A Look at a Promising but Still Untested Fund

 BlackRock Global Long/Short Credit's (BGCAX) duration-neutral strategy could help navigate a rising interest-rate environment, but it is still too soon to tell.

This relatively new fund differs from most non-traditional-bond funds in that its strategy is duration-neutral. Many funds in the category have the ability to hedge out interest-rate risk, but most have not, because owning duration has been a winning bet since 2008--that is, until recently. In May 2013, 10-year Treasury yields climbed to 2.16% from 1.63% just a month earlier. While the average fund in the category experienced losses (0.4%), this fund was up slightly (0.2%). Its credit-risk-management strategy also may set it apart. Managers Michael Phelps and Josh Tarnow test the portfolio daily to minimize losses in the event of a 10% credit spread widening. All told, the fund has had only two small negative monthly returns since inception, during credit sell-offs in November 2011 and May 2012.

On the credit-selection side, management shows promise. For example, in the first half of 2012, its decision to short Spanish sovereign bonds and senior unsecured bank debt against long higher-quality Spanish covered bonds and asset-backed securities paid off. Its United States bets on aviation-related credits and high-quality bank loans, as well as its shorts in technology and defense issuers, also benefited investors during the second half of the year. Those moves contributed to its solid risk-adjusted return (6.8% with 1.4% standard deviation) for the year. 

This fund is still green, however. Since its October 2011 inception, it hasn't experienced a market environment in which management could really show its finest colors (a period of rising interest rates, for instance) or its potential weaknesses (a long-term credit sell-off, for example). Furthermore, although management is experienced, it doesn't have much experience managing mutual funds, and the strategy doesn't have a stand-alone track record. Finally, although the fund is not expensive relative to most alternative funds, it is expensive relative to other non-traditional-bond funds and traditional bond funds.

All three of this fund's share classes are expensive relative to similarly distributed alternative mutual funds. At 1.20%, the Institutional share class is cheaper than the average non-traditional-bond fund, however. The fund's management fee of 0.95% relatively high.

The Long and Short of It
This fund is a diversified, fundamental long and short credit-selection strategy. Management selects from the broad universe of global sovereign bonds, investment-grade and high-yield corporate debt, bank loans, and asset-backed securities, although it concentrates in U.S. and European issuers. The fund is currency hedged and targets zero duration. The goal is to return 4% to 6% annualized with volatility within or below that range.

Phelps, BlackRock's London-based head of European credit investments, makes the European credit bets. Tarnow, who specializes in corporate credits and leveraged finance, runs the U.S. portfolio. The duo decides the portfolio's U.S./European split, but the fund's asset allocation is also informed by BlackRock's fixed-income chief investment officer, Rick Rieder, who meets with the managers weekly, as well as BlackRock's risk and quantitative analysis group. Tarnow and Phelps draw from BlackRock's team of 58 global credit analysts and 25 traders.

Positions are sized according to a worst-case scenario. Individual long or short positions rarely top 2% of assets. Some positions are outright long or short bets, and some are pair trades. Hedging is done at the individual security level, to obtain a better credit and interest-rate match. The traders and the risk and quantitative analysis group assist with hedging.

As of March 31, 2013, the fund was 91.3% long and 39.5% short. In terms of region, the fund was 21.6% long the U.S. and 29.6% long Europe. (There was also a small allocation to Sompo Japan Insurance and two Asian technology companies, Flextronics (FLEX) and  Taiwan Semiconductor Manufacturing Company (TSM).) In both the U.S and in Europe, the fund increased its net exposure over the previous quarter by reducing hedges.

The largest net long credit sectors as of March 31 were investment-grade corporates (24.2%), high-yield corporates (16.4%), and bank loans (16.4%). The fund was net short sovereigns (negative 4.2%). The largest long positions as a percentage of notional market value were: Netherlands sovereign debt (1.5%), Enterprise (1.5%), ThyssenKrupp (1.4%), AMR Corporation (1.4%), and Electricite de France (1.1%). The largest short positions were Spanish sovereigns (negative 2.9%), French sovereigns (negative 1.4%), Koninklijke (negative 1.2%, a Netherlands-based telecom company),  Deutsche Bank (DB) (negative 0.8%), and  Caterpillar (CAT) (negative 0.8%). The top net long corporate credit bets were banking (7.0%), insurance (5.7%), and communications (4.8%).

In terms of credit rating, about 83% of the fund was rated below BBB or unrated. The duration of the fund was zero.

Hedge Fund Experience
This fund has been managed by Phelps and Tarnow since inception. Phelps heads European credit, and Tarnow specializes in U.S. corporates and leveraged finance. Both have been working at BlackRock since 2009, when the company bought their former employer, hedge fund firm R3 Capital Partners. BlackRock's fixed-income CIO Rieder was the founder of R3. Rieder, who is a former Lehman Brothers executive, recruited both Phelps and Tarnow in 2006. The duo worked on sleeves of R3's flagship hedge fund, which are now the basis for this mutual fund's strategy. They are supported by BlackRock's large credit analyst and trading teams.

Prior to R3, Phelps worked for  JPMorgan (JPM), specializing in U.S and European credit and distressed debt. He has 14 years of investment experience. Tarnow spent most of his 20-year investment career at Lehman Brothers, specializing in aviation but also analyzing other transportation, utilities, and industrial credits.

Both Phelps and Tarnow invest in the fund, although Tarnow could invest more. Phelps has between $100,000 and $500,000 in the fund, while Tarnow has only $50,000-$100,000 invested.

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