The Muzinich Long Short Credit Yield UCITS Fund (“LSCY” or “fund”) won The Hedge Fund Journal’s UCITS Hedge Award for ‘Best Performing Corporate Credit Strategy’ over 2015 and over the three-year period from 2013-2015, based on risk-adjusted returns, shown in Fig.1. Muzinich’s long short credit strategy has generated strong risk adjusted returns since its inception in mid-2012. The fund’s 2015 performance is particularly noteworthy for its resilience in a challenging market.

LSCY managed to considerably limit its downside by reducing its exposure to the energy and commodity sectors and dynamically managed the aggregate duration of the fund during the turbulent times. The credit selection process focuses on finding good quality issuers. A strict control of risk budgeting in dislocated markets has been essential to protecting capital.

Lead Manager Jason Horowitz has worked in the credit markets in New York since graduating from the Yale School of Management in 1999. He began his post-graduate school career at DLJ( later acquired by Credit Suisse) and has been with Muzinich since 2005. Jason’s first role at Muzinich was as an analyst covering sectors including energy. He began managing the hedge fund strategy in 2010. The Fund utilises Muzinich’s firm resources including 50+ professionals, with portfolio managers and analysts mainly in the New York and London offices. The strategy also has a dedicated team including a trader, and two other investment professionals. Muzinich was founded in 1988 and Horowitz likes “being part of a deep organisation with a credit-focused skillset, and a seasoned investment team averaging 17 years’ experience”. He goes on: “Our analysts know credit, have lived through cycles, and know how to stress cash-flows”. Muzinich does its own research and analysis.

The power of the coupon, capital preservation and liquidity
Over the past 20 years, US high yield (measured by the BAML US Cash Pay High Yield Index – J0A0) has generated an annualized return of approximately 7%. This coupon-clipping has contributed most of the strategy’s returns. Building a nice carry for the fund is very different than adopting a buy and hold strategy. The carry creates a strong income base which is enhanced through active management. Muzinich looks to exploit volatility and inefficiencies in markets, which has created a greater dispersion of returns in the credit markets.

Though the strategy has a long bias, it aims to protect capital through credit selection, varying net exposure, shorts and hedges. As an absolute return fund, it is not benchmarked to high yield indices, and has lost less than the index when the latter fell. Of 21 negative months for US high yield, the aforementioned index would have cumulatively fallen 34.79% whereas the strategy lost a cumulative 7.95%, outperforming by 26.84 percentage points.1 Additionally the strategy made 1.59% in 2015 when the index lost value.

Long book: best ideas
The hedge fund consists of four different books: long, short, arbitrage, and short maturity. The long book (the largest of the four books) seeks out the best ideas for coupon and price appreciation based on detailed bottom-up analysis. Access to new issues is important and Muzinich, which manages $26.5 billion (as at30th April 2016) in global corporate credit, “is considered an important client for primary and secondary issuance,” says Horowitz. The size of the firm and relationships with banks helps to source bonds and gives access to liquidity in the secondary market.

Liquidity in credit markets is a concern for many investors, regulators and central banks. Muzinich has maintained normal weekly dealing terms for the strategy since the inception of the LongShortCredit UCITS Fund, launched in mid-2012. Horowitz observes that “liquidity is not as good as it was in 2004-2005 but it is manageable and we think about liquidity of the overall portfolio and individual bonds. Our trading desk works with roughly 15 counterparties and can sell most of our bonds in the market.”

Horowitz “diversifies the portfolio appropriately by sizing positions based on conviction, risk and liquidity”. The fund runs $1.8 billion (as at 30 April 2016) and Horowitz says “we monitor liquidity closely and are mindful of capacity for the strategy”. Capacity can be considered in relation to the strategy’s broad investment universe: it invests long and short mainly in US high yield but also investment grade credit, European high yield and bank loans.

