“It’s like the tide going out; you’re starting to see all the things that have been waiting to happen,” David Sherman of Cohanzick Management, 15 March 2023 web call summary.
David Sherman is one of the industry’s most consistently successful fixed-income investors. He founded Cohanzick Management on the premise “return of capital is more important than return on capital.” His specialty is the pursuit of distinctive, low-risk diversifying strategies for fixed-income investors. “We try to focus on what we know and what we do well. We do not pursue investment ideas or strategies that are outside of our core competency.”
Cohanzick and their CrossingBridge affiliate advise six funds, including one ETF. All four CrossingBridge funds managed positive returns in 2022, as did RiverPark Short-Term High Yield, which is an ultra-low volatility cash alternative fund. RiverPark Strategic Income, which will soon become CrossingBridge Strategic Income, lost just over 3%, which placed it in the top 6% of its Morningstar peer group. Cohanzick also manages a small number of separately managed accounts and private investment vehicles.
|Rating and group||2022 return||3-year return||3-year peer rank|
|CrossingBridge Low Duration High Yield (CBLDX)||Five-star, Multisector bond||1.01||6.3%||Top 8%|
|CrossingBridge Ultra Short Duration (CBUDX)||Ultra-short bond||2.45||n/a||n/a|
|CrossingBridge Responsible Credit Fund (CBRDX)||Multisector bond||1.81||n/a||n/a|
|CrossingBridge Pre Merger SPAC ETF (SPC)||Small cap growth||2.02||n/a||n/a|
|RiverPark Short Term High Yield (RPHIX)||Four-star, High yield||2.96||3.0%||Bottom 5%|
|RiverPark Strategic Income (RSIVX)||Five-star, High yield||-3.30||9.3%||Top 3%|
|Morningstar core bond category||-13.11||-2.79%|
|Morningstar high yield bond category||-10.09||5.6%|
|Morningstar multisector bond category||-9.85||3.3%|
In the second week of March 2023, the banking industry suffered a series of serious shocks. Those raised questions among investors on the stability of the US financial system. Those concerns were reflected in mass withdrawals of cash (about $250 billion in two weeks) from regional banks. Schwab got slammed by the panic over those banks, with its stock price dropping 37% in a month. A widely cited study (Jiang, et al, March 2023) raised the prospect that 186 other banks were vulnerable to bank runs similar to SVB’s. And the Fed extended its Bank Term Funding program to backstop the sector’s liquidity.
On rather short notice, Cohanzick invited people to listen to David Sherman talk about the significance of “recent developments.” Reportedly, 90 people called in. No slides, just David at his desk talking through two topics and fielding questions. CrossingBridge has shared the complete video. For readers who are either a bit impatient or a bit ADHD, our summary follows. Please note that we have tried to reproduce Mr. Sherman’s words as precisely as possible. That said, there may be some slips in our work. We will update it if we identify any misrepresentations.
None of his funds have exposure to banks or thrifts. Exposure to banks would double his exposure to certain types of risk (interest rate, capital market access) and layer on new sources of risk (leverage and asset mismatch) that he would prefer to avoid. Early in his career at Leucadia, he was taught that “we should avoid exposure to financial companies because they take spread risk, which is effectively what all of us do here. When we invest in fixed income, they take interest rate risk, which is effectively everything we do in fixed income. They’re levered, which we are not. They need access to the capital markets, which everybody here does. And … they borrow short with depositors and lend long, which is an inherent mismatch of assets versus liabilities.”
In a “moral hazard” sort of way, institutions worldwide have “adopted an umbrella policy: avoid any failure at all cost.”
Sherman’s policy preference would be a 1-2 bps/year charge for insurance on accounts over $250k with an opt-out provision and some sort of preferential payments scheme (akin, I think, to what happens in a bankruptcy liquidation) to avoid runs on the bank.
Nota bene: some members of MFO’s discussion board had a lively exchange about the topic. A lot of research points to the moral hazard risks of deposit insurance (DI). That is, the more deposit insurance a government provides, the more irresponsible the bankers behave. The seminal research (Barth et al., “Bank regulation and supervision: what works best?” Journal of Financial Intermediation, April 2004, a draft of which is easily accessible) has been cited nearly 3500 times and concludes that DI has a downside. The World Bank (2018) seems to agree: DI “comes with an unintended consequence of encouraging banks to take on excessive risk.” The subject is complex.
