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HYH Interview - Anon L/S Credit Analyst

HYH Interview - Anon L/S Credit Analyst

Diving into the world of Long/Short Credit

HY Harry
March 25, 2024

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Thank you to our Sponsor. Without further ado, let’s get into the interview.

Responses are from the Writer starting at this point, with questions posed by High Yield Harry

Responses are my thoughts and opinions – as much as this is ‘boilerplate’ investment language, point I really want to make here is everyone’s mileage may vary, and my experiences may not always jive with others. As such, would love to hear (positive AND negative) feedback and thoughts about what I’ve said – please direct them to HYH who will help pass it along to me.

1) Can you give us a vague sense of your background?

Roughly 10 years of credit experience, with roles at both big and small shops. Vast majority of my background is in opportunistic credit, although I’ve also been responsible investing for performing credit mandates.

2) How do L/S strategies differ from a typical LO credit strategy?

Defining the long-only strategy as the mutual funds (or other more ’regular way’ funds) – would say the biggest difference (outside of the ability to short) is the hold periods where LO are more willing to hold a credit to takeout (whether that be to maturity or some other takeout event – e.g M&A where a bond/loan gets called/refinanced), whereas L/S tend to be more opportunistic/tactical around time to take advantage of mispricings. What this also means is LO can also be more willing to sit through drawdowns (e.g prices go down 20 points) if they ultimately expect to be taken out at par down the road. Part of this is structural – mutual funds tend to focus on beating benchmarks (beta focus) whereas L/S strategies (which tend to be more alternative – alpha focus) tend to focus on consistent absolute returns, so more frequent trading is going to be expected to turn the book as the market ebbs and flows.

Being in leveraged credit, can’t discuss strategies and leave out CLOs, which I personally think is sort of a hybrid form of long-only. The CLO vehicle is structurally different vs a regular-way long-only fund, but otherwise similarly considers current income and par recoveries instrumental in the maintenance of the vehicle. Drawdowns are also managed somewhat similarly, partly driven by how the loan values can be marked at par depending on rating and price – but otherwise you also typically don’t see CLOs necessarily turning positions as frequently unless necessity calls for it, e.g. to meet a basket test, etc.

Technically, private credit probably should fall in the bucket of long-only as well, minus the ability of trading/resizing of your position at any given time. Personally, I have thoughts about this ‘golden age’ we keep hearing about – primarily, that you’re essentially just seeing same sort of credits getting invested in the private market vs being broadly syndicated – but in that sense, the work and analysis isn’t all that different in underwriting compared to the traditional LO strategy, and the differences lie primarily in the structuring of the loan (to the extent you actually can structure a good set of covenants).

3) Can you discuss how you differentiate performing credit vs. opportunistic credit?

I like to think of performing credit as ‘vanilla’ credit investing, playing for the expectation of a par recovery and getting paid via coupons. Focus is on protecting your downside – since your maximum upside on a credit instrument is effectively capped up to your principal and interest (discounted against whatever the spread to risk-free rate is). From there, you pay attention to relative value – where you start with the assumption that these credits are par recoveries, and you can buy some credits that otherwise trade at a wider yield over others/index to make excess return. For example, you might opt to buy Bond A that is 5x levered trading at 9%, over Bond B that is 3x levered trading at 7%, because you think Bond A will still be covered and recover par despite 2 turns of higher leverage. Conversely, you might prefer Bond B because 200bps incremental yield doesn’t compensate for the risk of higher leverage.

Conversely, I would simplistically describe opportunistic credit as being flexible about the expectation whether there is a par recovery, but that’s where the simplicity ends and there’s a lot of different ways to make money. In a way I liken it to (value) equity investing, because away from the higher targeted returns (yields), there is more dispersion in pricing that allows you to ‘buy low, sell high.’

To illustrate – consider 4 scenarios:

- you can buy a bond at 85 and expect that it goes to par,

- buy at 60 and hope to sell at 80,

- buy at 40, equitize your bond claim, and sell that post reorg equity at an ‘old-way equivalent’ price of 60 etc.

