How we did in July: The fund returned between 2.8% and 3.1% across different share classes, compared to EUR HY (BAML HE00 Index) 5.1%, US HY (BAML H0A0 Index) 6.0% and EM sovereign credit ( BAML EMGB Index) 3.3%. Performance in July, gross of fees in EUR, was from: (i) Credit: 379bp, with 305bp from cash and 74bp from CDS; (ii) Rates: -82bp; (iii) FX: -3bp; and (iv) Equity: 18bp and (v) Other: 0bp.
July has been a strong month for credit. Economic data continued to deteriorate but 2Q GDP numbers turned better than expected. Central banks turned more supportive on a net basis, with the ECB introducing a very flexible spread-compression tool and the Fed opening to a less hawkish stance with inflation data moderate in August. Nordstream 1 flows resumed post the maintenance period, albeit uncertainty stays high. Credit markets relieved after the very weak performance of June. Our fund benefited from having increased net investment substantially in May and June.
What we are doing now: We have been adding risk in May and June, and continued to add at the margin in July. We find credit valuations attractive, especially high grade. Spreads, including IG, now fully price a deep global recession over the next twelve months. The default rate implicit in credit indexes is in the high single-digits. In credit, June looked close to a full credit capitulation, with credit underperforming equities and outflows reverting inflows over the past two years (see our latest Algebris Bullet for more analysis).
Our portfolio is currently ~80% invested. We deployed capital mostly in investment grade bonds (both DM and EM) and index longs. More than half of our net is IG rated, so we have similar amount invested but substantial less risk than the average HY or EM fund. We are currently hedging 25% of our book DV01, so our duration is currently around 1.7y. Our main risk is thus in spreads of high rated credit across US, Europe and emerging markets. In July, we have marginally substituted index long for bonds and continued to add duration hedges. Our full book duration is 1.8y vs 3.8y on the cash book.
On the cash book, we focus long on quality and shorts on cyclicals across all areas. Among longs, we focus on US banks seniors and selected European AT1s in financials, quality sectors such as telecoms in corporate credit, and safe hard currency issuers (such as Chile, Mexico, or Peru) in emerging markets. As noted above, the level of spreads vs credit fundamentals suggest that high quality credit offers today very high multi-year expected returns, vis-à-vis moderate degrees of risk. Our shorts focus on unsustainable capital structures in selected European retail and real estate issuers (Takko, Signa), and on a few sovereigns which could incur refinancing risk in the current environment (Turkey, Egypt).
Credit markets have re-priced quickly and aggressively over the past few months. As a result, the market offers extremely high spreads on every single credit in the global space, irrespective of quality. While this mispricing can persist for a few months, valuations similar to the one currently prevailing in markets have historically been followed by strong annual returns in credit. We thus think the current set-up represents an important opportunity for long-term credit investors, and we position our portfolio accordingly.
Financial Credit Strategy
Risk assets reversed their negative momentum in June and generally ended better in July driven primarily by the perception that the worst in inflation trends may have peaked. In addition, Central Banks reiterated that any future rate hikes are data dependent whilst already guiding for lower economic growth in the coming quarters. As a result, most sovereign rates rallied across their curves, with 2s10s inverting on average c.15bps; as an extreme illustration, US 2s10s ended July at -20bps, some 100bps lower since the start of the year.
Despite ongoing geopolitical tensions and concerns over economic growth due to energy constraints, the above rates’ dynamic was a driving catalyst for a broad rally across different asset classes: credit indices tightened c.15% in spread terms, leading global equity indices appreciated c.6% on a total return basis, and the only exception was a c.6% decline in major commodities.
Across the Financials landscape, AT1s rose c.4pts, Subordinated spreads tightened c.40bps and Senior spreads closed c.15bps better. The only blemish was Eurozone banks’ equity index which was unchanged, unlike their broader European and US peers +2% and +7% respectively, and we believe this might just be temporary given the encouraging set of fundamental results that were reported.
