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By Nadia Papagiannis, CFA | 02-22-2012 03:00 PM

Credit Markets Most Attractive Since 2009

While duration exposure remains troublesome, large-scale bank deleveraging in the last year has credit markets looking ripe for investment, says Driehaus' K.C. Nelson.

Nadia Papagiannis: Hi. My name is Nadia Papagiannis, and today I have with me K.C. Nelson, who is the manager of Driehaus Active Income, ticker symbol LCMAX, and Driehaus Select Credit, ticker symbol DRSLX.

Thanks for being here with us today, K.C.

K.C. Nelson: Thanks for having me, Nadia.

Papagiannis: So, K.C., your funds are in the nontraditional bond category, and this is a category that basically is off of our Morningstar Style Box, so basically they can short credit or can short duration [a measure of interest-rate sensitivity], whether it's hedging or taking directional bets. Unfortunately last year, 2011, was a pretty bad year for these types of funds. The overall category was down just about 1.25%, whereas the Barclays Aggregate Bond Index was up almost 8.00%. So, maybe you can talk about from your experience in your funds, why it was a bad year for 2011. What do you think caused that?

Nelson: Last year was a very difficult year for a lot of hedge strategies. As you mentioned, we lost money in both of our funds for the first time last year, and the main reason why was duration. Duration made up essentially all of that 8% return in the Aggregate index that you referenced. Credit spreads at investment-grade credits actually went wider throughout the year. But to the extent that you own duration, and the Barclays Aggregate had a fair amount of it, somewhere between five and seven years depending on the point of last year you're looking at, you did quite well as the 10-year yield went from about 320 basis points to, I believe, about 180 basis points during the span of last year. So, that really made all the difference in the world.

Alternatives, in general, hedge strategies had a very difficult year. It was the first year that I've seen where every hedge fund index finished down; even short-bias hedge fund strategies finished down last year. So, that didn't even happen in 2008. I believe this year will be a lot better year for hedge strategies as a whole.

Papagiannis: So, K.C., besides duration being good to own in most nontraditional bond funds, hedging out duration, or in the case of your fund being duration-neutral, maybe another driver of the reason why hedge strategies didn't do so well last year was the increasing correlations among securities.

Now I know that that's really easy to view in stocks. We have a S&P 500 Implied Correlation Index, but how did that play out in the credit space? Was that also an issue with credit fundamentals?

Nelson: Yes. Correlations were extremely high in the credit markets in the U.S. and globally, as well, last year. It's not as easily observable as it is in the S&P 500, but you can look in the equity tranche of a variety of Markit CDX indexes and see that correlations spiked to all-time highs last year in the credit world, just like they did in equities. That makes it very difficult for more fundamentally geared investors like ourselves, where you're looking at individual credits, and you're trying to pick the fundamentals that drive those credits and position accordingly.

Most hedge strategies have a bias toward being net long because over time it pays to be net long. And in our case to the extent you're net long, you typically have a positive carry or positive expected yield in a portfolio. So, if you set up a portfolio that has a net-long bias to it, but correlations all spike such that all the credits move in the same manner, and last year that was down if you didn't own duration, then your strategy as a whole is going to lose money.

Papagiannis: So, how has the situation changed in 2012? Has it at all, both with duration and correlations?

Nelson: Yes. The long-term refinancing operation was extremely impactful, I think, much more so than the market estimated it would be.

Papagiannis: In Europe?

Nelson: In Europe, yes. So, that's given banks and sovereigns the ability to refinance at a very quick clip this year, and as a result it's eased a lot of the credit-stress indicators that we've seen since mid-December. So, correlations have been dropping now amongst credit and equities, so that's very positive.

Papagiannis: And do you think that is a short-term blip until we all get scared again?

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