Virtus Credit Opportunities Fund
2Q 2016 COMMENTARY
MARKET — The 12 months since the Fund’s inception in June 2015 presented a tale of two markets. First, high yield bonds and leveraged loans sold off significantly, reaching lows in February 2016. Then they rallied sharply, driven by a global search for yield that overshadowed fundamentals.
PERFORMANCE — The Fund posted slightly negative returns for its first year, but outperformed almost two-thirds of its mutual fund peers and significantly outpaced distressed hedge funds. We accomplished this with less volatility, lower correlations, and a smaller maximum drawdown.
OUTLOOK — Rather than chasing performance, we intend to stick to our knitting and remain disciplined value investors. We will continue to seek to avoid capital loss over the short term while constantly analyzing developing investment opportunities with the hopes of deploying our large cash position.
FIRST YEAR IN REVIEW
We had many successes managing the Fund over its first year, and, like any investor making decisions under uncertainty, we also had some shortcomings. The Fund (Class A NAV) lost about 0.51% in its first year. However, it outperformed almost two-thirds of its mutual fund peers, which declined roughly 1.33%. The Fund significantly outperformed distressed hedge funds, which were down almost 10%.
Notably, the Fund was much less volatile than its peers, had a much smaller maximum drawdown, and was significantly more liquid throughout the year. The Fund also had very low correlations to most asset classes, e.g., High Yield: 0.469 (Merrill Lynch High Yield Index), U.S. Equities: 0.227 (S&P 500® Index). Our credit selection remained disciplined throughout the year, and we were rewarded with many positions that performed extremely well and few that performed poorly.
Given how differentiated the Fund is from every other credit mutual fund, we want to provide an overview of the Fund’s investment strategy, explain how market conditions during the past year impacted our unique strategy, and give an outlook for the Fund over the near term.
INVESTMENT STRATEGY OVERVIEW
We manage the Fund with the objective of preserving capital over the short term, six to 18 months, while outperforming other credit investing strategies over a full credit cycle, generally three to seven years. We strive to achieve this objective with a bottom-up value investing strategy in which we buy and hold securities when they are trading at meaningful discounts to their intrinsic values.
The Fund’s strategy is unique among credit mutual funds because we have the expertise and mandate to invest in size throughout corporate capital structures and across the so-called risk spectrum, including in securities of distressed companies. When the market offers opportunities to invest in the securities of distressed companies at attractive prices, the Fund will invest heavily in such securities and maintain a low cash balance. When such opportunities are scarce, the Fund will invest in securities that are higher in corporate capital structures and safer on the risk spectrum and will maintain a higher cash balance—roughly 10% to 25%.
As a result, the Fund’s allocation to various types of credit securities will vary considerably throughout a credit cycle. Because of our dynamic allocation and higher weighting to idiosyncratic versus market risks, the Fund will be poorly correlated with traditional credit mutual funds, which have a more static allocation. We believe that poor correlation is an attractive attribute of the Fund and can result in greater diversification within an individual’s or institution’s overall investment portfolio.
To be clear, our strategy of investing in the securities of distressed companies at attractive prices is not the same as simply buying an index or basket of securities with low credit ratings, low prices, or high yields. First, we are skeptical of the competency of credit rating agencies and the accuracy of their ratings and, therefore, are agnostic to credit ratings. Second, and more importantly, price is only one side in the analysis of whether a security is attractive. As an obvious example, a bond that has traded down from par to $40 is only attractive if the expected recovery on the bond is greater than $40. And we always demand a meaningful margin of safety, that is, a belief that the expected recovery on the bond is significantly greater than $40.
Of course, finding securities at prices significantly below their intrinsic value is not like searching for Pokémon. No maps or iPhone applications exist that lead investors to attractively priced securities. Indeed, these opportunities are not always available. And when available, they are often difficult to cull from their overpriced look-alikes. Lacking a map, we do look out for a few guideposts to find potential distressed investments for the Fund.