Of the European banks that have reported second quarter results to date, the trends have been rather similar with the highlight being operating income beats from the expansion of net interest margins as future rate hikes in Europe begin to get priced in. Asset quality has yet to show any significant signs of deterioration despite growing pessimism around economic activity based on leading indicators. In some cases, banks have revised guidance lower on second half provisioning levels whilst still retaining Covid provisions.
Taking these factors in conjunction highlights why in a rising rate inflationary environment the significantly better capitalised financial sector is a natural benefactor. With the ECB striving to ensure “favourable financing conditions” to corporates, there is a genuine reliance on the financial sector to guarantee corporates have their access to funding markets. European banks have never been in such a position of strength and enjoy sufficient buffers that should comfortably accommodate any recessionary shock that is currently expected over the coming years.
Primary activity in July tends to be the quietest month due to blackout periods ahead of second quarter results from banks combined with the start of Summer. Issuance last month was the lowest so far this year but was still some 70% / EUR 4bn higher than last July. It was concentrated primarily in the Senior Preferred space as the ongoing widening of credit spreads forced banks down the cheaper MREL path. Interestingly the two new bank capital trades in July came in Singaporean Dollars, reinforcing the ongoing trend of supportive Asian-based demand for yield at the right price from leading issuers.
Financial Equity Strategy
As discussed in our June commentary, equity valuations in both US and European banks had reached a point where a substantial level of recession risk had been baked into stocks, with very little credit given for potential upside from higher net interest income. More specifically, bank stocks in both regions were trading below historical levels even assuming recessionary levels of credit losses. While the ultimate path of the macro environment is of course still unclear, what we had high conviction on was that the street was underestimating the degree of NII upside that would come first. So far as we have progressed through the 2Q earnings season, what we have witnessed is exactly that: banks beating on NII across the board, with almost no indications of credit stress anywhere across bank portfolios. Notably, we have seen this across geographies as well – in the US, UK, and even in Europe where the ECB has only begun its hiking cycle post the quarter. In fact in Europe, banks beat on NII by 5%, with costs in line and credit slightly better. Not the story bears were expecting when selling the group down to 5x forward earnings (which have been upgraded by 86 weeks in a row at last count). This all leaves bank equities as a highly attractive proposition, in our view: earnings estimates continue to grind higher, balance sheets look extremely well positioned, and yet valuations remain historically low.
As the market became myopically focused on credit risk and the inevitability of recession throughout 2Q, we took the opportunity to significantly increase our exposure to the US. In particular we bought into bank equities with strong deposit franchises, high levels of excess capital, good underwriting track records, robust reserves, and where valuations had reset substantially lower. We believe that as the Fed hiking cycle progresses, stock selection will become increasingly important. We have already started to see this play out with 2Q22 earnings, as banks with weaker deposit bases and capital positions have underperformed. So far, we are happy with our security selection on earnings, with the Fund holding six of the top ten performers in US banks last month and zero of the bottom ten. We suspect this performance dispersion within the bank sector will only accelerate over the next few quarters as winners and losers become increasingly apparent.
Outside of banks we have also built up our exposure to a small handful of capital markets and fintech names which have been forcefully sold down and where we see attractive risk/rewards for quality companies. We had largely sidestepped this space for much of the past year as valuations looked uninteresting at best, but given the dramatic selloff we have started to identify some “babies that had been thrown out with the bathwater”. One such opportunity is Carlyle Group, a stock we held for years in the past but had sold into the pre-Covid boom in Alts stocks. With the stock dropping 50% from its highs, the valuation reached a level where negative value was being ascribed to its future carry potential, which is absurd given they have one-third of the market cap in net accrued carry, and the company is likely to generate ~$1 bn of performance fees per year for the next several years. Carlyle is also doing a tremendous job of generating shareholder value via organic and inorganic growth and margin expansion, boasting 65% growth in its fee-related earnings in the past year alone and 15%+ per annum attainable as we look forward. Certainly worth more than 8x earnings, in our view. The market does not often offer up such opportunities in quality franchises but we will aggressively take advantage of them, and Carlyle is now one of the top holdings within the fund.