Short book for alpha and hedging
The short book has a dual role: it is intended to generate alpha, and reduce the beta of the overall strategy. Realistically in a strong market it is hard to make absolute profits on the short book, but it helps to reduce portfolio beta. The shorts earn their keep by effectively financing a larger long book than would be possible without them.

But at certain points of the cycle, Muzinich might expect to make absolute profits from shorts. As of mid-2016, Horowitz is of the opinion that some credits are over-valued. He explains: “In an effort to stimulate economic growth and encourage risk taking, central banks like the Federal Reserve, ECB and Bank of Japan have adopted very loose monetary policies. This has distorted the bid for risk. You may have observed that it only takes a dovish central bank statement (not even action) for the market to buy risk assets, even in the face of weakening fundamentals.”

But the markets are starting to become more discriminating. In 2016 it is getting harder for certain companies to issue paper than it was in 2014, and Muzinich has identified some vulnerable candidates. “With some more leveraged and cyclical companies or those with limited free cash flow having little margin for error, we are happy to bear some negative carry on shorts in return for what we expect could be 20 or 30 bond points of downside,” Horowitz says.

In addition to ‘alpha shorts’, the strategy has shorts that are more oriented towards managing volatility. To reduce portfolio beta, the strategy could, for instance “short call-constrained bonds of cyclical businesses, which have limited upside due to the call structure but significant downside in a recession. We consider this to be a good means of managing tail risk,” explains Horowitz. The short book consist primarily of single names, but will employ an index when the market is moving fast. The strategy’s basket of hedges could also include single name CDS, CDX on credit indices, puts on indices, and shorts or puts on individual equities. In keeping with UCITS rules, the fund is able to short through the use of total return swaps in addition to using credit derivative swaps.

Arbitrage strategy book
The third book is the arbitrage strategy. It could include capital structure trades involving two bonds of the same company, perhaps with one secured and the other unsecured. A long bond position could also be paired against shorts or puts on equity, where Horowitz sometimes sees downside. Pairs trades within the same sector are another trade type. The arbitrage book does not construct cash versus credit derivative basis trades on the same name, because “we are not experts on basis and have memories of the London Whale,” reflects Horowitz.

Short dated maturity strategy
The short dated maturity book (as distinct from short dated duration) is a low volatility, carry strategy that is managed as a separate, standalone book. Its holdings mainly mature within three years, and the short dated maturity sub-strategy has shown a beta of around 0.15 to the high yield market over the past three years.
 
Other firm considerations: interest rate duration and credit beta

The firm does not make substantial bets on interest rates, but aims to protect the portfolio from a spike in rates by hedging out some duration risk. Explains Horowitz: “There is no perfect hedge as you nearly always have basis risk between hedges and positions. In the past, we have also bought puts on ETFs owning long dated government bonds as a hedge but did not profit from them”.

In 2015, Muzinich ran fairly low energy and commodity exposure. ‘Risk off’ markets worry Horowitz more than interest rate sensitivity and the portfolio also had some bond shorts. All in all Horowitz estimates that the portfolio’s performance had fairly low sensitivity to the broader credit market sensitivity in late 2015 or early 2016.

Pre-emptive risk management
Muzinich avoids ‘black box’ approaches to risk, places less emphasis on quantitative metrics such as Value at Risk, and does more detailed fundamental work on individual credits, such as talking to companies, stressing cash-flows, and understanding industries. When this analysis alerts the team to potential downside Horowitz feels that sell discipline is crucial. “It is important to acknowledge that sometimes you are wrong and get out if need be. We may sell too early but we have seen bonds gap down 30, 50 or 70 points,” he recalls. The old adage ‘the first cut is the cheapest’ comes to mind.