WHERE WE SEEK OPPORTUNITIES
Large Companies: We seek out large distressed companies for several reasons. Large companies often need to exist in an economy and therefore are more likely to reorganize and preserve stakeholder value. However, even when forced to liquidate, large companies are typically able to afford the high costs of quality restructuring professionals who are necessary to preserve value for stakeholders. And perhaps most important for a fund that offers daily liquidity to its investors, the securities of large companies are usually the most liquid. Over the last 15 years, many of the largest Chapter 11 cases have been attractive investment opportunities, such as Lehman Brothers, Enron, Worldcom, American Airlines, Lyondell Chemical, Nortel, Washington Mutual, General Growth Properties, and Residential Capital.
Complexity: As the complexity of an investment increases, the number of investors who are able and willing to properly analyze and understand the investment’s risks and potential returns naturally decreases. Our extensive experience with distressed and other special situations gives us an edge and allows us to gain an understanding that others simply cannot. Thus, we seek out complexity, and in it we often find great investment opportunities for the Fund.
Lehman Brothers is probably the most salient example of complexity creating great investment opportunities. When the company filed for bankruptcy in 2008, it was the largest Chapter 11 case in U.S. history. It was also among the most complex—no one fully understood Lehman Brothers’ intricacies at that time. Distressed debt hedge funds dedicated entire teams to analyzing its complex balance sheet and corporate and capital structures, and many of those funds were rewarded with incredible returns on their Lehman Brothers positions over the ensuing eight years. And distressed debt investors continue to wring good returns from Lehman Brothers’ complexity.
Cyclicals at the Bottom of a Cycle: Obviously some companies are distressed because their industries are in secular decline, such as newspapers, or because shifts in technology, consumer preferences, or other factors have made them uneconomic, such as bookstores. Although we sometimes find value in the carcasses of those businesses, we generally prefer distressed cyclicals at the bottom of an industry cycle. The domestic homebuilding industry is a great example. We are certain that the domestic homebuilding industry will persist through cycles as supply and demand of housing stock peaks and ebbs. Historically, however, at the bottom of housing cycles markets price homebuilders’ securities as if no new homes will ever be built. When that scenario plays out yet again, we stand ready to invest.
Fraud and Surprise Defaults: Fraud and surprises are always bad, except, of course, when they are not! When companies disclose fraud or default on debt without warning, market participants’ immediate, seemingly uncontrollable reaction is to sell. Although somewhat understandable, that instinct is often mistaken. Several of the most lucrative recent distressed situations involved fraud, including Madoff, Enron, and Worldcom. When these situations arise, we sharpen our pencils and stay disciplined, rather than acting on emotion and heuristics.
Good Businesses with Bad Balance Sheets: This is the holy grail of distressed investing. Occasionally, a high quality business with sustainable competitive advantages and substantial cash flows, becomes over-leveraged and needs to restructure its balance sheet. In these situations, the most important analysis is often determining how the value of the business will be allocated among the company’s stakeholders. This is our wheelhouse.
Dry Powder as a Portfolio Allocation: Although many of the best distressed investing opportunities coincide with the end of broader credit cycles, several may appear at various stages of a credit cycle—often with short or no notice. We are constantly analyzing dozens of developing situations in the hope that a small handful will materialize into attractive investment opportunities, and when they do materialize, the window to invest may be only days or hours. When we have conviction and the window for investment is open, our strategy will only succeed if the Fund has sufficient cash on hand to invest in size.
We recognize that a large cash position can be a drag on the Fund’s performance in the short term, particularly when broader credit markets rally. However, we believe strongly that our ability to deploy cash quickly, with conviction, and in size, coupled with the potentially lucrative returns of distressed debt, will allow the Fund to quickly overcome that drag and outperform other credit strategies.
MARKET CONDITIONS AND THEIR IMPACT ON THE FUND
Since the Fund’s inception in June 2015, markets have been driven by central bank market intervention and, to a lesser extent, the continued collapse and volatility in oil prices that began in the fall of 2014. This led to a tale of two halves for credit markets and the Fund over the last year.
In the first half of the year, global central bank policy began to diverge, with the U.S. starting to tighten while most other central banks continued easing. In addition, crude oil prices cratered. As a result, markets were quite volatile, and, in particular, the markets for high yield bonds and leveraged loans sold off significantly, reaching lows in February 2016.
