Investing for total return in private debt

Many investors focus on indexing as a basis for investment selection, regardless of market conditions. The risk in chasing index returns in non-investment grade debt has the consequence that it could unintentionally expose principal to loss and underperform expectations. Many investors have failed to meet their targets by index investing. The challenge faced by investors in today’s low return, “risk-on / risk-off ” world is how to maximize returns and protect capital for a given level of risk. However enduring indexing may be, we believe investors are better served by shifting their attention to a total return mindset.

Instead of focusing on yield or income only, we believe a more suitable method is to maximize income while generating excess returns from prudent relative value risk management. A total return methodology, when successfully executed, will harvest profits, minimize losses and outperform traditional index returns. This investment philosophy can consistently be employed through fluctuating economic and market environments.

There are several methods to manage the risk relationships involved in total return investing. At CIFC, we first consider the basic credit risk of any exposure in which we are contemplating a purchase (or sale). This analysis is rigorous and takes into consideration the issuer’s ability to repay as well as an assessment of default and recovery risk. We also study the technical condition of the market including inflows, rate levels and macro factors that, irrespective of fundamentals, could impact the value of the investment. Furthermore, we employ issuer, industry and rating concentration limits. We also assess the liquidity of a particular investment to ensure we are assuming a balanced risk-reward position. Lastly, and we believe among the most important factors, we evaluate the relative value of a security compared to that issuer’s capital structure as well as other comparable borrowers in the market.

Fundamentally, we repetitively and rigorously compare the returns available on a universe of existing and potential investments. We seek to proactively exploit inefficiencies by capturing investment opportunities when relative value shifts. Overall, we believe that we are able to tactically craft higher return and lower risk portfolios utilizing this methodology.

To support our investment philosophy at CIFC we have a daily investment committee meeting, chaired by our Chief Investment Officer who possesses 36 years of credit experience, where we actively and meticulously review and debate the issues, concerns and items noted above. Our meeting is attended by our head of research, head of special situations and head of portfolio management and trading, all of whom each have over two decades of industry experience. We collaboratively utilize our diverse set of skills and knowledge gained over many investment cycles to identify investments.

INVESTMENT ENVIRONMENT – WHERE ARE WE TODAY?

CIFC believes we currently operate in an environment centered around below-trend economic growth combined with monetary policy that is focused on slowly normalizing interest rates to higher levels. We remain in a world of diminishing potential and, although we cannot accurately predict the future path of interest rates, we are of the belief that they will not move materially lower. The possible outcomes in this setting include a better economy with higher interest rates, a possible policy error or reduced growth phase leading to a recession, or the status quo where rates bump along and growth remains mediocre. If the economy continues to grow but at below trend levels while rates normalize, we expect underperformance in traditional equity products, which will be exposed to periods of “risk-on” and “riskoff ” volatility, as well as in traditional fixed income products which are over-exposed to duration risk.

From a secular perspective, the global financial system is being reshaped by new government directives. Traditional banks continue to be regulated out of the lending business while new lenders grow in size and scope. This is both a challenge and an enormous and scalable opportunity. This trend will be in place for many years to come. Investors are well-advised to gain institutional knowledge on this theme and understand how they can capitalise on it.

PRIVATE DEBT OPPORTUNITIES

Generally, we think that credit investments, whether high or low beta, will lag if they are exposed to interest rate sensitivity. The most sound debt investments offer insulation to potentially rising interest rates and those that provide structural security for investors. US senior secured f loating rate corporate loans possess these attributes. Additionally, loans continue to provide compelling absolute and risk-adjusted returns given low projected default rates and historically high recovery rates. However, the current cycle favors credit selection and portfolio construction grounded in fundamental analysis, along with total return risk management to capture relative value opportunities. Moreover, if the economy disappoints, loans should outperform given their seniority and other structural protections.

Overall, it’s a relative value world in the credit markets and hence participants need to weigh carefully the risks they assume versus rewards they reap. In rising markets issuers and investors are prone to over leveraging, poor structures and tight pricing. This combination of events usually occur at the most inopportune time. We prefer to pursue “smart risk” (i.e. assets that possess commensurate returns for the risk profile). One healthy observation currently is that investor skepticism is high and therefore risk premiums remain elevated in leveraged loans, whereas other markets such as high yield bonds, we believe, are richly priced. Appropriate loan investments today include issues with valuation discounts (or premiums), those with call protection, adequate OIDs and/or self-liquidating structures that provide multiple exit routes when the time is right. Investors need to remain alert and remember that fundamentals will matter most when the markets feel best.

CONCLUSION

We believe the private debt markets continue to offer compelling absolute and risk-adjusted returns in a world of below trend growth. Additionally, a total return approach to investing in the private debt markets can deliver a more balanced and better return profile to investors. By addressing the challenges inherent in traditional portfolio construction with a relative value methodology, private debt assets can generate income and capital gains while preserving wealth in choppy or overvalued markets. Total return investing can provide investors with solid risk-adjusted returns today and in the future.

CIFC Asset Management
CIFC is a fundamentals-based, relative value alternative credit manager with $12.6 billion of AUM from corporate loan based products as of 30 June 2014. CIFC currently serves a number of institutional investors globally including banks, endowments, insurance companies, pension funds and private wealth investors. CIFC is headquartered in New York, is a SEC registered investment adviser and is a subsidiary of CIFC Corp., a publically traded company (Nasdaq: CIFC).

Stan Sokolowski
Stan Sokolowski is Senior Portfolio Manager and Head of Portfolio Management and Trading for CIFC. He is a member of the firm’s Investment Committee and Operating Committee. As Head of Portfolio Management and Trading, he is responsible for the day to day management of the trading desk, overseeing the risk exposures of the business and is accountable for executing CIFC’s investment strategies.