Liontrust plans Ucits absolute return fund

1 June 2009

Simon Thorp was appointed head of fixed income at Liontrust in March this year. He joined the firm along with his four-strong team from Ilex Asset Management, where he was founding partner and chief investment officer.

Q: What are the plans for the Credit fund you brought with you to Liontrust when your team joined from Ilex Asset Management?
A: We have a Cayman Islands-domiciled long/short European credit hedge fund [formerly the Ilex Credit fund, now the Liontrust Credit fund] which was launched in June 2000, on the back of the introduction of the euro. It is managed by the five members of the fixed income team [Simon Thorp, James Sclater, Paul Owens, Quentin Peacock and Gareth Roblin] and has a minimum investment of €1m (£879,000).

We will have a Ucits wrapped version of it for the retail space, which will not be exactly the same thing, but will go long/short. We have not yet applied to the regulator for approval on this fund, but we are hoping to launch it later this year. The existing fund has 60% in European credit, but the average is higher than that.

We can buy global companies that have raised money in European currencies, but we will focus primarily on European firms.

Q: Liontrust places a lot of emphasis on having clear, documented investment processes. How far are you through documenting the process for the Credit fund?
A: We will document the process – we have started work on it and are aiming to have it done by the end of Sept­ember. It is a bit more com­plicated than in the equity space because there are two clearly defined parts of our process. One is the identification of an idea, the analysis and, therefore, the building up of a view. The other is how to actually structure that position.

There are many ways of struct­uring trades so we will have to talk about the process of how to analyse credits, to decide if they are improving or deteriorating. For example, with NTL [a telecoms company that has borrowed €3 billion which it will repay by 2012. Two weeks ago it announced new dollar and euro high yield deals to raise a further €500m] you could take the view that it is an improving credit, so you want to be long. Or you could take a negative view and short it through credit default swaps.

This is the same process we have used at Ilex for the last nine years, but I think we have refined it. In the process of documenting it, we may be able to fine tune it a bit. The biggest advantage will be that the quant team here will back test it and back it up with real facts and figures.

Q: How has fiscal stimulus in Britain and Europe affected bond markets?
A: The central view is that in the medium term we will see significantly higher yields because the price of
borrowing will have to go up due to the scale of debt that has been taken on. In our opinion, it is not a logical answer to get out of debt by borrowing more, but most people can appreciate that this needed to be done. The authorities had to stop the vicious circle that was eroding people’s confidence. [The results of fiscal stimulus] have not come through to the economy yet, but that is what we would expect to happen – you cannot turn around unemployment on a sixpence.

There has been talk of downgrading sovereign risk, associated with the risks of higher inflation. Sterling remained strong yesterday [two weeks ago], which was surprising on the back of the S&P – people are taking other factors as leading indicators.

But I would not be surprised if, in the next six months, we had a period where sovereign risk becomes the key concern for markets. Markets may start looking at overall debt to GDP, which could be detrimental to countries including Ireland, Hungary, Spain and the UK that have a high debt to GDP ratio. Ireland has a 221% debt to GDP. If the market loses faith then either the EU has to rescue it or Ireland defaults.

Q: How do you use shorting?
A: In credit you have asymmetrical risk compared with equities. We short because we find deteriorating companies that are mis-priced by the market. It is interesting to be able to short credit – it is a long-biased market so you are playing against the crowd.

There are two ways of doing it. You can short a cash bond, but it is quite expensive to do – you have to pay a
borrowing fee. Timing has to be taken into account, and the cost of carry of those trades. People were not managing long/short bond funds until 2003 because investors didn’t believe you could make money from them, but now we have an efficient way of doing it using credit default swaps.

In the high yield space, only 25% of firms have credit default swaps. Apart from the five-year part of the curve, they have been illiquid and not transparent, but the credit market is becoming more regulated and more transparent, and will become more liquid. Credit default swaps remain our instrument of choice for shorting credit.

Q: How do issuance and investment opportunities in the European market compare to Britain, and what is your outlook for the region?
A: If you root around in these markets, you can find opportunities that have not been seen for about 30 to 40 years. Over the next couple of years we will see which companies will come out in relatively strong shape, and which will go to the wall.We will see a continuing rise in the deflation rate.

Many companies are being opportunistic about refinancing – in a low interest rate environment, they are borrowing now. Refinancing risk will remain with us over the next two to three years – it requires a lot of workto find out which companies will be able to find liquidity. US corporates borrow 67% of their debt through capital markets and 33% through the loan market, while in the UK 91% is borrowed through the loan markets and 9% through capital markets. Europe will morph towards the US model because companies will not be able to borrow from banks, they will have to find other sources.

We will see a market for new borrowers start to come through, which will be good for investors – the balance of power will shift from borrowers to lenders. This will drive prices and spreads higher, depending on what is going on on the demand side.

Fixed income will play a bigger role in portfolios as investors look for certainty.