- sell short at 90, and hope to cover at 60

Investing in all 4 scenarios would be considered today as opportunistic, but away from scenario 4 (which is simply shorting), in the past, you would probably have called scenario 1 a stressed situation, scenario 3 a distressed situation, and scenario 2 lying somewhere in between. I’ll touch more when we discuss distressed opportunities why I’m making that distinction, but suffice to say that today’s concept of opportunistic investing is probably broader by virtue of how the market has evolved in the past few years, and probably why you’ve seen funds rebranding their more high-risk strategies towards the idea of opportunistic credit.

4) Can you give us a rundown on how you think about idea generation and finding opportunities in the secondary market?

Many different ways to skin a cat here, but I’ll start by acknowledging that idea generation is extremely difficult. Perhaps more so if you are generalist vs. being sector focused.

I think for sector-focused analysts – a lot of idea generations is driven simply by following the ongoing changes/trends in your given sector. Given your assigned coverage, you should be knowing the business models of your companies well, and be able to understand intuitively how (potential) changes/trends impact your names to come up with a view that hopefully develops into an idea.

For the generalists (which I think many opportunistic/distressed guys probably fall under)…would say trading price tends to be the starting point. You’re typically starting by looking at a credit trading at a discount, looking to learn about the business and figuring out what went wrong (ie – why does the credit now trade the way it does/wider vs the average) and making a judgment whether the issue is temporary or more permanent as you develop the idea.

Last extra point on shorts – I tend to think sector focused analysts probably have more of an edge here. Shorting is generically harder to grasp for credit analysts – largely because you have to worry about carry impacting your returns, and so timing becomes really, really important, not to mention conviction in your idea for the price change to offset the carry. With respect to the latter point, naturally the best shorts (from a risk perspective) start from trading as close to par as possible, which generically leads to opportunistic folks paying much less attention – if said credits are already trading at/close to par, opportunistic guys are less likely to be looking at them.

5) What are the key characteristics you look for when shorting? Secondly, when do you know when your short has run out of steam and it's time to cover?

Let’s say for a moment that a good credit long idea is made up primarily of 2 components:

1) Said credit has good defensible cash flows and can reliably make its cash coupons

2) Leverage is manageable and well within enterprise value – i.e LTV will for the most part maintain being below 100% such that the debt is covered and will recover par

3) There is technically a third element which is – relative value, where you can find excess yield/cheaper pricing relative to other credits, as we highlighted in the previous performing credit discussion.

Good short candidates therefore, would at least require the inverse the first 2:

1) Said credit burns cash, not just in the moment but for the foreseeable future – ideally to point where liquidity becomes a problem (impacting not such the payment of coupons, but also the ability fund the ongoing operations of the business itself)

2) Leverage through the credit instrument is excessive, and there is not enough value in the underlying assets to cover the outstanding claims, thereby impairing the recovery of the credit instrument

3) Shorting on the basis of relative value is EXCEPTIONALLY hard if the expectation of recovery is still par. This is because pricing movements is pretty unlikely to move enough to cover the cost of carry (i.e payment of the coupon) – said differently, even if there is a bad headline but it doesn’t change the expectation of a par recovery, it is unlikely to cause the credit to trade off more than say 2-3 points, and it usually takes more broader macro movements like a broader market selloff for these shorts to get to the realm of profitable.

The first 2 points harkens back to the similarities to value investing, but the nature of credit also adds the element of event-driven situations, primarily because the credits themselves contributes to the events. E.g a company needs to make a coupon on Jan 31, but doesn’t have the money, or the company has a debt principal due but isn’t able to refinance the debt or the broader capital structure. These present catalysts to realizing the value of assets and in turn the value of the debt instruments (via recovery) – which is what you are trying to play for (long OR short).