Global credit strategy
How we did in July: The fund returned between 2.8% and 3.1% across different share classes, compared to EUR HY (BAML HE00 Index) 5.1%, US HY (BAML H0A0 Index) 6.0% and EM sovereign credit ( BAML EMGB Index) 3.3%. Performance in July, gross of fees in EUR, was from: (i) Credit: 379bp, with 305bp from cash and 74bp from CDS; (ii) Rates: -82bp; (iii) FX: -3bp; and (iv) Equity: 18bp and (v) Other: 0bp.
July has been a strong month for credit. Economic data continued to deteriorate but 2Q GDP numbers turned better than expected. Central banks turned more supportive on a net basis, with the ECB introducing a very flexible spread-compression tool and the Fed opening to a less hawkish stance with inflation data moderate in August. Nordstream 1 flows resumed post the maintenance period, albeit uncertainty stays high. Credit markets relieved after the very weak performance of June. Our fund benefited from having increased net investment substantially in May and June.
What we are doing now: We have been adding risk in May and June, and continued to add at the margin in July. We find credit valuations attractive, especially high grade. Spreads, including IG, now fully price a deep global recession over the next twelve months. The default rate implicit in credit indexes is in the high single-digits. In credit, June looked close to a full credit capitulation, with credit underperforming equities and outflows reverting inflows over the past two years (see our latest Algebris Bullet for more analysis).
Our portfolio is currently ~80% invested. We deployed capital mostly in investment grade bonds (both DM and EM) and index longs. More than half of our net is IG rated, so we have similar amount invested but substantial less risk than the average HY or EM fund. We are currently hedging 25% of our book DV01, so our duration is currently around 1.7y. Our main risk is thus in spreads of high rated credit across US, Europe and emerging markets. In July, we have marginally substituted index long for bonds and continued to add duration hedges. Our full book duration is 1.8y vs 3.8y on the cash book.
On the cash book, we focus long on quality and shorts on cyclicals across all areas. Among longs, we focus on US banks seniors and selected European AT1s in financials, quality sectors such as telecoms in corporate credit, and safe hard currency issuers (such as Chile, Mexico, or Peru) in emerging markets. As noted above, the level of spreads vs credit fundamentals suggest that high quality credit offers today very high multi-year expected returns, vis-à-vis moderate degrees of risk. Our shorts focus on unsustainable capital structures in selected European retail and real estate issuers (Takko, Signa), and on a few sovereigns which could incur refinancing risk in the current environment (Turkey, Egypt).
Credit markets have re-priced quickly and aggressively over the past few months. As a result, the market offers extremely high spreads on every single credit in the global space, irrespective of quality. While this mispricing can persist for a few months, valuations similar to the one currently prevailing in markets have historically been followed by strong annual returns in credit. We thus think the current set-up represents an important opportunity for long-term credit investors, and we position our portfolio accordingly.
Financial Credit Strategy
Risk assets reversed their negative momentum in June and generally ended better in July driven primarily by the perception that the worst in inflation trends may have peaked. In addition, Central Banks reiterated that any future rate hikes are data dependent whilst already guiding for lower economic growth in the coming quarters. As a result, most sovereign rates rallied across their curves, with 2s10s inverting on average c.15bps; as an extreme illustration, US 2s10s ended July at -20bps, some 100bps lower since the start of the year.
Despite ongoing geopolitical tensions and concerns over economic growth due to energy constraints, the above rates’ dynamic was a driving catalyst for a broad rally across different asset classes: credit indices tightened c.15% in spread terms, leading global equity indices appreciated c.6% on a total return basis, and the only exception was a c.6% decline in major commodities.
Across the Financials landscape, AT1s rose c.4pts, Subordinated spreads tightened c.40bps and Senior spreads closed c.15bps better. The only blemish was Eurozone banks’ equity index which was unchanged, unlike their broader European and US peers +2% and +7% respectively, and we believe this might just be temporary given the encouraging set of fundamental results that were reported.
