This is a market characterized by low yields, high valuations and lack of volatility. The overall lack of volatility has been breathtaking and at times unnerving. Our tactical response is to anticipate that a spike in volatility is coming but avoid overreliance on it happening in the near-term. Until market confidence is shaken by a catalyst we will likely stay in this low volatility-low yield paradigm.

Chasing returns in this low volatility-low yield environment is unwise unless you stay extremely disciplined, targeted and maintain strong underwriting standards. We continue to think that these are markets (particularly given supply constraints) where the size of balance sheet matters. Total return and yield-oriented investors have struggled with a paucity of product particularly in the traditionally higher yielding sectors. LBO volume, often a source of high coupon paper, remains muted and is well off the pre-2008 peaks and dividend deals; CCC issuance is also quite subdued. These forces have conspired to keep an overall lid on yields and supported higher valuations. On the secondary side, distressed and stressed product is harder to source, particularly for the largest asset managers who arguably have excess capital versus the opportunity set.

We aim to be disciplined investors and have no reason to chase generic product or compete with large index oriented investors. Frankly, we think it plays to the strengths of smaller managers as it allows us to focus on niche opportunities either as function of scale or an ability to be more targeted in our research approach. In this regard, it is wrong to assume that the market is not presenting us with opportunities – the bigger question is where are we finding it?

Against this backdrop, we have been focusing on the less liquid segment of the corporate debt markets, primarily “off-the-run” high yield and leveraged loans where significant discount to underlying credit risk exist. We have found that opportunities persist in these “off-the-run” North American corporate credit issues as a result of ongoing regulatory, structural, and technical/liquidity factors that continue to cause market prices to decouple from fundamental value. Increased price dislocation in “off-the-run,” less-liquid, storied credits, especially in risk-off market episodes support further supports the opportunity set.

Why are we focused on opportunities in “off-the-run” loans and bonds? We have found that there is limited competition in these names as larger managers tend to focus on more scalable investment opportunities. These “off-the-run” names are typically smaller sized issues from private companies with limited financial disclosure and little-to-no sell-side research coverage which further reduces competition. Extensive due diligence is required given the complexity of these names as they are often businesses in transition. While there is typically limited research coverage on these less-trafficked names due to size, illiquidity, opacity and complexity, fundamental credit underwriting provides a significant edge. This is particularly true for MidOcean as we are able to leverage the resources and capabilities of our broader credit platform, which includes an established CLO business, allowing us to efficiently track potential opportunities and, ultimately, providing us with a tremendous sourcing advantage.

Why do we think this opportunity in “off-the-run” will persist? We feel this investment universe is sustainable and attractive as a byproduct of regulatory challenges, the aforementioned barriers to scale for larger managers and significant crowding in on-the-run names. Gap risk is another ongoing phenomenon in credit markets that suffer from bouts of illiquidity and technical pressures as result of downgrades, fund redemptions, and regulatory pressure acutely experienced in “off-the-run” names. Focusing more closely on regulatory pressure, we have seen banks become increasingly focused on balance sheet efficiency, which has led them to abandon their proprietary trading businesses and reduce holdings of leveraged loans and high yield bonds within their “held-for-sale” trading positions that are infrequently traded. We believe this development, coupled with a growing demand for liquidity from end investors, has left the less liquid end of the leveraged loan and high yield bond market underserved.

Furthermore, we are witnessing dealers becoming less willing to act as “shock absorbers” for credit markets, especially with less frequently traded issues. We believe this creates “noneconomic,” sellers who are forced to sell at discounted prices.

Liquidity Gap

This opportunity is supported by ongoing factors and further enhanced during periods of market dislocation. Credit markets are increasingly susceptible to market dislocations since the 2008 financial crisis. Shocks have been sudden, at times brief, and not dependent on an economic recessionary environment developing. Smaller, less liquid and more storied credits tend to be more exposed to “gap” risk for longer, deeper periods during these dislocations and shocks.

CCC Rated HY Index Average Price

Why are credit markets becoming more susceptible to these shocks and dislocations? In addition to the persisting structural factors that we have already highlighted, including the tremendous growth in the size of credit markets, diminishing market liquidity, and dealers becoming less willing to act as “shock absorbers,” we are also witnessing dramatic changes in fund flows. This has been exacerbated by the growth in retail oriented funds such as ETFs. Many of these funds offer daily liquidity which can cause a mismatch between the underlying liquidity of the assets held with the daily redemption features of the fund.

While most investors bemoan the low yields, high valuations and lack of volatility, we are continuing to find a series of technical breakdowns and perceived mispricing’s in loans and bonds (mostly secured) that are wildly opaque and complex enough stories to create a significant underfollowing. Ultimately, we believe this opportunity in “off-the-run,” less-liquid, storied credits will persist and we continue to focus on situations to capitalize on this dynamic.

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