Muzinich’s approach to the oil price crash is a case study of sell discipline. Prior to 2013, the strategy had substantial commodity exposure, as $100 oil provided a strong cushion for borrowers in that industry. As oil prices fell this cushion compressed and in the second half of 2014, Muzinich started lightening up on energy exposure, based on fundamentals and technical analysis. Muzinich does not make big bets on commodity prices and Horowitz admits “we did not foresee the magnitude of the sell off and did not know oil prices would go as low as $30 but had good reason to reduce the exposure anyway based on stressing cash-flows for capital requirements and refinancing risk”. There was in fact a window of opportunity in which to exit before the worst falls occurred – Horowitz recalls that between August 2014 and September 2014, it was possible to sell bonds of some energy firms between 90 cents and par.

Muzinich did not make a wholesale or immediate cut to its energy exposure but rather reduced it in stages starting with those firms most sensitive to oil prices or those it could not hedge via CDS or the equity market. “We first sold bonds of companies with few or no oil price hedges, and some oil services firms, while holding bonds of mid-stream pipeline companies that had fee-based contracts making them less exposed to changes in the price of oil. As markets started looking out beyond hedge expiry dates, we bought puts on equities of a basket of more leveraged oil companies”. This helped Muzinich to protect capital in late 2014, in 2015 and in 2016 as energy and other materials credits have been the largest source of losses for high yield. The strategy still had less energy exposure than the overall market when we met Muzinich in May 2016 and has not been exposed to the dozens of energy company defaults in 2016.

Avoiding defaults paramount
In fact, Muzinich has not had any defaults since 2010. And on a longer lookback, the firm’s historical default rate has been just 0.2% versus 3.25% for the overall market since January 1991. Muzinich accepts the consensus view that defaults will continue to rise in the troubled basic materials sectors and this increases the need for skilful active management to avoid them. “We expect the default rate to increase over the next few years as select stressed commodity sensitive companies miss contractual payments and file for bankruptcy.”

Though headline default rates might lead some allocators to infer that we are in the latter stages of the credit cycle, Muzinich “believe defaults will actually remain low in 2016 outside of the troubled basic materials sectors” says Horowitz. Indeed credit markets are arguably bifurcated between stressed and distressed resource-related names and other high yield companies that have actually improved their credit ratios. This is reflected in the dispersion of returns, shown in Fig.2.

This is not a normal credit cycle because most corporates are not over-leveraged. Explains Horowitz: “We believe this is somewhat of a unique credit cycle. A typical credit market cycle is characterized by increased corporate borrowing, an exogenous shock that leads companies to de-lever and right their balance sheets, and as the credit cycle turns and investors seek to enhance their equity returns, a return to increased leverage. We saw this in the 2001/2002 correction and the 2008/2009 correction. In the more recent period, companies (as opposed to governments) have been less likely to take on excessive debt. We also do not see many over-levered LBOs coming to market due to changes in the regulatory environment (Office of the Comptroller of the Currency). In addition, while total debt has increased for some companies, interest coverage ratios are generally strong owing to the multi-year low interest rate environment that has allowed companies to refinance and extend their debt at very low interest rates.”

He also argues: “In such an environment, we believe investors are best served investing with a manager who is focused on bottom-up fundamental credit research analysis. Avoiding defaults will be key to generating an attractive return over the next few years.”

In summary, Horowitz states: “We would encourage market participants to invest prudently and, when markets correct, have the courage to enter the market with a manager who shares their investment philosophy and approach to risk. Even better, we think, if that manager can successfully navigate and capitalize on market volatility through a variety of approaches rooted in good, fundamental credit understanding.”

Footnote

1. This information is shown in addition to the shorter performance track record of the Long Short Credit Yield Fund in order to show the longer track record of the investment manager in other accounts employing a similar strategy. The statement represents every negative month in the BofA ML US Cash Pay High Yield Index (J0A0) since July 2010, which was selected as the starting date for this comparison because the current primary portfolio manager began managing the fund in July 2010. Returns reflect the gross returns of the Muzinich Credit Hedge Fund Strategy Composite in USD. Past results do not guarantee future performance.