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The benefits of long/short credit exposure in today's market

Adopting a long/short approach before interest rates rise could be a good defense for investors

Mar 31, 2015 @ 7:30 am

By Dorothy C. Weaver

In the current low-rate environment, the search for yield has been an endless quest for advisers and investors alike. Moving up the risk ladder has been one of the only ways for investors to achieve a decent return on their fixed income allocations. As long as interest rates remained low and credit was a one-way “beta” trade, that approach worked fairly well. It may not feel like it, but we are six years into the recovery cycle.

Historically, this point in a recovery cycle has been when a conservative, opportunistic approach to credit selection is increasingly important, and when cracks typically appear, thereby creating compelling opportunities for shorting.

The markets became significantly more volatile in the second half of 2014, and that trend has continued into this year. The recent increase in volatility and dispersion across markets will likely continue throughout the rest of this year, and with complacency high in fixed income and a Fed rate hike looming, the credit markets could be especially affected. Therefore, we have increased our exposure to true long/short credit strategies in this environment because we believe their lower directionality can potentially not only provide downside protection in weaker markets, but could also be a source of positive returns due to their ability to go net short if conditions warrant.

(More from Dorothy Weaver: How to follow the lead of institutional investors)

Today's environment is one in which long/short credit managers can flourish, since their core skill set involves conducting in-depth fundamental research to identify winners and losers across markets. In recent years, the higher correlations in the “risk on/risk off” periods hindered their ability to do so, but the environment has returned to their sweet spot. In long/short credit, the recent sell-off in energy companies, which account for approximately 15% of the high-yield universe, has created significant choppiness, and therefore investment opportunities. Higher volatility and dispersion in bonds typically provide a supportive environment for a long/short approach in credit.

A true long/short approach in credit can be further enhanced if managers use current market dynamics to guide the overall portfolio positioning. For example, we have always been particularly interested in managers who have demonstrated an ability to be materially net long when economic and credit market conditions warrant, and materially short when they do not. Taking into consideration the technicals that are currently shaping the market is also important. For instance, if capital inflows into the asset class are strong, managers need to be able to adapt to that environment even if they have a fundamentally bearish perspective. This active management, trading and flexibility allows managers to easily adapt to the constantly-changing investment environment, and can lead to good performance even in weak markets.

(Related read: The long/short case for investors)

We find that long/short credit strategies can fill multiple roles within investors' portfolios. First, they can serve as alternatives to bonds for investors seeking credit exposure that can perform irrespective of market direction. The ability to go long and short provides an alternative return stream versus core long-only bond holdings. Further, these strategies offer credit-driven exposures that add diversification to traditional interest rate-sensitive bond portfolios.

The ability of a long/short credit strategy to capitalize on opportunities across all phases of a credit cycle, irrespective of market direction, is particularly important in today's investment climate, when the upside in credit appears to be extremely limited. We believe that any crack could cause panic among investors who have blindly taken on additional risk in their search for yield. That is precisely when the value of a less directional credit strategy with a well-built short book will become apparent.

As the saying goes, the best defense is a good offense. Investors need to be proactive rather than reactive and add long/short credit exposure before interest rates increase and drive bond prices down. The next few years could be dramatically different than the last few, especially where the credit markets are concerned, and investors should protect themselves by making long/short credit strategies a core staple of their fixed income allocations.

Dorothy C. Weaver has served as principal, chairman, co-founder and CEO of Collins Capital, and is a former chairman of the Federal Reserve Bank of Atlanta, Miami branch.

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