A LONG/SHORT CREDIT PRIMER
The “paired trade” is key to the long/short credit strategy. A credit paired trade involves buying a corporate bond long and selling a similar maturity Government of Canada bond short at the same time.
This investment technique has four important implications that help to deliver credit benefits to investors.
1. INTEREST RATE RISK IS ELIMINATED
There is a strong relationship between the impact of interest rate changes on IG and GOC bonds. When interest rates change, the values of the bonds move the same amount. But because a fund holds long and short positions, the movements are in opposite directions and cancel each other out.
For example, when interest rates go up, the value of IG and GOC bonds drops. If a fund holds IG bonds long, it experiences a loss, but it gains on the short GOC bond position. The loss and the gain are of the same magnitude and the net result to the fund is that the interest rate change had no impact.
Isn't shorting risky?
Shorting to increase investment exposure is risky. For example, if you short a stock your potential loss is infinite because the stock may keep rising in value. A credit paired trade does the opposite. It decreases investment exposure by eliminating interest rate risk.
Investment Grade (IG) bonds are corporate bonds that are rated BBB or higher. IG bonds are safer than high yield bonds.
Government of Canada (GOC) bonds are liquid bonds that have no credit risk.
2. INCOME IS GENERATED
IG bonds pay a higher yield than similar GOC bonds. A fund receives the higher yield and pays the GOC bond yield to the investor from whom it borrowed the GOC bond. The fund also must pay a fee to borrow the GOC bonds that it sold short.
The yield received less the total of the yield paid away plus the borrowing fee is known as “carry”.
3. CREDIT RISK IS ISOLATED AND GENERATES RETURNS
The price of an IG bond is measured as the difference between the yield of the IG bond and equivalent GOC bond. This difference is called the “spread”. The spread is earned for exposure to the IG bond credit risk. That exposure is the risk that the issuer will not repay the bond. The larger the spread in an efficient market, the riskier the IG bond. High yield corporate bonds have even larger spreads.
If the market perceives that credit risk is increasing, the spread will widen and the IG bond falls in value. If the credit risk decreases, the spread tightens and the IG bond gains in value.
Changes in credit risk can be triggered by events that impact the issuer specifically or that impact all issuers in a sector or in the market.
For example, an issuer may perform badly for several quarters in a row or might be part of an industry that is suffering. Or changes in credit risk may be spurred by a macro-economic climate that impacts virtually all IG bonds such as the economic slowdown triggered by COVID-19.
How returns are generated
Long/short portfolio managers add value by investing in IG bonds with improving credit over time, either because the bonds approach maturity when credit risk is extremely low and/or because the issuer is performing strongly. Unlike traditional funds, PMs also have the option of being long credit or short credit. In other words, if the PMs expect a negative sustained market for IG bonds, they can reverse the paired trade. They can buy GOC bonds long and sell IG bonds short. The fund will then benefit from widening spreads while maintaining an interest rate hedge.
4. LEVERAGE ENHANCES RETURNS
Long/short credit funds use prime brokers operated by major banks. Prime brokers allow a fund to create leverage within tight risk limitations. A long/short credit fund most often creates leverage by borrowing GOC bonds.
When a fund enters into a paired trade, it borrows a bond from its prime broker, sells it, and uses the cash it receives from the sale to buy another bond. The only cash required from the fund is a small amount of collateral to protect the prime broker. Because only a small amount of capital is necessary to execute a paired trade, a fund can increase the size of the paired trade above the amount of cash it holds. These increases in size – or leverage – must stay within limits set by the prime broker and the manager’s assessment of the risk embedded in the IG bonds.
Leverage has the impact of increasing the carry earned by a fund. It also magnifies any changes in the value of the fund as a result of spread changes. In other words, it enhances returns.
A fund with assets of $1 million is able to sell $3 million of GOC bonds short and use the proceeds from the sale to buy $3 million of an IG bond. It would be required to post collateral – say $100,000 in this example. The PM could invest the remaining $900,000 in cash in a low risk bond, including a floating rate note without interest rate exposure, or use it as collateral for incremental paired trades.
Let’s talk about Leverage
Leverage is misunderstood. To most investors, leverage means unacceptable risk. In reality, leverage is a valuable tool used to apply risk to a low-risk investment.
Leverage is borrowing to increase returns on invested capital. It is either embedded in an investment or it is added to an investment by a portfolio manager. For example, Canadian bank stocks have 17 – 19 times of embedded leverage.
The critical leverage question to answer for any investment is: what is the total leverage? In other words, what is the embedded leverage plus any leverage added by a portfolio manager?
Short-term investment grade bonds are low risk investments. They have exhibited consistently low volatility. On the other hand, long term IG bonds and equity securities are considerably more risky.
This chart compares the total risk (embedded risk plus leverage) during 2020 of three types of Hydro One securities. Risk is measured by volatility and the two bonds are hedged to eliminate interest rate risk.
Volatility Leverage Volatility
Short-term Bond 0.7% x 5 3.7%
Long-term Bond 19.6% x 1 19.6%
Common Stock 36.3% x 1 36.3%
In this example, unlevered long-term bonds and stocks were approximately 5x and 10x more volatile than levered short-term bonds.