Beyond the Ordinary: Credit Opportunities for Yield and Return

Massive disruptions in the fixed income landscape are creating unprecedented credit-related opportunities as market volatility, regulatory changes and increases in capital requirements are forcing financial firms to sell assets—some at steep discounts. Rick Rieder, Co-Chair of BlackRock's Special Credit Opportunities Investment Committee, believes investors can capitalize on this environment and discusses the benefits of incorporating credit strategies into a fixed income portfolio.

• Conventional fixed income investments can carry additional risk in a low-yield environment, in that it takes only small interest rate increases to drive returns to zero.
• Structural changes in capital markets will continue to force financial institutions to exit businesses, sell assets, and transfer risks, creating unique yield and return opportunities in credit securities.
• Investors should consider allocations to a wide range of credit-related investments for diversification and potential yield and return benefits.

What has changed in fixed income markets over the past few years?

Fixed income markets have changed profoundly since the financial crisis began in 2007. What was once a world of credit expansion and strong economic growth has turned into the opposite. Balance sheets are contracting. Traditional financial asset holders such as banks are restructuring in response to regulatory and capital requirements, causing them to sell and exit otherwise attractive assets and find new sources of long-term capital. Specifically, the financial sector is undergoing powerful longer-term structural changes in the sources of their capital and funding. Assets that used to be the exclusive domain of the financial system such as project finance and trade finance are being sold as a result of these changes, creating investment opportunities.

Numerous regulatory regimes—Basel III, Dodd-Frank, the Volcker Rule, for example—are forcing these changes on the financial markets. Furthermore, the European sovereign debt and banking crisis and slow global economic growth is driving market risk-on and risk-off sentiment, fuelling volatility that is pressuring institutions.

In this environment, investor risk aversion is significant enough that conventional fixed income investments are offering historically low yields, a new risk for investors to consider. It would take very little in the way of a rate increase for investors to lose their total returns across many traditional fixed income sectors (see Figure 1). If you take the example of the 5 to 10 year credit component index of the Barclays US Aggregate Index, it would take only a 72 basis point increase in interest rates to eliminate the total return of that index. Similarly, agency mortgage-backed securities could withstand only a 36 basis point rise in rates before the sector total return is eroded to zero.

In short, it's a very complex and much different fixed income world than it was only five or six years ago.

What do these changes mean for fixed income investing?

Because the environment is so different, we feel strongly that investors need to change the way they think about fixed income investing. In today's historically low interest rate environment, it is difficult to find a buffer against rising rates. So given slow but positive US economic growth, we recommend moving down the credit spectrum to gain yield and return. The higher yields associated with credit investments provide better protection against increases in interest rates, should they occur, and offer better opportunities for total return.

In addition, we think investors need to invest more diversely throughout the world, and take a global approach to access opportunities. The next 5 to 10 years will require a broader vision of investing in order to be successful. Finally, since the net supply of certain fixed income securities is contracting (see Figure 2), investors need to look to other investments such as credit securities which may become available in the market. Moving quickly and being opportunistic about investing in portfolios and assets being sold by delevering financial institutions—banks, mortgages companies, real estate or lending institutions—presents a powerful way of gaining yield and return and will be key to portfolio success.

What opportunities are arising out of these market changes?

The net result of the deleveraging that is taking place across the financial system is that attractive assets or portfolios need to be sold as financial institutions work their way out of trouble and into compliance with new regulations. In addition, market anomalies from changing investor mix and capital requirements will present powerful opportunities for investing and trading.

For example, European financial institutions may hold assets on their balance sheets that they cannot afford to sell, e.g., US non-agency residential mortgage-backed securities (RMBS), but that present unattractive capital requirements. Those financial institutions may want to transfer those risks to a third party and gain capital relief. As part of a solution to this problem, we may be able to effectively "buy" a portfolio we can analyze and underwrite, but at a much more attractive price than could be obtainable in the open market.

Can you give us another example?

There are a number of ways investors can capitalize on the current market disruptions (see Figure 3). As an example, we're seeing opportunities in mortgage servicing rights ("MSRs") that banks are looking to sell because upcoming changes in Basel III capital requirements cause them to be a less attractive on-balance-sheet asset. An MSR is a right to a stream of cash flows from a diversified pool of mortgage loans for performing mortgage servicing functions (e.g., providing reporting or collecting fees) or delegating the functions to a third party sub-servicer. Accessing these cash flows at attractive pricing because of the selling pressure and operational complexity can offer attractive opportunities for investment.

