King Street Capital Management, the large and notoriously secretive credit hedge fund founded in 1995 by Brian J. Higgins and Francis Biondi Jr. produced unaudited gross returns for the second quarter and first half of 2016 of 1.46% and 1.4% respectively.

According to the fund’s August 2nd second quarter letter to investors, a copy of which has been reviewed by ValueWalk, King Street’s first half profits were driven by gains in energy and power investments as well as the fund’s investment in Lehman Brother’s debt and structured credit, a popular trade among hedge funds.

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The key bets that paid off for the fund in the second quarter were its long position in TXU, which performed well on stronger pricing power driven by natural gas price improvements. Structured credit also performed well during the three months to the end of June as both CLO equity tranches and mezzanine bonds rallied following a decline in new issuance. Spreads comparable to high-yield and loan instruments narrowed. The fund was adding exposure to this sector throughout the quarter.

See also: Hedge Funds Continue To Profit Off Crisis Bets

With regard to the Lehman position, King Street writes that the US Lehman estate received the proceeds from its derivatives claim settlement with JP Morgan during Q2 and was, therefore, able to pay a special interim distribution in June. Also in June, the Lehman US broker-dealer paid a distribution of nearly 50% of its remaining asset value.

bear sterns and lehman brothers stock price

King Street: Steady returns 

Overall for the second quarter, King Street saw gains of 1.9% on its long portfolio and -0.1% on the short portfolio for a net performance of 1.82%.

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Directional hedges detracted 0.2% from performance and other losses cost the fund 0.34% for a total return of 1.46% quarter. For the year to the end of June, King Street’s long positions have returned 2.56%, short positions have cost the fund 0.32% for a net return of 2.25%.

Other losses detracted 0.84% from the fund’s performance for the first half for a total P&L of 1.4%.

A long overdue credit cycle 

Brian J. Higgins and Francis Biondi Jr. use King Street’s second quarter letter to issue a warning to investors. The duo writes that they believe we are in the early stages of a long overdue credit cycle that has been exacerbated by years of extremely low-interest rates, resulting in capital misallocation. Even though the equity bull market is well into its seventh year, GDP growth and corporate profitability remain challenged and political risks are growing. Brexit, Turkey the Italian banking system, uncertain levels of Chinese growth and the upcoming elections in the US are the major upcoming risk events that markets now face.

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King Street’s founders believe that Brexit may only accelerate the unwinding of the credit cycle and as a result, the billionaire managers adopting a cautious investment strategy.

The fund is investing in stressed corporate and structured credit instruments, which have additional upside. The underlying issuer must have a strong underlying business that is facing short-term concerns. On this front King Street sees a strong pipeline of distressed energy and consumer focused issuers. In Europe, the fund sees opportunities in the banking sector and commercial real estate market.

On the short side, King Street is targeting high-yield issuers that have benefited from the search for yield but are overleveraged and have deteriorating fundamentals.

As the credit cycle progresses and corporate distress surfaces more broadly, King Street expects to find plenty of additional opportunities in the credit market, a view echoed by others including Anchorage Capital.

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