the first quarter and plans to sell more later in the year at a premium price. At the end of first quarter, the fund had comparatively increased exposure in equities as investment in RMBS was reduced. CVRF was able to generate the highest return in its RMBS and bonds portfolio in the first quarter, and the only asset class that contributed a net loss was the fund’s loan portfolio.

Canyon Loans

We are in the gap period says Canyon

The letter explains that gradually the stage has been set for another distressed period in U.S markets. The consistent policy of quantitative easing has raised asset prices to an all-time high. Debt issuance of high-yield bonds has risen and reached $380 billion in 2013 and at the same time underwriting standards have been deteriorating. Canyon points out that covenant-lite loans now account for 52% of JPMorgan Chase & Co. (NYSE:JPM) Leveraged Loan Index compared to just 17% before the financial crisis. Another factor that should raise concern is the unstable environment in fixed income trading where the ownership of ETFs and long-only mutual funds in sub-investment grade debt securities has increased dramatically. Since these vehicles need to be fully invested and there are fewer traditional liquidity providers, there is a much greater chance of instability in down periods.

“At the same time, regulatory initiatives have gutted some of the traditional liquidity providers in this space (broker-dealers and proprietary trading desks).There are fewer mechanisms to prevent the flow-driven buying that has defined the past few years from transitioning quickly into disorderly flow-driven selling.”

The commentary goes on to say that even though defaults are rare, these factors demand caution from investors.

“We find ourselves in a middle or “gap” period between the aftermath of the financial crisis and the next distressed cycle. Among the more prominent features of this “gap” period are weaker tailwinds behind risk asset prices than we have generally seen over the past few years.This kind of market is a reminder of the paramount importance of security selection, which sometimes gets overlooked in headier market environments where asset prices move more in lockstep and there is less dispersion in returns. “

The managers say that they are constantly on the lookout for cheap assets, which in these times are hard to find. They call their experience with finding cheap assets a competitive advantage.

Canyon allocation

Canyon’s major moves in Q1

CVRF also collected some cash from the sale of IG bonds of a cable company, which traded up as its debt became a target for acquisition.The fund also cut down its exposure in a radio company’s debt due to lack of any near-term tailwinds; however, Canyon is still invested in the company. The fund closed out its positions in a European financial company and in a shipping company in the first quarter.

Canyon asset class

Canyon also bought the loans of a highly levered gaming company this quarter. Additionally the fund also took up a position in a supermarket chain’s bonds, as the chain is a likely target of M&A activity. Although the letter does not mention any names, talk of a Albertsons and Safeway Inc. (NYSE:SWY) acquisition has been hot in this year. Canyon initiated an equity position in a U.S cable company where it was already invested in credit. In addition, the fund bought up new corporate loans in Europe.