Finding a Sweet Spot in the Middle
Hedge Funds Help Fill Liquidity Voids
By the Mesirow Advanced Strategies team
Although 2008 seems like a long time ago, the lessons learned are hard to unwind. During that market upheaval, liquidity was the rally call of the day and many institutions turned away from longer-term commitments. Those events – and the resulting fear – are still fresh in the collective market memory, leading many institutional investors to react to current economic and financial trends with a similar aversion to risk. Yet for those willing to take capital out of the mattress, pockets of attractive opportunities have begun to appear in the medium-term segment of the fixed income market.
Macro Factors Have an Outsized Impact
Today, central banks in Europe, Japan and elsewhere are trying to inject liquidity into faltering economies, while also facing more stringent capital requirements. This deleveraging is also happening at a micro level as companies around the world respond to similar pressures to clean up their balance sheets.
Recent policymaker actions have further compressed the supply of capital, especially in the medium-term liquidity segment. Among the many provisions of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act was a restriction on the amount of inventory investment banks may hold on their balance sheets. Primary dealer positions have shrunk 57% since March 2011 and may continue to shrink.1 The Fed's current program, Operation Twist, aims to extend the maturities of assets on its balance sheet by purchasing long-term bonds while selling shorter term issues. Although intended to reduce borrowing costs and spur the economy, the Fed action has served to increase aversion to risk in the equity markets.
Combined, these "macro" factors are driving investor decisions much more than earnings or other fundamentals. This outsize influence is manifesting itself through increases in both market volatility and correlations between asset classes.
Fear of Commitment, Desire for Growth
Fearful of over-committing capital, many pension fund managers have parked assets in cash to minimize return volatility. But with money market and bond yields hovering near historic lows, managers may not be able to find the returns they need to address future liabilities. The big question is where else to look.
The Opportunity in the Middle
Historically, hedge funds and long-only funds have tended to gravitate around an investment horizon of 1-2 years, a maturity realm that may well continue to experience high volatility and correlations over the next several months. The longer-term sphere has generally been dominated by private equity, which requires tying up a large sum of money for up to 10 years to harvest potentially attractive returns. Currently, there may be something of a “sweet spot” opening up in the middle in the form of unique bond structures for investors who are willing and able to commit capital for 3-6 years.
- Residential mortgage-backed securities (RMBS) are still trading at stressed levels with a general improvement in collateral quality. The U.S. Administration’s efforts to strengthen home ownership during this election year are expected to offer positive support for RMBS markets. However, it will be important to monitor the housing market, particularly as U.S. consumers remain under pressure from a stubbornly high unemployment rate. Security selection will remain critical for protecting capital.
- Collateralized loan obligations (CLOs) tend to offer competitive yields with muted price volatility and could see a boost as secondary markets normalize and liquidity improves. In addition, because CLOs generally trade at a discount to the underlying cash loans, a high level of defaults likely would need to occur before there were meaningful losses. However, as further deterioration in corporate fundamentals could adversely impact CLOs, investors should take an active approach when evaluating these types of opportunities.
- European structured product strategies – including RMBS, residential whole loans, commercial mortgage-backed securities, commercial real estate debt, consumer asset-backed securities, and corporate debt and loans – may present attractive opportunities if European corporate, residential and commercial property markets normalize. They are also likely to see tailwinds if economic conditions stabilize and policy actions strengthen the European banking system. Conversely, a low-to-negative European growth environment could hurt the segment.
In addition, pockets of opportunity may develop in other segments, such as:
- Asian corporate credit (loans, bonds, convertible securities)
- Trust preferred collateralized debt obligations (TRUP CDOs)
- Middle market direct lending
- U.S. residential whole loans
- Bank regulatory capital relief transactions
While attractive investments may be difficult to find in markets dominated by uncertainty and limited capital, these unique mid-term bond structures may provide compelling risk/reward ratios for pension funds or foundations whose near-term liabilities are adequately funded. However, it is important to note that identifying sound investments in this sphere of non-standard fixed income requires diligence and the skill to understand and parse complex nuances.
1 As of July 18, 2012. Source: Federal Reserve.
This information does not constitute an offer to sell or solicitation of an offer to buy any interest (an "Interest") in any investment fund sponsored, managed or advised (a "Fund") by Mesirow Advanced Strategies, Inc. ("MAS"), or in any other Mesirow Financial investment vehicle(s). Any offer of an Interest will be made only to qualified investors by way of the approved offering materials for the relevant Fund or other investment vehicle(s) and only in jurisdictions in which such an offer will comply with applicable rules and regulations. Securitized products are subject to significant prepayment, credit, liquidity, market, structural, legal, and interest risks, among others. The performance of a securitized product is affected by a variety of factors, including the level and timing of the payments and recoveries on the underlying assets and the adequacy of the related collateral. Special risks may be associated with investments in structured credit products which includes collateralized debt obligations, synthetic credit portfolio transactions, and asset-backed securities. For example, synthetic portfolio transactions may be structured with two or more tranches, each of which receives different proportions of the interest and principal distributions on a pool of credit assets. The yield to maturity of any given tranche may be extremely sensitive to the default rate in the underlying reference portfolio. This information has been provided for informational purposes only and should not be considered investment advice or a recommendation for any particular security, strategy or product. Information is has been obtained from sources believed to be reliable, but is accuracy and completeness are not guaranteed. Any information or opinions expressed herein are subject to change without notice. Mesirow Advanced Strategies, Inc. and Mesirow Financial Investment Management, Inc. are SEC-registered investment advisors.
Mesirow Financial refers to Mesirow Financial Holdings, Inc. and its divisions, subsidiaries and affiliates. The Mesirow Financial Name and logo are registered service marks of Mesirow Financial Holdings, Inc. © 2012, Mesirow Financial Holdings, Inc. All rights reserved.