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Credit Markets Most Attractive Since 2009

Nadia Papagiannis, CFA

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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Nelson: No, I think the LTRO program is going to do wonders for us in terms of buying us time because essentially what it's doing is it's allowing banks to take care of their near term, and that being three years of funding needs. And really, I think, buying time is one of the greatest tools we have in battling this crisis. If you take a look back at what happened in the U.S. markets during the credit crisis, a lot of people said, "Well, if you look at our housing situation, if you look at our debt-maturity wall in the case of corporate credit, if you look at our unemployment situation, if you look at the condition of our banks, all of these problems aren't going to be fixed for years."

So a lot of people had a very bearish bias as a result, and they make the same argument now, such as "Well, look at Europe, the system is wrecked and it's not going to get fixed anytime in the near future."

That may be true, but if you stepped out of the markets in January 2009, you missed out on a lot of investment opportunities and a lot of potential gains across a variety of asset classes during these past three years. And what helped us get through that mess and earn those positive returns? Well, it's the combination of easy money from the Federal Reserve and investors' fears calming down, which enabled a lot of these banks and corporations to refinance their debt. And as they did that, that alleviated some of the near-term pressure on the jump-to-default sort of scenario, and a result then investors, I'd say, put on their investing hats and became much more comfortable looking at the risk/reward proposition of a lot of these investments over time. They termed out a lot of this debt, and as a result, you didn't see sort of the systemic crisis.

So, there wasn't any silver bullet so to speak that cured our housing crisis. We're still dealing with it now, with our unemployment situation or the condition of our banks, but we did calm a lot of investor fears and make a lot of those institutions stronger from a balance sheet perspective, which enabled us to make some very good investing opportunities over that time.

Papagiannis: So, stress is coming down on the credit side. What do you think is the outlook for owning duration?

Nelson: From a duration standpoint, I think it's not the best bet, right now. The investing proposition looks a good bit worse than at this time last year. Right now, the Barclays Aggregate has about a 3% yield, and around six to seven years of duration in it. What that's telling you is if Treasury yields bump up by about 50 basis points, or 0.5%, from beginning of the year to the end of the year, you're probably going to eat through all of that expected yield that you're planning to get from that portfolio. So 50 basis points, given the volatility in Treasury yields that we see now, is not that much at all.

We started the year right around 1.85% on the 10-year Treasury, and that's been right around 2.05%. So, it's already moved 20 basis points. I think the risk/reward profile of owning a high-duration instrument is pretty poor right now. Before we got into this mess last August, the 10-year Treasury yield was at 3.25%. I don't see any reason why we couldn't head right back there if we see a good bit of the stress in Europe continue to subside.

Papagiannis: So, then now, where does it look good in terms of bond investing?

Nelson: I think the credit markets look particularly attractive right now. In my opinion, they haven't looked this good since mid-2009, and the main reason why is that there was a large-scale deleveraging in the primary-dealer community in the back half of last year. The primary dealers, as you know, are approximately the largest 20 banks in the world, and they held at the beginning of 2011 around $110 billion of U.S. corporate bonds. At the end of the year, they only held about $60 billion of it. That would have made a lot of headlines if there were a couple of large hedge funds blowing up that caused them to liquidate about $50 billion of securities. But it doesn't make a lot of headlines if it's credit products coming off the trading desks of large banks. But nonetheless, the effect is the same, that is that there was a lot of pain in the credit markets because these banks were deleveraging at a very rapid clip.

Papagiannis: What were they selling?

Nelson: They were selling everything from investment-grade down to distressed credits, but based on our conversations with a number of our trading counterparties, it's pretty clear that banks, because of their own strategic decisions and in anticipation of Basel III requirements and the Volcker Rule, were highly compelled to sell their high-yield and distressed products, so the farther out the credit curve you went in terms of risk, the more dramatic the selling was. And so that played a big role in the markets last year.

Anytime you get a huge technical selling event like that, it's very similar to what happened in 2008; there is a lot of good product that gets flushed out. To the extent you have the ability to analyze credits and look through the trash pile, so to speak, of what was sold, hopefully, you can pick up some good investment opportunities.

Papagiannis: Thanks so much, K.C., for your insights.

Nelson: Thank you very much.