The fund returned 3% for the second quarter, net of fees and expenses, bringing year-to-date estimated net returns through June 30 2.81%. In the last quarter the fund made a number of changes to its portfolio significantly to reduce the risk profile of the fund. Many of Canyon’s recent investments have been in, “ballast” securities that, “are likely to anchor the portfolio and subdue its risk profile across a relatively broad spectrum of potential macro outcomes.” The letter continues “In general, we have found the implicit medium-term protection embedded in these kinds of assets to be undervalued relative to the explicit short-term protection offered by traditional hedges, particularly in a market that continues to resemble a global central bank coordinated short squeeze.” Recent investments include:
- $350 million of senior mezzanine (A-2) tranches of US residential NPL portfolio securitizations;
- $110 million of bonds in a home alarm company – these bonds formed part of the financing for an LBO;
- $120 million of debt of a rapidly growing telecom operator which needed to extend maturities to facilitate an asset sale;
- $80 million of debt of a post-bankrupt business security and compliance services provider that we expect will pursue asset sales to reduce debt.
These trades were part of Canyon’s rotation out of equities and into “ballast” debt securities. The fund’s equity exposure was reduced by 10% over the course of the first half. Exposure was added in debt products. Five points of exposure to corporate debt and two points of exposure to securitised products.
Canyon: The debt markets are sending a warning
Canyon is extremely concerned about the current state of the financial markets. The fund writes in its second quarter letter, “in the face of stubbornly weak growth and persistently increasing debt balances global central banks have stretched their policy easing tools to new frontiers, driving interest rates to record lows. The imperative for many institutional investors to obtain yield (in a world where it is not only disappearing, but morphing into its own unnerving opposite, negative yield) has lifted a broad spectrum of financial asset prices.”
Canyon’s letter goes on to note that for the first time ever this month the 10-year US Treasury bond and the S&P 500 Index have hit record highs at the same time, an anomaly that sends mixed signals. On one hand, record highs for the S&P 500 signal that investors are optimistic about the future. However, on the contrary, the record low Treasury yield indicates concern.
Specifically, the hedge fund states:
In the face of stubbornly weak growth and persistently increasing debt balances, global central banks have stretched their policy easing tools to new frontiers, driving interest rates to record lows. The imperative for many institutional investors to obtain yield (in a world where it is not only disappearing, but morphing into its own unnerving opposite, negative yield) has lifted a broad spectrum of financial asset prices. For the first time ever, the 10-year US Treasury bond and the S&P 500 Index have hit record highs at the same time. The fact that this anomaly has coincided with a prolonged US earnings recession, coup and secession attempts in Europe, and heightened geopolitical unrest suggests that the traditional transmission mechanism between risk and security pricing has been deeply distorted by central bank alchemy.
While headline prices imply euphoria and/or complacency, recent changes in market dynamics suggest that investors are uneasy about both the sustainability and ultimate endpoint of this kind of policy experimentation. Fear of the unknown is manifesting itself in a higher frequency of volatility events. Over the past year, the VIX has had a daily close above 25 twenty-six times (something that occurred only twice in the previous three years). More frequent shocks, in conjunction with dwindling shock absorbers in the financial system (as regulation has undermined Wall Street’s traditional buffering role), make for a potent cocktail. During these high volatility periods, access to capital markets tends to dissipate, particularly for highly levered companies, leading to pressured selling and severe reactions in security prices (accentuated by rapidly retreating market liquidity).
Q1 2016 represented just such an episode, and the fractures (and opportunities) that arose from it reverberated well into Q2. In its wake, we have found mispricing far more regularly in the debt universe than the equity universe.
Markets are becoming more volatile that much is clear. Canyon underlines the fact that while headline prices imply euphoria recent changes in market dynamics suggest investors are uneasy. Fear of the unknown is manifesting itself in higher volatility.
Over the past 12 months, the VIX has had a daily close above 25 twenty-six times. More frequent shocks combined with dwindling shock absorbers in the financial system, “make for a potent cocktail.” During these high volatility periods, access to capital markets shuts for highly leveraged companies, leading to pressured selling in severe reactions and security prices, a trend that’s only amplified by rapidly retreating market liquidity.
So far these dislocations have been confined to the fringes of the market but how long will it be before high debt levels, illiquid markets, stringent regulation, and volatility pops the euphoria bubble.
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