Even after netting a tidy profit from the recent banking turmoil, Boaz Weinstein isn’t gloating. In fact, he says, the big gains for those wagering on a credit crunch are only just getting started.
(Bloomberg) — Even after netting a tidy profit from the recent banking turmoil, Boaz Weinstein isn’t gloating. In fact, he says, the big gains for those wagering on a credit crunch are only just getting started.
That’s how his hedge fund, Saba Capital Management, is positioned — with bets on stress he says is probably already ripping through private credit and insurers. Saba runs a tail-risk strategy that thrives in dislocated markets, one of a handful that feed his flagship fund which gained 73% in 2020’s pandemic. The $4.3 billion hedge fund clocked up returns in March from banking turmoil including a trade on Credit Suisse Group AG, according to a person familiar with the matter.
“From where I sit, the chance of a major selloff in the next six months, relative to how inexpensive it is to hedge it, has never been higher,” Weinstein said in an interview at Bloomberg’s London office.
In his view, that selloff could push credit spreads toward crisis levels, trigger a surge in bankruptcies and upend life insurers that have piled into private credit and commercial real estate.
To profit from falling markets, the firm looks for aberrations in credit-default swaps on individual companies. It writes protection on high-quality names whose CDS it views as expensive, and buys protection on cyclical companies and financial companies whose risks are being underpriced.
Recently Weinstein, the former co-head of credit at Deutsche Bank AG, has sensed banks getting nervous. He says they’ve been quietly cutting risk through credit derivatives in an effort to build up capital ratios against a coming wave of defaults.
“For the first time in my career we traded Apple CDS. I’m confident the buyer doesn’t think the spread is too low, but that’s because they needed a hedge,” Weinstein said. “The amount of CDS they need to buy at times can seem almost insatiable.”
Weinstein reaped gains from a dual long and short bet on Credit Suisse in March, according to the person familiar, who declined to be named speaking about private information. The so-called curve trade anticipated the Swiss lender would face greater volatility in the next two years than the subsequent eight.
Perhaps his most famous trade came in 2012, when he rode a bet on a bank rushing to offload risk, taking the other side of outsize wagers made by JPMorgan Chase & Co.’s so-called London Whale.
Like almost everyone on Wall Street, Weinstein admits he didn’t foresee the failure of three US banks and the government-facilitated takeover of a fourth in Europe.
But now he sees signs of distress virtually everywhere. Seemingly on cue, First Republic Bank’s deposit outflows and earnings shattered a fragile calm this week.
Similar to the regional lenders who suffered an exodus of depositors, insurers could struggle to manage so-called lapse risk, the rate of policyholders cashing-in or not renewing contracts.
“I’ve been approached by funds that want to compare notes on the risk of misjudging policy lapse, where life insurance companies can have issues on the liability side which can cause concern around their assets,” he said. “In a downturn, I foresee this CDS widening a lot more than other sectors and along with regional banks, life insurance sector getting the most scrutiny about the marks.”
Five-year default protection on investment-grade rated Lincoln National Corp. has spiked to around 335 basis points since the bank turmoil erupted — and unlike broader CDS gauges, never recovered. In an April 5 tweet, Weinstein said he holds default protection on Lincoln and also recently sold some.
Shadow lenders that amassed huge bets on illiquid, unrated companies in the cheap money era are another target. Last quarter was the busiest January through March stretch for US bankruptcy courts since 2009, according to data on large corporate filings compiled by Bloomberg.
In the private space, problems are often masked because prices aren’t marked to market as often if at all.
“I think there’s going to be a huge problem in private credit in the next year,” Weinstein warned. “Some investors talk about how great it is to be able to buy 11% yielding secured loans as if it’s an amazing environment. Tell that to those companies that have to pay so much more in interest expense.”
Dire Warnings
The bond market contains dire warnings about the state of the economy, Weinstein said. Virtually the entire Treasury curve remains inverted and yields aren’t far from levels reached in the aftermath of the collapse of Silicon Valley Bank.
But with equities and credit sedate by comparison, and an economy and labor markets that remain robust, bets on an imminent downturn may backfire.
The VIX Index of US stock volatility has tumbled to below 20 from 26 during the bank turmoil. In credit, US investment-grade corporate bond spreads are signaling the all-clear, with risk premiums narrowing more than 20 basis points from their March peak.
Most tail-risk strategies use deep out-of-the-money puts on the S&P 500 index or calls on the VIX, rather than the credit-default swaps favored by Saba.
Weinstein argues that in a slow-burn bear market, credit derivatives are less dependent on the timing of a crash and bets on specific names may capture volatility spikes better than classic Black Swan strategies, whose returns have mostly stalled since the big pandemic selloff.
He acknowledges the tail-risk proposition is likely to suffer in a bull market, especially one boosted by quantitative easing. Saba historically has made money when volatility has been high, but a decade-long rally in credit following the 2008 financial crisis meant fewer opportunities to profit. The Saba Capital Master fund suffered five years of losses in the period from 2010 through 2019 right before delivering its best year on record in the pandemic.
If the Federal Reserve engineers a soft landing of the US economy, the best days for tail-risk hedging may be over for now.
But for Weinstein, the full impact of the central bank’s 475 basis points of policy tightening have only begun trickling through the economy. He says that a recession is likely to happen within one year, and that a wide range of outcomes and risks are going overlooked.
“There’s a fog of uncertainty” he said. “When the fog clears, prices will better reflect fundamental value again.”
–With assistance from Claire Boston.
More stories like this are available on bloomberg.com
©2023 Bloomberg L.P.