Russell Clark’s investment grade bonds short thesis
After a rough start to the year, Russell Clark’s Horseman Global has put in a strong performance during the second half of the year.
According to the fund’s monthly newsletter for the month of October, Clark reports that the fund added 2.04% for the month of October, taking the year-to-date performance to 0.25%.
The beginning of 2017 was turbulent for Horseman, which has been called the world's most bearish hedge fund, as the firm's short bets cost it money in a broadly rising market. The fund lost 3.5% in January, 3.2% in February, 1.1% in March and 2% in April before it decided to reverse course and dramatically reduce its short position and increase long exposure (as shown in the chart below). Since the change in strategy, Horseman's performance has improved significantly, although this strategy change hasn't stopped the fund's assets under management declining from over $1 billion of $597 million at the end of October.
At the end of October, the firm had a gross long position of 89.9% and a gross short position of -132% for net exposure of -42%.
Shorting investment grade bonds: Perfect timing?
Clark uses his October newsletter update to discuss the risks that the expanded universe of BBB rated bonds now poses to the global financial system and his investment grade bonds short.
He writes that investment grade bonds now make up 50% of the index of investment grade bonds, the highest allocation of all time. These bonds are at the highest risk of being downgraded and becoming "fallen angels," when formerly investment grade rated bonds fall into the junk basket.
With such a large percentage of the bond universe on the edge of a cliff, Clark opines "Mifid II will come into force soon, and a lot of research that used to be free, will need to be paid for. This has been a reason to ask ourselves some serious questions, namely what research do I read, and what has made me the most money. Strangely the research that has been most profitable for me, will remain free even post Mifid II as it Is publicly available. The International Monetary Fund produces Global Financial Stability Reports. The stand out report for me was the April 2008 report that highlighted Eastern European banks vulnerability to wholesale funding. I shorted many of the banks named in the report. Most fell 70% to 90% subsequently.
What does the most recent issue of the Global Financial Stability Report have to say? It notes that ERR bonds now make up nearly 50% of the index of investment grade bonds, an all time high. BBB bonds are only one notch above high yield, and are at the greatest risk of becoming fallen angels, that is bonds that were investment grade when Issued, but subsequently get downgraded to below investment grade, or what is known these days as high yield." Another point Clark highlights is "the mutual fund share of the high yield market in the US has risen from 17% in 2008 to 30% today." This data comes from the IMF, which is worried about the growing size of the BBB market and investors' reliance on such instruments to produce yield. The current average yield offers little for the extra risk taken on, and investors are leaving the door open to huge capital losses if a bond is downgraded. All of this points to the conclusion "investors in high yield mutual funds are much flightier than they used to be Essentially the IMP are telling me that if you get a large enough fallen angel. the high yield market will freak out, and volatility will spike causing volatility targeting investors to dump leveraged positions. Sounds good to me - but with growth so good and the market so strong, how on earth would we get a fallen ."
Where is the first downgrade likely to occur? Here's Clark's view:
"The biggest of the BBB issuers happened to be the large telecommunication companies. The sector has over $300 billion of BBB rated debt compared to a high-yield market of $1 trillion. I am not a debt specialist, but I have noticed that falling share prices tend to be good lead indicators on debt downgrades, and the US telecommunication sector has not been participating in the market rally this year."
In terms of shorting Horseman notes in a recent document describes his process
Great long ideas have a habit of moving higher and higher over time, and typically end with a parabolic move. A long position will increase in size naturally as it moves higher, meaning that investors will be most heavily invested in a long idea as it moves parabolically. Momentum investing works well with long investing. > Short ideas tend to fall more erratically, with the first move lower being the most profitable. Being profitable at short selling requires the ability to pre-position in a stock before it moves lower, so timing is key. Momentum investing rarely works with short selling. > When deciding to short sell an industry, I utilise a three part process – Macro, Micro and Market. > I only short when all three parts are pointing towards an optimal moment to short sell.
Look for a change in trends in the macro environment – Currencies – Commodities – Interest rates and bonds
In particular I focus on currencies, as they have a strong mean reversion bias. If we forecast significant currency weakness I can short sell exporters to those countries.
Typical signals of potential currency weakness include the following:
- Large current account deficits - Negative net international investment positions - Large short foreign exchange positions within the financial system - Declining industries (ie falling oil prices, tend to weaken the currencies of major oil exporting nations)
What are individual companies are seeing and doing – Excess capital expenditure – Regulatory changes – Increased competition
Most industries are cyclical. Cyclical tops are often caused by new entrants and excessive competition entering the market. A cyclical downturn typically ensues.
Market returns can also be reduced by regulatory change, when governments seek to promote competition within an area.
When the Macro and Micro are in agreement, I then look to Market based signals to help determine when to short.
Indicators that I look for are following:
– Unsupported bull market (see next page) – Dispersion – particularly small caps underperforming large caps – Overweight holdings in the market, and large ETF participation
Short Selling Theory Expanded – Supported and Unsupported Bull Markets
> Short selling opportunities are often identified through the idea of supported and unsupported bull markets. > A supported bull markets rests on the idea that when an industry is doing well the players supporting the industry (eg customers) are also doing well. > An unsupported bull market is a market when all the profits aren’t accruing evenly. These markets are inherently unstable and tend to offer good shorting opportunities.
Iron ore is a key component of steel, therefore iron ore and steel (proxied here with the share prices of a large Chinese steel maker and a large Brazilian iron ore producer) tend to have similar fortunes.
However, in 2008 and again in 2011 the iron miners’ share price broke away from the steel producer. This constituted an unsupported bull market and offered good shorting opportunity.