Okada: Three Opportunities That May Offer Attractive Returns

Mark Okada|CIO, Highland Capital

The current state of the U.S. economy is nothing if not conflicted. Most recently, investors cheered the performance of the manufacturing sector during April, but their optimism was quickly tempered by a disappointing jobs report.

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Our prediction that the U.S. would experience a prolonged period of low growth rates characterized by risk and uncertainty has now become a reality.

As investors look to navigate this complex landscape in search of higher yields, we have identified three opportunities that we believe offer a combination of attractive returns and downside protection: Bank Loans, Long/Short Strategies and Distressed for Control.

Bank Loans

During periods of low economic growth, high yield credit has historically outperformed other asset classes. Within the high yield credit space, we believe bank loans are on track to outperform bonds for the remainder of 2012.

High yield bonds have clearly benefited from the Fed’s policy decisions, which have driven interest rates lower and flattened the yield curve. Now that the average bond is trading near 103, we believe this play has run its course.

Over the past several months, there has been a massive flow of money into retail bond funds, which has continued to drive the market higher. This “hot” money has the potential to flee the market as quickly as it came in and precipitate a significant decline in returns.

Bank loans, in contrast, are trading at a discounted average price of 95, which we believe will provide more upside potential (and less downside risk), particularly since flows into loan funds have been tepid following the market correction last August. If the U.S. economy stalls due to the lingering effects of the European debt crisis and other macro issues, bank loans, which are more senior in the capital structure, should provide a higher degree of safety than bonds.

Bank loans also have a floating interest rate structure that protects against rising rates, which the Fed can only delay for so long.

Long/Short Strategies

Long/short strategies can provide an ideal means for investors to diversify their portfolios and reduce their overall risk profile. In addition, their correlation relative to the broader markets is typically low, which allows them to mitigate their losses during market downturns.

On the flip side, when the markets rally, the potential upside for these strategies is generally lower compared to traditional, long-only funds. The objective is to create a stable return profile with an emphasis on capital preservation, while producing attractive risk adjusted returns. We believe the most successful managers are those who are nimble and can dynamically adjust their net exposure based on prevailing market conditions.

In addition, managers with unique sourcing can take advantage of market volatility by identifying alpha generating opportunities on both the long and short side. Although long/short strategies have historically focused on equities, the number of long/short credit funds — and the assets they manage — began to proliferate in the post-crisis era due to increased volatility within the bank loan and high yield bond markets.

Distressed for Control

Distressed for control opportunities arise when companies with sound market prospects suffer from poor management. Although these situations may be exacerbated during times of financial stress, there is a continuous pool of good companies with bad balance sheets during any market cycle. Managers who are best able to capitalize on these opportunities typically have a large sourcing platform that allows them to identify troubled companies early and build a position in the controlling debt tranche.

The key to achieving value is to create order out of complexity, which starts with a restructuring team that is capable of navigating the bankruptcy or reorganization process and maximizing value for the controlling debt holders. Once this process is complete, the manager must have a dedicated operations team with robust skill sets (lean six sigma, strategic advisory, talent management, etc.) that can streamline the organization. The investment horizon for this strategy is typically longer (4 to 7 years) and is subject to greater volatility, but it also offers the prospect of higher targeted returns that may range from the low to mid-twenties.