The Fund was well-positioned for these market conditions. At inception, several legacy distressed situations continued to offer attractive investment opportunities, such as Lehman Brothers, Nortel, TXU, and Caesars. Several of those situations satisfied many of the criteria we seek in distressed investments—large, complex, good businesses with bad balance sheets—so we invested heavily in them, and they have performed well.
In addition, we found several non-distressed situations that were complex, event-driven, or undervalued based on nuanced legal issues. These positions, including Argentina and Citgo Holdings bonds, performed well. However, these initial investments only amounted to about 20% of the Fund, and we were unable to find additional attractive distressed opportunities. We invested the remainder of the Fund in stressed credits and high quality credits that we believed were undervalued on a fundamental basis and maintained a large cash position of roughly 40%.
In short, the Fund was defensively positioned, and we remained patient, disciplined, and hopeful that market volatility would create additional investment opportunities. From inception through February 11, 2016, the Fund (Class A NAV) returned -2.59% on a total return basis, while the Merrill Lynch U.S. High Yield Index returned -12.43% on a total return basis, and many distressed debt hedge funds were down over 20%. From December through February, we slowly began finding interesting situations and started nibbling.
And then markets turned—violently. From February 11, 2016 through June 3, 2016, the Fund (Class A NAV) returned 2.14% on a total return basis while the Merrill Lynch U.S. High Yield Index returned 14.1% on a total return basis. The rally was, and continues to be, driven by a realignment in global central bank policy and a massive increase in monetary stimulus, including:
significantly reduced expectations for interest rate increases by the U.S. Federal Reserve in 2016,
continued aggressive purchases of corporate credit by the European Central Bank, and
huge stimulus programs in China—as much as $1 trillion by some accounts.
Collectively, these forces combined to create a widespread search for yield across the globe, which in turn led to a persistent and increasing bid for relatively higher yielding domestic credit securities. Macro and technical forces overshadowed fundamentals.
As a result, many developing distressed opportunities disappeared—and not solely because the price of distressed securities rose to unattractive prices. In several instances, distressed companies that were beginning to face potential liquidity issues, whose debt was trading for pennies on the dollar in February, were able to raise billions of dollars in debt and equity by spring.
FUND POSITIONING AND OUTLOOK
The Fund continues to hold about 20% distressed debt and 25% stressed debt, although we have increased our holdings of high quality, relatively low-yielding securities such as first lien bank loans, and have decreased our cash position to about 25%.
We are cognizant that maintaining a defensive positioning and large cash balance would lead to relative underperformance in a market with accommodative monetary policy. However, we believe a more cautious approach is prudent for several reasons:
First, we are value investors and insist on buying securities only when we believe they offer a significant margin of safety. When securities trade up in a market rally, they become less attractive to us. We have no intention of chasing performance by buying ever more expensive securities.
Second, we do not believe that intervention by global central banks is making markets, economies, or individual companies more stable. Rather, we believe that further intervention will potentially cause increased instability and mispricing that will fuel volatility in the future and create attractive investing opportunities.
Third, monetary stimulus is rapidly exhibiting diminishing marginal efficacy. In the midst of the global financial crisis, the Fed increased its holdings of Treasuries from about $800 billion to $2.1 trillion. Without question, this first round of quantitative easing worked, averting a global depression. But since then, the Fed’s actions have been much less effective. While the Fed has further increased its balance sheet by about $2.4 trillion since 2010, U.S. GDP growth has been anemic and inflation has lingered below 2% for almost five years. Likewise, recent intervention in Europe and China is showing decreasing efficacy. While China has deployed almost $1 trillion in monetary stimulus in 2016 to date, its GDP growth rate continues to decline. The ECB’s continued quantitative easing seems similarly unable to stimulate the European real economy. To be clear, further monetary stimulus will certainly force prices for financial assets upwards, potentially causing a “melt-up.”
Rather than chasing performance, we intend to stick to our knitting and remain disciplined value investors. We will continue to seek to avoid capital loss over the short term while constantly analyzing developing investment opportunities with the hopes that they become attractive ways to deploy our large cash position. We do not know how markets will move in the short term but believe that our strategy will outperform over the long term, while maintaining a portfolio with limited volatility and a high level of liquidity.