Once tucked away in the nontraditional bond category, long/short credit funds are finally moving into the spotlight. Should they be a part of investors’ fixed-income allocation?
The answer, of course, will vary, depending on each investor’s goals, return expectations and risk tolerance. But given today’s uncertain investment environment, we think it’s a good idea to understand how fixed-income alternative strategies such as long/short credit work and what they can offer.
Before we do, though, let’s look at why this strategy deserves to stand on its own.
Carving Out a New Category
Last month, Chicago-based investment research firm Morningstar decided to pull 21 funds out of its broad nontraditional bond category and assign them to a new long/short credit category.
Some investors may be wondering, why now? A better question might be, why did it take so long?
To some extent, Morningstar’s playing catch-up here. Nontraditional bond strategies vary widely (Display 1) and so do the managers who run them. Grouping them into one catch-all category makes it hard for investors to find the best fit. Isolating long/short credit in a category of its own should help.
Understanding Long/Short Credit Strategies
As the name suggests, long/short credit strategies involve taking long or short positions in a wide variety of global credit assets to exploit price anomalies. Most long/short credit strategies eschew benchmarks. Returns come from the quality of a manager’s credit selection rather than broad market exposure—not a bad thing at a time when many global fixed-income sectors are in the late stages of the credit cycle.
Long/short credit strategies try to reduce volatility by diversifying investors’ sources of returns. They can do this by hedging out various types of risk, including credit and interest-rate risk. As policies and economic conditions around the world diverge, we expect dispersion among companies, sectors and regions. That should provide opportunities for credit hedging strategies such as long/short.
Another potential advantage: when shorting a bond, there’s a limit to how much investors can lose. That’s because as bonds move closer to maturity, their prices migrate back to par, as secondary market trading tends to dry up. The most a short seller can lose is the par value of the security.
It’s different with equities. An investor who shorts a stock faces potentially unlimited losses because there’s no limit to how high the stock’s price can go. For instance, an investor might short 100 shares of a stock at $35, expecting its price to fall. If he’s wrong and the price rises to $70, he’s $3,500 in the red. If he doesn’t close his position, those losses could grow, since the stock price can keep rising.
There are many ways to implement long/short credit strategies:
•Directional trades involve taking a long position in a specific corporate bond that’s expected to rise, or a short position in one expected to fall. A company with high debt levels, negative cash flow and an uncertain sales outlook might be a strong short candidate.
•Paired trades let a manager express views on two different but correlated companies by going long the bonds of one and short the bonds of the other.
•Capital structure trades are bets that one security in a firm’s capital structure is undervalued relative to another. For instance, a company’s bonds and loans might trade as if they had similar risk. But if the creditor safeguards written into the bonds are weaker than those in the loans, a manager might buy the loans and short the bonds and hope to profit when the prices diverge.
•Event-driven trades seek to profit from events like mergers and defaults. A manager who expects one company to buy another might take a long position in the target company’s stock and a short position in the acquiring company’s bonds.
In each instance, managers lean on thorough credit analysis to identify potential long and short opportunities.
Manager Selection Matters
Of course, investors who want a long/short strategy should make sure to pick a manager with proven skill in shorting. It’s an acquired skill, and it’s difficult to do well. Asking a long-only manager to start shorting credits is probably asking too much.
Building an effective fixed-income allocation requires the right mix of strategies. By increasing opportunities to add alpha and reducing interest-rate and credit risk, long/short strategies may complement the stability and income that traditional core bond portfolios provide.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.