Mod Note (Andy): Q&A/Interview Tuesdays! Email me ([email protected]) if you'd like to do a Q&A or interview for WSO My background is working in a high yield/distressed trading desk as a research analyst and trader, before making the move to a credit hedge fund within one of the major PE firms. The guys on the public side of the wall are a different breed than the private-side banking guys, who I think have a pretty high level of representation on this board relative to fund guys. A little rougher on the edges, and probably a little more intense in general. Hopefully I can shed some light on the dark corners of the world of credit trading... I started my career as a research analyst and a trader at one of the BBs back in the 08-09 time period, and got poached by one of the big PE funds for their credit investment group. The personalities on the trading desk are very unique, as is the heavy partying/client interaction aspect of it which I truly think differentiates it from banking. I'd love to discuss any questions people have on the trading environment at a BB, the type of work at credit funds, culture, goals, etc.
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1) In terms of how risky a business is, I typically take a top down approach. I look at the overall sector drivers and then focus on the company itself. That makes it easier to frame the story - for example, if I'm talking about a iron ore miner, I'll start the conversation off discussing the macro demand drivers, supply, and recent trends. Then look at the main players, then look at the specific company, then within the structure which tranche makes the most sense. I guess my main considerations when analyzing the company's fundamentals: - the sector overall and where within the sector the company at hand fits in (for example, within the energy sector I would view a pure exploration company differently than a service provider) - the company's operating performance relative to peers within the sector (basically a Porter Five Forces lite) - the company's debt profile and leverage, including the history of issuance, as well as a covenant analysis of each tranche of debt - the company's cash flow generation ability and how its invested its cash flow - How these fundamentals fit in with the investments potential return, and what the catalysts are I think the biggest difference from sellside is evaluating the business much more than just the financials - the competitive position, contract structures, buyer/supplier relationships, macro outlook, regulations, etc. play a big role in our investment pitches on top of just saying 'Free cash flow over debt is 20%' or 'Leverage fell from 7x to 5x'
2) In terms of deciding what part of the structure to invest in, at a high level there are two main things we consider: - Coverage versus yield: typically people simplify this as basis points of spread per turn of leverage, but really its looking at where you have protection. If you are secured by real assets or actually pari passu, if you have a 1st claim on cash flow, etc. - Amount of leverage we can apply - a higher quality security yielding 6% but that can be leveraged 2x might make more sense then a 9% security that is relatively illiquid and gets no leverage
Hope this helps - pretty high level, I know
Sure - when I say coverage I don't mean 'interest coverage' - I rather meant asset coverage of the bonds. So you try to take a look at the underlying business (either from a EBITDA multiple or collateral value perspective) and see how that covers your bonds given its security.
In terms of turn of leverage versus spread: spread is just the level of yield you get from the security over existing treasuries. So if you get 5% more than match-dated treasuries, your spread is 500bps.
For example, say you are looking at a two-tranche structure, with a $100mm secured loan and $300mm in unsecured debt. The company's EBITDA is $50mm. The secured loan is yielding 4% and the unsecured bond is yielding 10%.
1st lien loan: $100mm/$50mm = 2.0x leverage. 4% yield/2.0x leverage = 2% yield per turn of leverage. Unsecured bond: $400mm/$50mm = 8.0x leverage. 8% yield/8.0x leverage = 1% yield per turn of leverage.
So from yield versus turn of leverage, you are 'getting paid' more for the 1st lien loan. The incremental leverage of the unsecured bond does not offset the additional yield you pick up. Now once you do this analyst, you have a few options: - Go outright long the 1st lien, getting 4%. - Go outright short the 2nd lien, for example if you think the company is going to file or prime these bonds to raise liquidity, the yield could actually become even worse. - Do a pair trade: if you think EBITDA is going to increase 50% next year, you can take the view that the unsecureds will rally more than the loan (perhaps the loan's upside is call constrained). Here you can short the loan and go long the unsecured.
The turns of yield (or spread, where you just substract the match-dated treasury yield from the calcs) is just a basic way to establish a framework, but not a way to make a real decision.
In terms of leverage being applied, this is something my PM handles with our sellside counterparts that provide us leverage - from my understanding, its a grid-based system based off of the credit ratings (so if Moody's has a loan as a BB, it can get more leverage than a B). Of course, banks all compete to provide leverage because that increases their share of other services, and you can get a discount on leverage if its a loan/bond that the bank is the lead dealer for.
Typically, we run at 4x-5x leverage from my understanding. If we think a CCC bond yielding 12% is going to move to 8% in 3 months following a strong earnings announcement, even if we can't get leverage, we could still like the potential return. If we think a BB bond yielding 4% will go to 3%, but we can get significant leverage on it, that is still favorable.
Do NOT worry about your lack of accounting skills. What you should do is download a book on financial accounting and a few on value investing, and go through some 10-Ks. When it comes time to interview for spots in your rotation, you'll be largely on the same page. I had NO accounting skills - I didn't even intern in finance the prior summer, I worked at Bain/BCG and lateraled for FT.
We traded a fair bit of CDS, but because of the risk weighting for CDS holdings, we typically did not have much of a prop position in CDS and instead focused mostly on market making. We did do some compression trades, but it was typically the hedge out risk in the cash book within the same name. CDS is an interesting product from an investing perspective, but given the relatively low spreads in the liquid names and the illiquidity in the truely stressed/distressed names, my trading 'pod' usually stayed away.
The most common trades we did were basis trades (long cash short CDS, picking up spread). Man, I haven't done CDS in so long I totally forgot about it. Its a crazy fun product to trade if you have a lot of share though. Given we were focused more on stressed/distressed there wasn't that much liquidity in what we did.
It is totally different than an analyst-PM role. My PM is a boss (though they usually act as a 'first among equals' at my firm). The traders I worked with as a research analyst were technically my peers - a senior research analyst and a senior trader both reported into the head of the group, as opposed to the analyst reporting into the trader.