Of the European banks that have reported second quarter results to date, the trends have been rather similar with the highlight being operating income beats from the expansion of net interest margins as future rate hikes in Europe begin to get priced in. Asset quality has yet to show any significant signs of deterioration despite growing pessimism around economic activity based on leading indicators. In some cases, banks have revised guidance lower on second half provisioning levels whilst still retaining Covid provisions.
Taking these factors in conjunction highlights why in a rising rate inflationary environment the significantly better capitalised financial sector is a natural benefactor. With the ECB striving to ensure “favourable financing conditions” to corporates, there is a genuine reliance on the financial sector to guarantee corporates have their access to funding markets. European banks have never been in such a position of strength and enjoy sufficient buffers that should comfortably accommodate any recessionary shock that is currently expected over the coming years.
Primary activity in July tends to be the quietest month due to blackout periods ahead of second quarter results from banks combined with the start of Summer. Issuance last month was the lowest so far this year but was still some 70% / EUR 4bn higher than last July. It was concentrated primarily in the Senior Preferred space as the ongoing widening of credit spreads forced banks down the cheaper MREL path. Interestingly the two new bank capital trades in July came in Singaporean Dollars, reinforcing the ongoing trend of supportive Asian-based demand for yield at the right price from leading issuers.
Financial Equity Strategy
As discussed in our June commentary, equity valuations in both US and European banks had reached a point where a substantial level of recession risk had been baked into stocks, with very little credit given for potential upside from higher net interest income. More specifically, bank stocks in both regions were trading below historical levels even assuming recessionary levels of credit losses. While the ultimate path of the macro environment is of course still unclear, what we had high conviction on was that the street was underestimating the degree of NII upside that would come first. So far as we have progressed through the 2Q earnings season, what we have witnessed is exactly that: banks beating on NII across the board, with almost no indications of credit stress anywhere across bank portfolios. Notably, we have seen this across geographies as well – in the US, UK, and even in Europe where the ECB has only begun its hiking cycle post the quarter. In fact in Europe, banks beat on NII by 5%, with costs in line and credit slightly better. Not the story bears were expecting when selling the group down to 5x forward earnings (which have been upgraded by 86 weeks in a row at last count). This all leaves bank equities as a highly attractive proposition, in our view: earnings estimates continue to grind higher, balance sheets look extremely well positioned, and yet valuations remain historically low.
As the market became myopically focused on credit risk and the inevitability of recession throughout 2Q, we took the opportunity to significantly increase our exposure to the US. In particular we bought into bank equities with strong deposit franchises, high levels of excess capital, good underwriting track records, robust reserves, and where valuations had reset substantially lower. We believe that as the Fed hiking cycle progresses, stock selection will become increasingly important. We have already started to see this play out with 2Q22 earnings, as banks with weaker deposit bases and capital positions have underperformed. So far, we are happy with our security selection on earnings, with the Fund holding six of the top ten performers in US banks last month and zero of the bottom ten. We suspect this performance dispersion within the bank sector will only accelerate over the next few quarters as winners and losers become increasingly apparent.
Outside of banks we have also built up our exposure to a small handful of capital markets and fintech names which have been forcefully sold down and where we see attractive risk/rewards for quality companies. We had largely sidestepped this space for much of the past year as valuations looked uninteresting at best, but given the dramatic selloff we have started to identify some “babies that had been thrown out with the bathwater”. One such opportunity is Carlyle Group, a stock we held for years in the past but had sold into the pre-Covid boom in Alts stocks. With the stock dropping 50% from its highs, the valuation reached a level where negative value was being ascribed to its future carry potential, which is absurd given they have one-third of the market cap in net accrued carry, and the company is likely to generate ~$1 bn of performance fees per year for the next several years. Carlyle is also doing a tremendous job of generating shareholder value via organic and inorganic growth and margin expansion, boasting 65% growth in its fee-related earnings in the past year alone and 15%+ per annum attainable as we look forward. Certainly worth more than 8x earnings, in our view. The market does not often offer up such opportunities in quality franchises but we will aggressively take advantage of them, and Carlyle is now one of the top holdings within the fund.