When is it time to cover? Depends on how your thesis is playing out, relative to the current trading price, which should be the basis of how you assess your risk-reward consistently. Judging event probabilities is really hard as timelines progress and the body of facts change, and how good you feel about capturing more PnL vs taking the win/loss and moving on. I think it’s crucial to always keep in mind what you are playing for in order to keep your judgment (and especially biases) in check – that’s usually your biggest ‘risk management’ factor as an analyst, and unfortunately where many analysts can go wrong (speaking from experience!).

6) Have you found yourselves in any situations where trading volume and liquidity gets dicey? Do we see "Short Squeezes" in credit in the same way we see them in the equity markets?

Absolutely – tend to see them in situations that get towards a restructuring process, which in themselves carries some risk as a short because, by virtue of your position, you are not involved in the process and have very little ability to influence the process for a positive outcome (while there are others on the opposite side to do exactly that).

In processes, trading liquidity gets impacted as the longs are typically going to be part of lender committees as they look to improve their recoveries, and what we are increasingly seeing in the market is the prevalence of co-op agreements, where members of said committees sign on to these agreements. They are meant primarily to deter lender-on-lender violence, but they also encourage the members that to withdraw lending/pull borrow on the securities – which in turn increases borrow cost and reduce trading liquidity. When borrows get pulled, and forces shorts to cover in order to return securities, it forces prices up when everyone is trying to run towards the same (shrinking) exit – voila, you have a short squeeze.

This for me is sometimes the most frustrating part of certain shorts, where you can be absolutely right on your thesis, but still potentially get killed due to the dynamics of these processes. Definitely have seen a handful of these play out fairly recently.

7) What are the best ways to earn your PM's trust and win buy-in?

Make money consistently, or at least, don’t lose too much money when you do. I say this half-in-jest if only because that really is the goal of our jobs – to generate consistent profits and minimize losses. As you build your track record over time, your PM hopefully will develop an understanding on the way you work and how you assess risk, and that gets them comfortable with your approach to consistently want to put on your ideas.

At the start where you might not have yet developed that track record or trust, the best way in my opinion is to be more upfront and have strong illustrations on the risks of your investment ideas – I find that if you are more upfront about what can go wrong, you present yourselves as having more balance and awareness of your biases, which allows you to build your credibility with your PM over time. Once you have credibility, things naturally get easier, but one must never forget that in this role, we are only as good as our next best money making idea, and that credibility can flip way faster than the time it takes to build it.

8) What are the key considerations you think about when flipping from an overweight to underweight (or vice versa) as well as flipping from a Long to Short (or vice versa)?

This is a very good question – mostly because I have seen analysts face difficulty primarily because we are often going to be inherently biased towards our view. Not to mention, on the point of building and maintaining credibility with PMs, a 180 change in view can call into question your general level of conviction in your views, which can be disadvantageous if not managed correctly.

The most important thing is always understanding the drivers of your thesis, and assessing whether the ongoing facts are continuing to provide evidence towards how you anticipate events to unfold in the given situation. For what is essentially a 180 degree change in your view – you need to be able to recognize not just that the facts are different, but being about to identify how/whether the implications are big enough to change your thesis the other way.

To use an example – consider Envision which I think many would agree has been one of the most topical distressed situations in recent history. Illustrating further how this could hypothetically look:

Initial long thesis: Envision provides an essential service (emergency medical staffing) – backed up by strong contracted rates where the company effectively enjoys pricing power due to the ability to balance bill (note: I’m being intentionally vague on the details here, primarily for the sake of brevity).

Thesis changer: The No Surprises Act (NSA), which effectively prohibits balance billing, is enacted. Envision no longer can use a core driver of its bargaining power with insurers to drive its earnings going forward.

New short thesis: Envision’s earnings was driven in large part by its ability to keep effective prices (rates) high, such that the outlawing of balance billing would be likely to have a significant impact to earnings. If you quantified what this impact would be – you might conclude that earnings on the forward could be so impacted that the company would burn cash, the capital structure is unsustainable under a new run-rate EBITDA, and if the company files, the value of the going concern is now massively reduced such that the existing debt could be impaired. You think the recovery on the debt is materially lower vs where the debt currently trades, and so you short it.

