This publication recently interviewed Avenue Capital Management about why HNW investors should be interested in exposure to specialist areas of the global credit market.

Here, Jeff Gary, portfolio manager of the Avenue Credit Strategies Fund, talks about the corporate credit markets and what they have to offer high net worth investors. Gary has over 25 years of experience in distressed and high-yield investing. The Avenue Credit Strategies Fund logged a total return of 23.74 per cent for the investor share class and 23.98 per cent for the institutional share class for the one-year period ended June 1, 2013. This publication recently asked Gary about his firm and the strategies adopted.

Why Avenue?

The Avenue Credit Strategies fund should be of interest to HNW investors because it is a global, opportunistic, event-driven fund that invests in high-yield bonds, bank loans, and distressed securities with a value-oriented, total return focus. The fund is available to retail investors with a $5,000 minimum investment, and the institutional share class has a $1 million minimum.  

The fund’s investment strategy is summarized as follows:

Our investment team of more than 50 professionals focuses on distressed and special situation credit investments. We bring together Avenue Capital’s best ideas across 50 to 80 corporate opportunities, generating alpha through superior credit selection. The fund can invest up to 20 per cent of its portfolio in the same distressed securities owned by Avenue Capital’s private distressed funds. It can have an unlimited amount of “issuer overlap” - i.e., same company but different security in the capital structure - with other funds managed  by Avenue Capital.

Opportunistic strategy

 .              The fund invests in what we believe to be the best opportunities in high-yield bank loans, and convertible bonds  across the performing, stressed, and distressed credit universe

Global investment mandate

 .              The fund allocates capital to the geographies where we are able to find the most compelling investment opportunities

a)            Avenue Capital has investment professionals in nine different countries – including nearly 20 professionals focused on Europe, where Avenue expects abundant stressed and distressed opportunities

b)            The fund invests in corporate debt securities and not in sovereign debt 

c)            Its mandate is to pursue investment opportunities in developed, rather than emerging markets

Event-driven strategy – we recognize the need for a catalyst to drive value higher

Hedging and defensive strategies are used opportunistically to manage downside risks, including macro and interest rate risks

Q: What drove the fund’s success?

The fund strives to achieve total return from capital appreciation, interest income, and fees, with outperformance primarily driven by individual credit selection based on proprietary research.

Specific opportunities that helped to drive the fund’s total return were found among companies in the financial sector, including: Ambac, MGIC, Radian, Genworth, American General/Springleaf, RBS, and Lloyd’s.  Additional investments that drove total return included Edison Mission, TXU, Ameren, Kerling, Schmolz, ArvinMeritor, Hovnanian, Nortek, Edgen Murray, CHC Helicopter, and Hercules Offshore, among others.

Q: What are the main risks associated with this strategy?

A primary risk, but also part of the opportunity, stems from the fact that this fund invests in our high conviction ideas in a more concentrated manner. If the manager invests in securities that perform poorly, this could negatively impact the fund’s performance. However, Avenue Capital has successfully invested in this high conviction manner throughout its history, and therefore views concentration in terms of the opportunity to add alpha and outperformance through superior credit selection. Avenue mitigates this risk by employing a team of over 50 investment professionals who focus their time on a limited universe of investments so that they can perform more in-depth research. 

Second, most high-yield bonds have fixed interest rates, as opposed to bank loans that have floating rate coupons.  As a result, fixed rate bonds could be negatively impacted by a significant rise in interest rates. Historically, high-yield has had a very low correlation to interest rates over multi-year periods, and a much higher correlation to the equity markets and default rates than other types of bonds.  Even so, Avenue is aware of the risk of rising rates, given that interest rates have fallen to historic lows in recent years.  As a result, we have increased the fund’s exposure to floating rate bank loans and have opportunistically increased the hedges/short positions in the portfolio, with a focus on asset classes that have historically shown high negative correlations to interest rates (such as investment grade bond index funds). 

Q: Outlook for credit and implications for investors?

