Algebris CIO favours financials, fears regime change

Ivan Vatchkov argues that financial credit offers plenty of upside, with little risk of a 2008-style repeat of investor losses – but radical changes to the status quo could destabilise bond markets.
Algebris CIO favours financials, fears regime change

Ivan Vatchkov, CIO at Algebris Investments, has been located in Singapore since 2010. He oversees a credit fund that invests in European Ucits long-only funds with daily liquidity, which has returned 8.1% on an annualised basis since 2012; as well as the Financial CoCo Fund, a long-short strategy offering monthly liquidity, has returned 8.4% annualised since its 2011 inception.

Q  Why focus on investing in finance-sector securities?

A  Financial institutions currently represent 33% of global credit issuance globally, and over 21% of global equity market weighting originates from financials. In emerging markets, financials represent 29% of the MSCI emerging markets index. 

Despite the importance of global financials, it has remained an orphaned sector: regulators have increased oversight, demanded extreme levels of capitalisation in tandem with de-risking, [and imposed] record-breaking legal fines. At the end of September 2016 financials within the S&P 500 index remain 20% below their October 2007 peak, the only sector within the index that has not fully recovered [from the global financial crisis of 2008].

[However,] financials in the S&P 500 have returned 338% since the March 2009 market low, exceeding the S&P 500 index return by 62%.

Q  How do you add alpha in financials?

A  One of the areas that has changed considerably since the crisis has been the regulatory oversight of financials in all global markets. We spend time with regulators, central banks, and other key influencers to ensure we understand the future direction of regulatory oversight and the impact these regulations will have on the ability of financial institutions to prosper.  

Q  Where does this fit within an institution’s asset allocation?

A  In the past, our bank hybrid credit funds were esoteric enough to fall firmly within a client’s alternative asset portfolio. In the past two years, as bank hybrid credit has grown substantially as an asset class, many clients now include our funds within their traditional fixed-income portfolio allocation.

Today, a majority of our discussions with client alternative-investment teams focus on our private-equity structures, whereas our equity and credit funds tend to remain within the equity and fixed income teams.

Q  Why should investors be looking at this kind of investment now?

A  In this environment funds such as our bank hybrid credit funds have been an important allocation for our clients, who receive 7% to 9% yields in hard currency on a portfolio comprised of major globally and domestically systemically important bank [G/D Sifi] credit. We have also seen our investor base expand dramatically to include insurers and pension funds who are growing alarmed by the asset/liability mismatches they face in the future under the existing zero/negative rate environment.

Q  How do global macro factors affect the strategy?

A  In credit we are focused on investing in what central banks don’t own, with macro overlays to reduce volatility and manage portfolio macro risks. The current macro strategy takes into account concerns about the growth of private debt outpacing GDP, debt overhangs that are still growing, the long-term collateral effects of quantitative easing, the reversal in petrodollars, and the uncertain political environment.

Q  What about political issues such as Brexit and the US election?

A  The political environment is a challenge for all funds. In the US often the rhetoric on the campaign trail doesn’t make its way into formal policies. The key will be to generate economic growth well beyond what we have seen since the crisis. We believe not only in the US but across the European Union and Japan there is a recognition that banks are important transmission mechanisms for economic policies, and therefore a more accommodative regulatory environment will support economic growth.

Q  Will your strategy blow up if we have another crisis like 2008?

A  Our proposition is straight-forward: global Sifi banks have undertaken unprecedented capital rebuilds since the crisis while deleveraging and de-risking their balance sheets. There has not been a time in the past 30 years when banks have maintained such low levels of risk on their balance sheets, while regulatory stress testing against severely adverse economic conditions worse than 2008 are undertaken annually to assess each bank’s ability to survive. This certainly does not mean another 2008 style crisis is an impossibility: we just don’t believe that the same level of systemic risks are present today.

What has been interesting for us, and a source of outperformance in 2015 and 2016, is the dislocation between market volatility and what we believe to be the underlying reality. We saw this in the sell-off of bank equity and credit in the first quarter of 2016, where our assessment of the fundamental strength of bank balance sheets signaled extreme over-sold conditions. We were proven correct.

Q  What are the issues that are most important to you as a fund manager at the moment?

A  We share the market’s concerns with the momentous amounts of debt that has been accumulated since the financial crisis, and the ongoing central bank monetary policies that are exacerbating the long-term consequences of low rates, asset bubbles, resource misallocation, rising inequality and lower productivity. What we fear now is regime change that upsets the fixed-income market and causes a broader dislocation globally.

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