Ex-Jefferies Bond Trader Anticipates Junk Swoon: Canada Credit

Fiera Quantum, one of the winners of the meltdown in Canada’s asset-backed commercial paper market, is looking for its next trade idea in junk bonds.

The Toronto-based hedge fund manager owned by Fiera Capital Corp. started the FQ Income Opportunities Fund in May to take short positions, or bearish bets, balancing bullish investments in U.S. and Canadian high-yield bonds. Fiera Capital oversees C$82 billion ($76 billion) of assets.

“If there’s ever a time to get more cautious, it’s now,” said Angus Rogers, who left his job as head of high-yield trading at Jefferies Group LLC in New York in March and moved to Toronto to start the fund with Greg Foss, who started betting on restructured commercial paper four years ago. “Most of the credit rally has happened. Over the next two years, defaults are definitely going higher.”

With speculative-grade defaults and yield spreads the lowest since before the 2009 financial crisis, the credit cycle heat map the fund uses to describe its strategy is flashing yellow, signaling hold or neutral. A rise in defaults will push the map into red, triggering a shorting strategy Rogers and Foss say will help them beat annual junk-bond returns that will average less than 5 percent over the next five years.

High Risk

Junk bond spreads, a gauge of risk perception, dropped to a seven-year low of 3.35 percentage points in June, according to index data compiled by Bank of America Merrill Lynch, while defaults -- and losses -- are about to rise, according to Moody’s Investors Service.

“When high-yield is yielding 5 percent before defaults, you have to say the perception of risk is pretty low. People are saying ‘Oh, what could possibly go wrong?’” Foss said, adding a 1.2 percentage-point yield increase would wipe out your coupon with a 5 percent price depreciation. “Actual risk is very high.”

The Fiera fund managers are in good company. Marathon Asset Management LP’s Andrew Rabinowitz in New York said he “hates” the market and is taking short bets against it. Martin Fridson at Lehmann, Livian, Fridson Advisors LLC in New York has said the market is about as overpriced as he’s seen in his 40-year career.

Investors struggling to meet return targets to offset near-zero interest rates have piled into high-yield bonds. The value of bonds in the Bank of America Merrill Lynch Global High Yield Index has soared to more than $2 trillion. It took 12 years for the gauge, started at the end of 1997, to get to $1 trillion, and only four years to add another $1 trillion.

Default Rates

“You look at the amount of issuance we’ve seen in the global leveraged finance markets,” Rogers said. “Credit downgrades typically take place between 18 and 24 months after the fact, that’s when the things start to unravel.”

On average since 1993, U.S. companies that lack investment-grade ratings defaulted on 4.4 percent of bonds, according to Moody’s Investors Service. The rate is projected to jump to 2.8 percent by February from 1.9 percent in the second quarter. At the height of the credit crisis in 2009, almost 15 percent of high-yield bonds defaulted.

“You need to be long-short rather than long only because at some point it will end painfully for the long only crowd,” Foss said.

One of Fiera Quantum’s most-profitable investments was snapping up restructured asset-backed commercial paper worth 65 percent of face value after a court-ordered conversion of the short-term instruments into longer maturity holdings in 2009. With the debt now trading at about 95 cents on the dollar, the firm’s Canadian ABCP Fund LP returned 57 percent since its November 2010 launch, compared with a gain of 37 percent for the Merrill Lynch U.S. High-Yield Index over the same period.

Vulnerable Prices

Foss competed for the Master Asset Vehicle notes with New York hedge funds Anchorage Capital Group LLC and Daniel Loeb’s Third Point LLC. Many of the New York-based funds cashed out last year in an auction of the debt.

While Foss and Rogers say they don’t see anything as enticing as the MAV notes in today’s market, they say prices are vulnerable to what they call systemic risk, an event that pushes global bond yields higher.

Even signs of an economic recovery could be bad for the market: high-yield bond returns sank 2.6 percent in June 2013 after then-Federal Reserve Chairman Ben S. Bernanke sent the market into a tailspin by warning that stimulative monetary policies might be coming to an end. The index is on pace for a 0.6 percent drop this month. It’s up 5 percent this year through last week.

“There’s lot of systemic risk in the market right now,” Foss said. “The main risk in the high-yield market right now is for yields to go from 5 percent to 6 percent.”

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