Stenham’s Beck: My three big credit calls

Tim Beck Stenham

As investors grow more wary of emerging markets, opportunities are opening up in the distressed debt sector of the space, says Tim Beck, manager of the Stenham Credit Opportunities Fund. 

He also sees value in structured credit and is hoping to profit from the high-yield sector, where he is expecting a wave of energy company defaults. 

Emerging market distressed debt

We remain bearish on many areas of current credit markets, and remain short performing high yield, but we are still finding pockets of opportunity. One such area we have recently made an allocation to is in emerging market distressed debt. 

We are negative on emerging markets overall and believe many economies in the developing world face serious headwinds. There is slowing growth in China, fund flow reversals as US interest rates rise and, for some, continued challenges with the price of commodities. This is going to open up a lot of opportunities in distressed areas of the market. 

We currently have allocations to Argentina, as well as exposures to countries such as Ukraine and Greece. Elsewhere in credit markets, we have started to see many commodity-related areas coming under pressure. Ultimately, debt trading at levels of 20c or 30c on the dollar is unsustainable, which means we will continue to see volatility in the market. 

A good example of the many opportunities, but also risks, remaining out there in credit markets can be seen in Lightstream Resources. The Canadian oil producer recently refinanced unsecured debt held by two large bondholders in exchange for 2nd lien debt. The unsecured suddenly are further subordinated in the event of a default and the secured holders better protected, which resulted in a sharp reduction in price for those investors remaining in the unsecured debt. We suspect more financings of this type will occur as stress continues in the market.  

Structured credit

We also find value in structurally inefficient areas of the market, such as structured credit. We are currently focused on non-agency residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). While these parts of the market have performed strongly, we still see opportunities to add value.

The beta in owning mortgage-backed securities has been much reduced and is largely now unattractive. However, in a complex asset class, idiosyncratic opportunities persist in securities with individual collateral, recovery or delinquency characteristics. Representation and warranty claims on non-agency RMBS bonds are also important. 

Many of the large Wall Street banks have made multi-billion dollar settlements with investors as a result of misrepresenting the quality of collateral underlying the issued bonds. These amounts create the headlines, but there are numerous other cases hedge funds are pursuing, which could lead to strong returns largely independent of market moves. In CMBS, we are nearing the beginning of a wave of re-financing.  

High-yield to be profitable but energy default wave coming

High yield credit has fallen 3.28 per cent so far this month and is 2.15 per cent lower for the year. Expectedly, CCC-rated credit is the worst performing area of market, while commodity high-yield names have been hit hardest, with metals and mining plunging 13 per cent and energy down 5 per cent. 

High-yield spreads are around 630bps, which is about 115bps wider since the beginning of June. Excluding commodities, the spread is about 540bps. However, this is not as high as the 724bps at the end of 2011. 

Using the historic average excess spread, the high-yield market (excluding commodities) is pricing in a default rate of 3.6 per cent. However, sell-side default expectations are approximately 1.5 per cent for 2015 and 2016. 

The high-yield market is pricing in more defaults than is anticipated, so being long high-yield will probably prove profitable. But it is clearly not as attractive as at the end of 2011. With real issues in commodities, the overall default rate will be higher than the 2012/13 period, when being long high-yield generated strong performance. The issues in energy have created knock-on opportunities and spread widening, but this is not massive.  

JP Morgan is forecasting high-yield energy defaults of 20 per cent to 35 per cent through 2017, depending upon the price of oil. Energy high-yield is pricing in a 19 per cent to 23 per cent default rate, depending upon a recovery rate of 30 per cent to 40 per cent. Of non-defaulted high-yield bonds trading below 70 cents on the dollar, 77 per cent are in energy and metals and mining. In other words, only 1.9 per cent of non-commodity related high-yield is trading at truly distressed levels. 

We do not expect to increase our long high-yield exposure dramatically from here, but being short is less attractive than it was. The real opportunity will be when the energy companies default – we expect some in 2015 and 2016, but this will intensify in 2017.  

Tim Beck is manager of the Stenham Credit Opportunities Fund.