He believes interest rates will remain higher for longer than commonly expected unless the fed has to accommodate a systemic risk. A Fed “pivot” now would be “a bad sign regarding speculation and future inflation.”
Nota bene: many now speculate that the SVB shock did the Fed’s work for them by inducing precisely the sort of credit slowdown that they were trying to trigger. Which that effect endures, or is substantial enough, remains to be seen.
The commercial real estate market, which is reliant on floating rate securities, is a major and generally unrecognized risk. High quality lenders like BlackRock “are handing the keys back to the bank.” Eventually, the government will need to pursue a solution like the Resolution Trust (1989-1995) to work to resolve the savings & loan crisis.
Q: Is the banking system close to a meltdown?
A: no. With the exception of a few incidents involving insolvent micro banks, there are no “FDIC-regulated banks where uninsured depositors didn’t get their money back.”
Q: Are you positive on high yield this year?
A: we don’t speculate, but “in general, actively managed high yield will outperform the stock market over the next couple of years.”
Q: Has the risk-return equation become more compelling? Are you playing offense or defense now?
A: “I love this question. Compliance hates it. We love markets like this, even if they’re frustrating, difficult, or stressful, because they create volatility, and volatility creates opportunity … it’s like the tide going out, and you’re starting to see all the things happen that have been waiting to happen among corporate credits. You’re seeing profit margins of some businesses being challenged, and you’re seeing a decline in revenue, you’re seeing pricing differences, you’re seeing people having different views on what will happen on interest rates, you’re seeing people being forced sellers to raise liquidity because people had bad years last year. And those have all been developing, which has allowed us to be more offensive over the last several months.
“Although our dry powder remains quite high across all of our strategies and hasn’t really been diminished, the money that we’re putting to work is at substantially higher returns, and I think much better returns relative to the risk. And the dry power is really a view that we think they’re going to be more of those opportunities.”
Nota bene: “dry powder” refers to a fund’s cash-like holdings. At the end of 2022, Mr. Sherman’s RiverPark funds were 30% and 70% dry powder. In the context of this discussion, he seems to believe that a problem in the commercial real estate market is “going to rear its ugly head,” and that will create a new wave of investment opportunities for folks expert at distressed debt.
Q: Where do you get such great ideas?
A: I swiped one from a student in my Global Value Investing class at NYU. (Roughly.)
Q: Has the opportunity set changed since the beginning of 2023?
Mr. Sherman’s answer seems to come in two parts. First, we’re being really, really risk-conscious just now. “So, look, I think we focus on the business model, and the group tries to be disciplined in our credit work in all periods. Everybody, whether they want to admit it or not, occasionally gets out of their lane, including us. I think it’s disingenuous to say you never do. If it was true that everyone could stay in their lane, you wouldn’t have people that dieted, strayed, and then got heavy again. But the answer is we’ve been, for quite some time, focusing on staying at the highest level of the capital structure and the highest quality.”
Second, yes, leveraged loans look to offer some new and interesting possibilities. Mr. Sherman notes that leveraged loans are “being priced off a forward curve, and the forward curve was predicting rates to go down over time. And every day that rates stayed higher for longer, you made a higher return than the year yield was being projected on a forward curve … there has been a lot of technical pressure in the loan market for two reasons. One, a lot flowed into funds because people wanted to own a floating piece of paper as rates went up. And now, it’s flowing out because people are waiting for the pivot. But two, there’d been a lot of CLO issuance. A lot of that CLO issuance is in its harvest period now, meaning they can’t reinvest … we saw an opportunity based on that set. We see an opportunity today. Even if the Fed were to pivot, we think there’s a lot of opportunity there. Our funds and our strategies are at some of the highest levels of leverage loan ownership that it’s been for years because of those dynamics. You’re at a point now where leverage loans that are pari passu with the issuers’ bonds are trading at a significantly higher return than the bonds themselves with shorter duration.”
It appears that two elements common to a “strategic income” portfolio are presenting unusually attractive opportunities. High yield bonds are priced to outperform stocks for the next couple of years. The leveraged loan market is under pressure which allows investors to buy higher yields with shorter durations than companies can offer in their bonds. Finally, dislocations in the commercial real estate market might present serious opportunities in the months to come, justifying a high level of “dry powder” in an investor’s portfolio just now.