Hedge fund managers who bemoan their image problems should spare a thought for Susan Kobayashi. The director of fixed income portfolios for Mellon Capital Management (Mellon CM) was in Australia last month promoting a fund associated with not one, but three phrases made notorious by the meltdown – ‘quantitative’, ‘market neutral’ and, most challenging of all, ‘credit default swap’. In Kobayashi’s favour, Mellon CM’s Credit Market Neutral Fund was one of about three products in the world that actually made money in 2008 – a gross absolute return of 828 basis points, in fact, before its fee of 1 per cent and performance incentive of 20 per cent over cash. Kobayashi said that credit default swaps had been “lumped in with CDOs and SIVs and all the other things with three-letter names”, whereas the CDS market has maintained high liquidity throughout the crisis, and has a reputational problem caused only by isolated players using too much leverage.

“The likes of AIG should never have had the ability to sell protection on CDSs without the posting of collateral, that was insane,” Kobayashi said. CDS acquired a risky reputation for a lack of transparency in the wake of AIG’s sudden, largely unanticipated collapse, and Kobayashi admitted she was now explaining the asset class as much, if not more than, she explains and promotes her own CDS fund. However, she said the scrutiny of CDS has had an upside: it had “sped along” the formation of the CDS market’s first clearing house for the buy and sell-side. “A central counterparty will help show people these assets are not inherently toxic,” Kobayashi said, by moving the market away from over-the-counter status to one in which valuations and contracts are standardised, the size and price of trades must be reported, and counterparty risk (a la Lehman Brothers) is minimised.

At presstime, the US-based IntercontinentalExchange was leading the race to become the default clearing house, with single-company CDSs due to be tradeable through it in this quarter. Mellon CM’s Credit Market Neutral Fund lives up to its name by being US dollar neutral and neutral on shifts in spreads beyond 10 per cent (ie where a CDS on a spread of 50 bps moves more than 5 bps in either direction). Kobayashi said the fund typically holds between 85 to 95 of the roughly 340 US names on issue. It’s big money-maker in 2008 was short positions in US home builders. It became a seller of protection in the builders in early 2007, when their average spread was around 40 bps, which subsequently blew out to multiples of that.

“Home builder credit spreads were tight because they had good balance sheets, and people just didn’t think the risk was there,” Kobayashi said, adding the fund had resumed long positions in the builder CDSs about three months ago. The travails of the long-only CDS investors have probably not helped the Credit Market Neutral Funds’ assets under management, which sat around US$78 million at presstime. JANA’s head of investment outcomes, Ken Marshman, said the consultancy had taken insufficient interest in CDS to contribute to this article. However, Kobayashi said the Fund’s track record of performance, and never having imposed a gate or lock-up, was creating goodwill among institutional investors seeking alpha opportunities in credit.

She added that unlike many investors, the Mellon CM Fund did not make investment decisions based on ratings from credit agencies, because they were often slow to incorporate changing company fundamentals. “We look at model valuation versus market spreads and risk as measured by the price behaviour of actual credit defaults swaps…Our goal is to react quickly to changes in company fundamentals and the rapidly changing market prices of related pieces of the capital structure such as equity and volatility, allowing us to identify trading opportunities.” Kobayashi said the recent volatility and confusion in credit markets had increased those opportunities, as market participants reacted in a kneejerk fashion to managing their credit beta exposure by trading credit indices, bolstering the tendency for mispricings between individual corporate issuers.

Leave a comment