Opportunities in a volatile market

By Neil Mason, Senior Managing Director, Man GLG

Published: 31 March 2016

Introduction

The markets have witnessed an extremely volatile start to the year. Equities had been in retreat until mid-February but have recently rebounded. Despite this bounce, we still believe that a new downward phase of the cycle is possible. While we do not view another 2008-style scenario as a current threat, we do think that significant volatility (the S&P 500, for example, has already dropped 11% and risen 9% this year) and stock dispersion may continue.

Warren Buffet has been right so many times that his pronouncements have become platitudes. But with palpable oscillations between fear and greed on the financial streets, this could be the kind of environment in which investment opportunities may begin to show themselves. Below, we set out our four highest conviction ideas for potentially taking advantage of this volatility.

  1. Merger Arbitrage

M&A (mergers and acquisitions) arbitrage is a strategy in which managers seek to benefit from price discrepancies in the stocks of acquirers and targets undergoing corporate takeovers. 2015 was the best year for merger and acquisition volumes since the financial crisis [1], and we think this pattern may continue through 2016. As macro risks escalate, we believe CEOs are going to be more likely to put their often ample war chests to work in order to combat volatility with diversification.

But if volume is increasing then so is complexity. M&A spreads – the difference between the target’s current price and that which the acquirer has said they will pay – have widened noticeably since the middle of 2015. [2] Wider spreads can be considered as an indicator that the market has less confidence the deal will be completed. We see this scepticism as having two causes. First deals appear to be getting bigger and more legally complex (think US tax inversions, for example), and secondly, the volatility described above seems to be making investors nervy that many proposed mergers will collapse.

So risk has increased, but so has opportunity. We believe that if you have the will and the expertise to really engross yourself in the minutiae of the regulatory landscape associated with these deals then attractive opportunities could exist.

  1. Bank Capital

Despite staging something of a comeback in recent weeks, financials have been experiencing price movements that recall the sovereign debt turmoil of 2011 and the credit crisis 2008/9. We believe that price drops in the recent volatility may have represented significant buying opportunities, due to the clear differences between this panic and previous ones. In the two past crises, banks were at the centre of the panic due to their leaking balance sheets, bloated with dubious assets. Today, though, banks appear to be in improved financial health. The vast majority have less exposure to the energy and commodity firms who have been suffering due to China’s travails. Since 2008, they have raised large amounts of high quality capital whilst reducing leverage. In addition, the large, government-backed lines of credit that have been put in place since the Global Financial Crisis (GFC) aim to avert any short-term liquidity crisis. There are of course exceptions – we are hesitant about whether Italian banks have actually recovered from the fallout of 2008/9 and 2011 – but why a stable UK lender such as Lloyds should have had such a white-knuckle ride this year is mysterious to us. We think there could well be further volatility to come and future troughs may provide more opportunities.

A space that warrants particular mention is AT1 (additional tier 1) contingent convertible bonds, commonly known as CoCos. These instruments sit between equity and subordinated debt in a bank's capital structure. They are issued as a source of additional capital in case the bank hits trouble. At the February nadir these bonds fell into the 80s on a cash price basis.  We believe this was partly due to technical pressure as daily liquidity income funds panic-sold on an indiscriminate basis – a turn of events which we believe may be repeated in the near future. Under such circumstances we feel the asset class could be considered for selective investment.

  1. CLOs

Two years of low volatility and high prices in the levered loan market came to a dramatic end at the start of 2016. Much of the pain has been felt by companies associated with energy, mining and utilities. In the chaos we believe there are often instances of overreaction. Identifying them involves detailed work around the fundamentals of credit investing: poring over the numbers, running stress tests, talking to stakeholders, and undertaking in-depth collateral and documentation reviews.

One potential way of participating in loan market dislocations is to invest in tranches of CLOs – securities which reference a pool of underlying levered loans. Doing this requires a secondary level of analysis to find a manager with the expertise to look through to the underlying loans and employ rigorous credit selection in the construction of their portfolios.

Success in this analysis offers the opportunity of capitalising on a double dislocation with stressed, technically-driven pricing in both the underlying loans and in the CLO tranches which reference them. There is distress in the marketplace, certainly, but pricing levels have dropped across an entire universe of securities, in excess of what we see as being justified by underlying fundamentals. That splashing sound you can hear? In our opinion it's babies being thrown out with the bathwater.

  1. Distressed Securities

Consistent with other views expressed in this article, we believe that a new distressed cycle has started. Energy has already been hit hard and could offer significant potential in our view. The sector appears to be rich with assets that are expensive to replicate. Energy businesses are also often highly operationally geared and so, if bought into at the right time, attractive returns may potentially be generated in a normalisation scenario. We think that price stabilisation over recent weeks may be further supported by supply-side contractions, noting the capacity reductions in the dry bulk market as evidence of this.

We expect that the number of distressed opportunities will be bolstered by an increasing lack of access to financing. In our view there are a number of companies which are over-levered and have been limping along in recent years.  We feel there is a significant possibility that banks would be ever-more capital-constrained and we believe there may be a reversal of the loose credit environment enjoyed by firms in recent years. We would not be surprised to reach a position where only the most credit-worthy companies will be able to access the debt markets to refinance their loans. Many others could well be forced to restructure, and further opportunities may arise.

Conclusion

The general theme as we see it is this: the markets appear to be entering a new phase of the cycle and the more swiftly investors acknowledge and react to this, the better. Whilst recent weeks have seen a positive reversal in credit and equity markets, we believe volatility is more likely to persist and continue to produce potential opportunities for investors with the ability to act. We expect there will be recurring technical pressures on many in the markets. A clear head in response to these moments could help investors to identify situations where fundamental value is being ignored.

[1] The Wall Street Journal – 03/12/2015
[2] Bloomberg

 

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