Reuters / Mike Blake
- Josh Friedman, the co-chairman and co-chief investment officer at Canyon Partners - one of the world's largest and most successful credit hedge funds - spoke exclusively to Business Insider.
- He explained why his firm is shorting the commercial real estate market as a hedge against a broad economic slowdown.
- Visit Business Insider's homepage for more stories.
When cracks start to form in the market landscape, some investors panic. Others see the turmoil as an opportunity to make shrewd, opportunistic trades.
Josh Friedman, the co-chairman and co-chief investment officer at Canyon Partners - one of the world's largest and most successful credit hedge funds - fits firmly into the latter camp.
Over the course of his multi-decade career, Friedman has carved out a reputation as a prudent investor who sees opportunities in distressed areas many might be overlooking. A recipient of Institutional Investor's "Lifetime Achievement" award in 2014, he's a giant in the hedge fund industry.
Friedman's ability to spot opportunities - or potential pitfalls - was rarely more apparent than in the lead-up to the mortgage crisis that rocked markets in the mid-2000s.
Sensing something was amiss, he and his colleagues at Canyon started shorting mortgages in 2005. By 2007, it had morphed into a mega-profitable trade, according to an Institutional Investor profile from 2014.
While the firm wasn't ultimately insulated enough to fully withstand the 2008 credit meltdown - which resulted in its worst year on record - it roared back in 2009. Two of the firm's funds returned more than 54% on the year.
In the end, it could've been far worse. And the profits made shorting mortgages in the years leading up surely softened the overall blow.
Given Friedman's track record of immense success, any big market wager he makes should grab the attention of the investment community. He revealed one such trade back in March: a more than $1 billion short on commercial real estate. More specifically, he lodged bets against so-called CMBX indexes, which track mortgage-backed securities.
"We're short through the CMBX indices, in particular the most recent ones: 9, 10, and 11," Friedman told Business Insider in an exclusive interview. "Our view is that the credit standards have deteriorated in the underwriting on CMBX. If you look at those versus the earlier vintages, where those securities sit in the capital structure has been pressed down deeper."
He continued: "The underwriting for the individual mortgages is looser than it used to be. There's a higher percentage of interest-only loans, there are lower-quality borrowers in terms of their ability to hit income projections, and the performance has deteriorated."
But Friedman wants to be clear that this is not a directional bet. Canyon is shorting CMBX in order to secure some form of downside protection against a weakening economy. He said on Bloomberg Television in March that it performed well during market turbulence in December as stocks dove and credit spreads blew out.
"It's a hedge with some optionality," he told Business Insider. "It is something that trades extremely tight in today's market. It will definitely widen when the market widens for all other credit instruments, and it has the potential to widen quite disproportionately."
He continued: "We like this kind of hedge. It doesn't cost that much to carry it."
Friedman's caution as it pertains to the credit market is shared by many experts across Wall Street. And they're largely focused on the same portion of the bond spectrum as Canyon: BBB-, the lowest-rated tier of investment grade.
The BBB class now makes up roughly half of the investment-grade market, the biggest share in history. Their presence has doubled in size over the past 10 years.
Since that debt is already on the precipice of being labeled high-yield - or junk - it's especially vulnerable to any shift in market conditions that would make it more difficult to service debt. Whether that change is a simple slowdown or a full-blown recession, risks are mounting as the economic cycle pushes further into its later stages.
The fallout could be swift and punishing. Bonds clinging to their investment-grade status could see their ratings downgraded into junk territory. That, in turn, would make it harder for them to pay back their loans and could even lead to default. Once that happens, bankruptcy may not be too far off.
This is exactly the economic slowdown scenario Friedman is guarding against. And given his propensity for getting ahead of potentially damaging market events, chances are he'll emerge from the next blowup mostly unscathed - at least relative to his less prepared peers.