As previously mentioned, high-yield bond and bank loan returns are more correlated with corporate default rates than other types of bonds.  The best times historically to invest in high-yield bonds and bank loans have been from the time that default rates begin to decline, while defaults remain low, and until the default rates (on a forecasted, actual or combined basis) begin to significantly increase. The excess spread that an investor receives on a bank loan or high-yield bond is primarily to compensate for default risk. 

During periods of lower or declining default rates, investors may be willing to accept a lower spread as a result of lower default losses, which in turn can drive prices higher. The opposite is the case during times of rising and elevated default rates.  As a result of the hundreds of billions in new issuance used to refinance existing debt over the past two plus years, the amount of debt maturities for US-based companies with high yield and bank loans has fallen substantially. 

Given that the primary reason a company defaults on its debt is because it cannot repay its debt when it comes due, this has substantially reduced the default risk in the US markets.  The latest 12-month default rate for high yield and bank loans in the US is below 2 per cent, and JP Morgan forecasts that default rates in these US markets will be 2 per cent in 2013 and 2014, with a large probability that the actual default rate will be below the 2 per cent forecasted default rate. This compares to a long-term historical corporate default rate average of approximately 4 per cent. 

The current spread on US high yield bonds is approximately 500 basis points, which is approximately equal to its long-term average. Given that spreads are in line with the long-term average and default rates are expected to remain at approximately 50 per cent of the long-term average, we believe the present conditions are attractive for high yield and bank loans. 

Q:  How do your investment perspectives differ based on the geography of the investors?

There is no change in our strategy for investors based in different geographies.  The fund has a global mandate to opportunistically invest in high yield, bank loan, and distressed investment opportunities wherever they may arise.  While the fund invests in securities denominated in developed market foreign currencies, the fund always hedges 100 per cnt of any currency risk immediately.  Avenue believes its comparative advantage is corporate and distressed investing and thus focuses on its ability to generate alpha in these markets. 

Q:  Where do you see the main investment opportunities?

There are a number of attractive investment opportunities across the risk spectrum in the US and Europe at the moment.  These include the continued investments in financial companies including the mortgage insurance companies, MGIC, and Radian, as well as Ambac, MBIA, and Spingleaf – each of which has a unique catalyst and event to drive value higher. We also see attractive opportunities in distressed utility companies including Edison Mission, TXU, and Ameren; convertible bonds in Hovnanian and ArvinMeritor; a private distressed France-based construction company; a public Germany-based steel company; and a European medical device company focused on joint implants, among others. 

We also believe there will be continued attractive distressed opportunities in the US and Europe for several years in the future. While default rates are expected to remain low in the US, a 2 per cent default rate on a market nearly $1 trillion in size for high yield and bank loans still results in nearly $20 billion of new defaults each year, plus many other companies that avoid default, but whose securities could trade at distressed levels. Avenue’s assessment of the pipeline of potential stressed and distressed opportunities in the US for the next three years is expected to consist of 95 issuers with roughly $425 billion in total debt as of May 29, 2013. 

Further, nearly 7 per cent of bank loans issued to European companies are still owned by the traditional commercial banks, and there has been minimal refinancing of these loans over the past couple of years. It is estimated that the European commercial banks need to reduce their loan assets by approximately €400 million over the next few years in order to meet regulatory capital requirements. Given these facts and the fact that that Europe has endured a lengthy recession that we believe will be followed by lower than normal growth, we believe the environment in Europe should provide for attractive distressed and stressed opportunities for many years in the future.

In terms of Europe, the pipeline of potential stressed and distressed opportunities over the next three years is expected to include about 220 issuers with roughly €570 billion of total debt as of May 31, 2013.  

Avenue Capital Management has offices in London, Luxembourg and Munich, and four in Asia.  As of April 30, 2013, Avenue oversaw assets of approximately $11.6 billion on behalf of pension funds, family offices, foundations, insurance companies and sovereign wealth funds.