Why the math supporting alternative credit has become exceedingly easy

Portfolio manager on fund's three-year winning streak, his rigorous investing strategy, and how his COVID-19 playbook echoes 2008

Why the math supporting alternative credit has become exceedingly easy

Once upon a time, the logic behind investing in fixed-income securities was straightforward: aside from hedging against the volatility of the stock market, they provided a regular stream of income for investors. But as central banks extend the current climate of low interest rates further into the foreseeable future, the incentive to abandon traditional balanced portfolios in favour of risk has gotten stronger than ever.

With the yield on the U.S. 10-year Treasury sitting at roughly 70 basis points – adjusted for inflation, that points to negative returns in the long term – the math behind investing in riskier assets like high-yield debt and equities has become terribly easy. But given the emotional pain that comes with stretches of volatility like what markets saw at the end of 2018 and earlier this year, investors might be inclined to use alternative investment strategies, including alternative credit.

That’s where the Purpose Credit Opportunities Fund has distinguished itself. Launched in 2013, the strategy has been recognized at the Canadian Hedge Fund Awards for the past three years.

After clinching the honour of Best 1 Year Return in the Credit Focused category in 2018, it won Best 5 Year Return in the Credit Focused category in 2019. This year, it won Best 3 Year Return in the category: over the three-year period from June 2017 to June 2020, it posted an annualized return of 6.06%, compared to the 1.72% annualized return of the HFRI Credit Index.

“I think it’s a validation of our approach,” Liang told Wealth Professional. “We’re about doing the work in advance, and we think our fundamental research-based strategy has really proven itself over the years.”

As a seasoned veteran of the business, Liang has been able to refine his approach over roughly 30 years. Rather than using leverage to boost returns, his strategy is built on a commitment to “doing the homework” and “getting to the finish line” in terms of doing fundamental research.  That means uncovering all aspects of upside and downside risk.

“We try to stay away from situations where there’s secular decline, so you won't see a lot of decline industries in our book,” he said.

Aside from looking at the supply and demand trends prevailing in different industries, he and his team make it a point to get to know companies’ management teams. With the view they should act as stewards of capital, Liang has met with over a thousand management teams over the course of his career.

The fund’s portfolio primarily consists of non-investment grade corporate credit, which Liang said is able to make roughly 80% of the return seen in equities over time with just around half of the risk. That’s before his team gets involved and adds alpha with their strategy, which avoids leverage and focuses on markets that trade every day.

“There's always trade-offs in different areas of alternative credit,” Liang said. “If you go into private credit, you’re taking on liquidity risk, you have to do your own documentation, and you have to negotiate all your covenants. Other investors have been levering up into investment-grade [bonds] with three or four times the risk; in the spring of 2020, people realized that often also means increased volatility, for which they won’t always get compensated in returns.”

The havoc in financial markets earlier this year came as the COVID-19 pandemic sharply accelerated many industry trends as well as the business cycle. Recalling the 2008 downturn, Liang said the worst of it took place from when Lehman Brothers went out of business in September 2008 until the time former U.S. President Barack Obama spoke about “green shoots” in March 2009.

The impact of the pandemic was similar in magnitude, though it was quicker to subside. He said markets took roughly one month to recover from the COVID-19-induced downturn. And while the outbreak did lead to a second-quarter decline in U.S. GDP, he said the third quarter appears to have brought about an economic recovery.

“The second wave notwithstanding. I think that the timetable in this pandemic has actually been accelerated in terms of both business cycle and industry trends,” Liang said.

He said the playbook he’s gone with for the COVID-19 pandemic is very similar to the one he had as a money manager in 2008. The difference was in how quickly the team moved: in late March and April, they found a lot of areas of dislocation, and had to be very decisive not just in terms of their research to uncover those dislocations, but also in having a conviction to act on.

“We found that there were various markets and industries where the selling may not have been fundamental or was fear-based,” he said. “Some of the industries we stepped into in April and May were involved in commercial real estate, but with very strong asset value protection where the value of the real estate has to go down a lot before we get hurt.”

While some areas of commercial real estate are extremely challenged, including shopping malls are and hotels are very challenging, Liang said other areas have held up well as tenants continued to pay their rent. His team has also stepped into secured lending in the airline space, where the fund has collateral to be protected even if the downturn persists for a couple of years.

“We're always thinking like a lender,” Liang said. “We're investors and we're not traders.”


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