The Credit Fund invests in credit markets with an EM focus. The portfolio managers seek to generate absolute returns by investing in Sovereign, Corporate and Distressed Debt, as well as Special Situations with event-driven upside.
The investment philosophy is to build a credit edge on each investment idea and keep it during the life of the investment. The investment process is primarily a bottom-up, deep-value approach rooted in fundamental credit, asset valuation and documentation analysis. The team is made up of three portfolio managers, and calls on a team of credit and quantitative analysts.
The managers typically seek to hedge the exposure to interest rates and FX risk. In February 2006, Finisterre allocated capital to a dedicated Special Situation strategy, which was launched as a separate Finisterre investment product in August 2007. This newsletter represents the actual performance since inception of the strategy.
In October, the Fund returned 0.24%, amounting to -1.25% over the last 12 months and 9.65% for the strategy since inception. Year to date, CEMBI broad is up 3.57%, of which 8.91% is the US Treasury component and -4.91% the spread return. Risk markets bounced sharply from September, with EMBIGD up 4.40%, CEMBI 6.25%, ML US HY 5.86% and MSCI EM 13.26%.
We interpret this performance as a combination of a short-covering rally and well-anticipated redemptions not materializing in the context of low inventories and little risk appetite from the sell-side.
Although it is too early to have a full picture of Hedge Fund returns in October, we suspect that funds with unconstrained credit mandates would have underperformed this sharp bounce.
The October rally was principally triggered by yet another European summit, which ended by not quite providing the comprehensive solution expected.
In this context, while traditional asset managers may have felt frustrated by their high cash positions, Hedge Funds with a credit focus, such as ourselves, do not yet feel comfortable investing bottom-up in such a schizophrenic macro-environment. Interestingly, 5-year bond spreads of Greece, Ireland, Italy, Portugal, and Spain all drifted wider in October, while French OATs fell on rating concerns.
We rebuilt risk positions during the month on the back of the analytical tool described below and with a view to position the fund for an ongoing secular deterioration in credit, which would affect primarily HY issuers.
The best performing positions in the fund were therefore:
1) a long core position in an EMEA bank distressed senior debt;
2) a relative value position in Venezuelan Energy vs. the Sovereign;
3) a long tactical position in Chinese property HY bonds;
4) a relative value long position in Greek distressed bonds vs. a short of Portuguese bonds.
Losses were taken in:
1) a relative value position in Argentine credit;
2) short credit positions in African Sovereigns
When considering the outlook for risk markets and EM credit markets in particular, one has to factor in primarily the weight of the European crisis: short-term, the relief rally can carry on, supported by a change in the domestic political scenes in Greece and Italy, a new (more pragmatic?) leadership at the ECB and a sense of urgency (finally) among European policymakers. The background however, remains of a self-reinforcing loop of stress in sovereign funding and bank funding.
It is estimated that the largest European banks alone are looking to shed $2trillion of Risk Weighted Assets over the next 2 years, which will lower growth in Europe and on selected EMs. We believe this could be particularly severe in EMEA. We also note that recent changes in the ML HY index will exclude a number of EM issuers, reducing demand for EM HY bonds in the near future. As a result, we favour High Grade over High Yield issues, as well as a selected amount of distressed situations in Europe which seem to fully price in low-recovery scenarios.