This is a type of credit-related investment that most investors usually don't see and there are some unique risks associated with cash flow streams and with working with third-party subservicers. As such, we strongly believe that it is critical to have deep expertise in analyzing these risks as well as deep relationships with exceptional sub-servicers to mitigate these risks.

Banks and financial institutions have a range of investments that are impacted by decreased risk appetite and less capacity for origination given the changing environment for risk and regulation. Another example is bridge loans, instruments in which investors take a role in supporting the placement of bond offerings into the market (i.e., providing a "bridge" to getting it to market). The investor generates an underwriting fee, or takes ownership of a well-priced bond. This is another type of investment that many investors won't usually come across.

Of course, these sorts of investments entail their own risks, including credit risks (the possibility that the issuer of the bond will not be able to make principal and interest payments) as well as the fact that investments in non-investment-grade debt securities could be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.

How big are these sorts of opportunities?

This is not a niche marketplace we're talking about. We believe the opportunities are huge and that this market is much larger than many think—certainly larger than the "fire sales" that occurred in the aftermath of the Savings and Loan crisis of the 1980s or the Asian debt crisis of the 90s – perhaps 10 times those crises combined. We estimate between $5 trillion to $10 trillion of assets will be sold in the next 2-3 years, though they will come at unpredictable times and in unpredictable ways (see Figure 4). Our estimates include between €1.5 and 2.5 trillion in sales of impaired or other assets from European financial institutions over the next 18-24 months, over $1 trillion of asset sales from US financial institutions, and significant volume of commercial real estate debt scheduled to mature between 2012 and 2017. Additionally, we expect over $400 billion in FDIC problem bank assets will come to market as opportunities.

Do these opportunities entail greater risks than traditional fixed income credit investments?

Each of these opportunities is a different situation so it's hard to group them together but generally we will seek investments within a defined term or payback period, but with generally high current cash flow. Investors should consider carefully the correlations within and among markets, and how they accomplish diversification within their portfolio. We talked about some of the credit-related risks earlier and to that I would add that an investor needs to also manage liquidity risk, currency risk, and other credit and interest rate risks. Ultimately, though, we believe that the best way to approach such a complex marketplace is by working with an experienced asset manager who has the tools, expertise and research capabilities needed to uncover the opportunities in these sorts of special situations.

So how does an investor go about approaching these markets?

In our case, we use a multi–stage process founded on risk management. Because the infrastructure and local market knowledge are so paramount to understanding value, the investment teams work together to source attractive investment opportunities from across the globe. At the same time, the investment team and relevant portfolio managers engage with BlackRock's risk and analytics teams to conduct due diligence on opportunities from the bottom up, a critical part of the risk review. Investment recommendations from the investment team are reviewed and approved by an Investment Committee after careful analysis of the investment versus the strategic profile of the strategy and the expectation of achieving an appropriate risk-adjusted return. Following an investment, the investment team continues to work closely with portfolio managers to execute the strategy, perform ongoing management, and exit the investment.

It sounds like you need a great deal of resources to access these markets. What advantages do size, scale and reach provide?

Tremendous advantages. With BlackRock's collective experience and expertise we are able to see the flow of capital and opportunities throughout the world. We can rely on a diversified global team that can look at what is happening in certain markets, and where there is value in the world. Having such reach means we have local knowledge and we often end up being the first call in the case of an opportunity. Think about financing markets 10 years ago—commercial paper markets, bank backstop liquidity facilities—there were multiple ways companies could finance themselves, but many of those are gone.

Financial institutions are looking for partners that can provide them with holistic solutions. Contrary to other market participants who believe they can buy assets at fire-sale prices, BlackRock believes financial institutions are smart asset holders who are looking for realistic pricing and a partner of size. So having the ability to commit substantial capital and partner with companies is so important in today's more difficult credit environment. Size and scale allow us to look deeply at assets around the world and consider them quantitatively and fundamentally, through scenario analysis and stress tests, whether we decide to own particular assets or not.

Any final thoughts?

In today's environment, with the risk that volatile rates may wipe out traditional fixed income returns, we believe investors need to look beyond the ordinary and seek out a much wider range of credit-related opportunities for yield and return. With the complexity and rapidity of the credit markets, we recommend that investors rely on a professional active investor to oversee the allocations across yield curve, credit risk and other risks. Any investment decisions should be made in alignment with an investor's goals, risk tolerance and time horizon and in partnership with a professional financial advisor.

 

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Investment involves risks. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities (high yield or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/ developing markets or smaller capital markets. Investing in derivatives entails specific risks relating to liquidity, leverage and credit that may reduce returns and/or increase volatility. Asset allocation strategies do not assure profit and do not protect against loss.

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