Can your portfolio survive sub-prime? - Emirates24|7

Can your portfolio survive sub-prime?

 
 

Up until July, the economic environment could not have been any better. Global growth was healthy, inflation modest, asset volatility low and share prices steadily rising. Corporate default rates and credit spreads were at historic lows providing easy access to cheap loans. In the United States, rising real estate prices served as an ATM to consumers who faced no difficulties increasing their mortgages.


In August the markets turned. The sub-prime issue turned into a sub-prime crisis. Falling property prices and rising mortgage costs led to rising delinquencies and mortgage defaults. Although the sub-prime sector is a relatively small share of the overall mortgage market, the global impact may be substantial and the extent to which the crisis will spread to other areas is unknown. Already, analysts are warning that regional banks may be much more exposed than previously forecast. 
 
Securities earlier considered “investment grade” by respected rating agencies were suddenly downgraded to junk status. The sub-prime crisis shut the market for structured credit and suddenly the banks could no longer offload their loan commitments. The terms of the loans did not fully reflect the risk and today the banks can only sell those loans at a discount to buyers who are now dictating the terms. Some market analysts estimate the write-downs will amount to hundreds of billions of dollars.

What will the future bring? While company fundamentals are still relatively strong the economic environment is likely to remain clouded. US growth, and to a smaller extent global growth, will be affected by the sub-prime crisis, and inflation is rising. At the company level, fundamentals are slowly deteriorating. In conjunction with slower growth and more expensive financing, corporate default rates will rise. The economist’s nightmare – stagflation – is not inconceivable anymore.


What should the investor make of this? Global equities may continue to rise, but the risk has increased and markets have become even less predictable. It might be time to start allocating some funds to investment strategies, which can benefit from a clouded economic outlook. When investor sentiment turns from greed to fear, rational investors can benefit.

The low hanging fruits in this environment are bonds and loans of good quality that have been traded down in line with loans of poor quality. Private equity and specialised hedge funds have raised billions of dollars to benefit from this change in market sentiment. Where hedge funds should benefit from the current environment are managers that invest in distressed securities.

These are typically debt securities of companies that are either already in default, under bankruptcy protection, or in distress and heading towards such a condition. Investors doubt the ability of the issuer to repay the debt and hence the securities trade below par, often below 80 cents on the dollar and feature a yield-to-maturity in excess of 10 per cent above treasuries.

How can managers generate value from distressed securities? Behavioural finance is an important factor. Distressed securities often trade at a discount to their expected recovery value because investors tend to drop them like hot potatoes once they see the headlines.

Added to this selling pressure is the fact that institutional investors are forced to sell securities that are below “investment grade”.
 
Skilled and experienced managers in distressed securities do particularly well in difficult, recessionary economic environments when corporate default rates are high. To be successful, distressed managers need experience and patience and exceptional legal, valuation and negotiation skills.
One example for a successful company turnaround was a company that suffered design flaws, construction overruns and poor management and thus prompted bankruptcy in 2001.

The federal bankruptcy judge approved in 2003 the sale of the company to a hedge fund manager. The company’s old theme was replaced with a celebrity infused Planet Hollywood brand and a $100m (Dh367m) re-development to fix design and marketing inadequacies has been instituted. Also, property for time-share alliance has been created. These activities generated outstanding returns for the investors who conducted the turnaround, while at the same time many jobs were created.

Obviously the strategy is complex and risky and hence it should only be accessed through specialised hedge fund managers. So while equity markets are still quite strong it may be a good time for investors to take a moment to review their portfolio and check if it can weather a storm.

The economic outlook is clouded, the cost of money is more expensive and difficult to access and volatility is back. The credit markets have sent out a warning that staying for too long in the game may end in tears.

 

The writer is Chief Executive Officer, Man Investments Middle East.

 

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