Notice that I’m calling out both the ‘thesis changer’ and ‘new short thesis’ stages, primarily because it’s not enough to say ‘the thesis has changed’ – you really need to say the ‘the thesis has changed so much that it warrants a change in the position,’ which is why you need to be able to quantify the impact to support your ‘flipping’ position.

9) How do you view the current opportunistic landscape?

This might be a lame answer – but I really think it’s going to be market dependent. You really need to see more volatility in order for prices to have more dispersion to be able to take advantage of, and we generally have been going through periods of relatively low volatility as the market consistently seems to find ways to shrug off negative data. That being said, rates are still higher and decently above what we’ve been used to over the past few years so you might be able to make decent return, but I’m not entirely sold yet of the quality of credits we are getting relatively to said returns.

10) What do you think the distressed environment over the next couple of years will look like? Do you think we'll see lower recoveries, larger DIPs, and lower creates?

Low recoveries yes, larger DIPs likely, lower creates – not sure how to respond since lower creates are really just a function of prices. I think the general theme of distressed for the past few years has been one of the dearth of opportunities – a low rate environment for the longest time has allowed too many companies to be levered, and noboby necessarily wants to own crappy companies on the other side of restructuring.

Going back to a comment I made earlier – in my opinion distressed has evolved away from the traditional loan-to-own strategy mostly because of this reason, and towards these ‘capital solution’ approaches where you are essentially trying to establish your spot as a new 1^st lien lender ahead of everyone else and getting paid for it. Said differently, you’re not going after equity-like returns anymore, but getting a better rate on higher risk 1L debt – which is what’s pushing this concept of ‘distressed’ into the ‘opportunistic’ world. And why people get more creative around providing liquidity solutions – you still want to make money but have increased protections as you get invested in riskier situations.

So if the opportunity set is still built on these lower-quality names, which were a function of the low-rate environment, we probably will see more of these ‘aggressive’ transactions where people care more for capturing ‘first dollar’ risk – because no one has confidence yet on taking equity risk in these names and are actively trying to avoid being the fulcrum. Maybe things will change in a few years as the vintage of names turns over time – we’ll just have to wait and see.

11) What does the long term career path look like for someone in your seat?

Currently, I would consider myself a senior analyst. Path wise – I could consider staying down this path for the rest of my career, where the focus is simply to generate profitable ideas. However, just like many aspirational investors, my goal would be to find a PM seat in a few years, which would require me to outperform exceptionally in my senior analyst role for a few more years.

Assuming that works out and the PM years are good, I’d like to be able to start my own shop – largely because I want to have more control over the style I invest. Whether or not that’s feasible…ask me again in a few years. Scale is probably the largest barrier to entry, especially in credit, to starting your own fund, never mind past performance.

12) What are the best ways for someone junior to break into and succeed in a path like yours?

Willingness to learn is extremely important, but so is the ability to apply what you have learnt, and put them to work ideally as quick as possible, whether it’s in simple analyses or broader actionable investment ideas.

Don’t be afraid to ask as many questions as possible, even if you think they may be stupid – you’d surprise yourself at how often you’re not the only one thinking about those questions. In my opinion, ours is a profession where skepticism is and should be encouraged, especially in credit where upsides are capped and downsides are material, as evident in the growing number of situations that have blown up.

It’s also how you learn; even if you might look stupid for a short minute, you are going to become smarter for an entire career.

Finally, at the risk of sounding boomer-y – you want to be in office and have as many in-person interactions with your seniors as you can. Development in investing is very much a master-apprentice model, and as juniors develop the reps required to get good at investing, you need a lot of guidance in those reps to improve quickly. In that spirit, there’s nothing like being able to turn to your seniors to get quick responses and immediate feedback in order to develop as an investor.

Wow. This was a conversation I really enjoyed having.

Until next time,

Harry

Harry’s Corner:

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HYH Interview - Anon L/S Credit Analyst

Diving into the world of Long/Short Credit

Sponsored by

A Message from Heron Finance: Earn a target 11-16% APY net of fees, without investing in the stock market!

Harry’s Corner: