The Long and Short of Fixed Income

Terry Flanagan

The ability to go short on credit, i.e., to borrow a bond and repurchase it at a lower price, is an attractive option in today’s environment of low volatility and zero interest rates. With the expectation that both will increase, savvy portfolio managers are assessing the opportunities to express negative views on certain bonds or credit sectors.

“Depending on what you’re trading, there’s a lot of opportunity with the volatility in interest rates right now,” said Richard Michalowski, senior trader at Maritime Capital Partners. “There’s a lot of dislocation in the market between different groups. There’s a lot of opportunity for long/short because of volatility starting to increase.”

The ability to short is becoming more important in the current environment. “A long-only strategy works when the market is going up,” said Greg Gurevich, managing partner at Maritime. “As we shift from a zero-interest-rate environment to a more volatile environment, the ability for portfolio managers to go short becomes vastly more important.”

Cutwater Asset Management doesn’t run dedicated long/short credit funds, but it does incorporate short selling within some of its strategies.

“Cutwater is very much a credit shop. We don’t take significant bets on duration,” said Jesse Fogarty, managing director at Cutwater Asset Management. “Our portfolio managers and analysts through their research identify companies they like and also those we don’t like or appear overvalued. The primary way to express that point of view is the CDS market.”

The CDS (credit default swap) market has proven to be an efficient way to express negative views on credit. “Prior to CDS, it was much more challenging to borrow a bond in the retail market. It’s much more efficient to do in in single-name CDS,” said Fogarty.

Over the last 18-24 months, particularly in investment grade credit, issuers have started to employ financial engineering, issuing debt and using those funds to lever the balance sheet at the expense of bondholders. “There are particular sectors and names that are prone to leveraging that are not adequately priced. This is a credit picker’s market. We think there will be idiosyncratic opportunities. You can buy protection against general spread widening but still be long risk,” Fogarty said.

The benefits of a long/short approach are that the investor can potentially profit from both positive and negative views on individual credit securities, according to BlackRock, the world’s largest investment firm. The manager can position the portfolio to be long, short or neutral to market moves. Furthermore, a manager can take advantage of disparities that occur between two credits that the manager believes are not currently represented in the right spread relationship.

The borrowed market for fixed income is a little less well-developed than equities, so investors have used products like CDS and other derivatives to gain short exposure. “For the past several years, we have been in a zero interest rate environment which dampened volatility, making it expensive to short,” said Gurevich. “Now that volatility is picking up, we are seeing a lot more people actively doing long/short strategies focusing on credit.”

Credit fundamentals are good but there are specific names and sectors that can be identified as being overvalued, Fogarty said.

“The thing that keeps you up at night is a big leveraged recap or an LBO,” he said. “In this environment, there’s cheap optionality, i.e., spreads are generally tight across the board, where you can find specific opportunities to go short.”

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