BDCs, AI Disruption, Iran Oil Shock: What Lies Beneath in Credit Markets

Anu Rajakumar: For credit investors, one of the more challenging backdrops is when things in markets and the economy look stable on the surface, but the underlying picture is getting more uneven. Until this week, that's a simplified version of what we've been seeing so far this year in credit markets, where company and sector-specific issues have been rising, while overall index credit spreads have been largely unchanged. That combination can be uncomfortable and trickier to navigate because it can mean risk is building without much additional compensation.

That was before new concerns over artificial intelligence disruption and military action in the Middle East added more layers of complexity to the macro outlook for credit investors. My name is Anu Rajakumar, and today I'm joined by Ashok Bhatia, chief investment officer and global head of fixed income at Neuberger. Today, we'll be discussing what lies beneath the surface in credit markets, AI, software concerns, BDCs, oil-driven inflation, and more, and what investors should be watching across fixed income as we look ahead. Ashok, welcome back to the show.

Ashok Bhatia: Hi, Anu. Great to be back with you. Thanks for having me.

Anu Rajakumar: Of course. Thank you. Ashok, let's start with the situation in Iran and the Middle East. Perhaps the biggest known unknown is what's going to happen to oil, but there's lots of things to think and potentially worry about. How do you think about this in your macro outlook at this point, and what are some of the potential implications for inflation as well as the Fed?

Ashok Bhatia: Sure. I think if I just take a quick step back, I think this year we've had three big sort of risk factors come to the forefront of the market. One has been AI disruption, and that sort of at least possibly near-term peaked when we saw the Citrini Research piece about a week ago. The second has been, as we'll talk about, some of the concerns about BDCs and liquidity and defaults on software companies. That's obviously linked to the first. Then the third now has been the attack on Iran.

I think the market saw the buildup that the US was doing in the region and certainly was assuming this was how things would play out. I think the bond markets and the equity markets have seen all three of these risk factors now put on the table and out in the open, and we're all talking about them. I think that's been the big change in the credit markets this year has been all three of these risks becoming very visible.

On your question about how this plays out for inflation and the Fed, I think two main points. One is everything suggests that a crude oil price spike is going to be a short-term shock to inflation. The second and more important point is that it is highly likely to be much more disruptive to growth. This is, I think, a pretty consistent track record macroeconomically as well as in the Fed research, which is this shock in crude prices will reduce real wages, it will reduce consumption, it will change consumption baskets, and even by the Fed's own work, it leads to an easing bias, not a hiking bias. Some of the reactions we've seen in the bond market that the Fed may need to hike, we think, are just sort of wrong.

Anu Rajakumar: Yes, sure. Great points. Even before the Iran attacks, the dynamic in credit markets was, maybe just capture it as calm surface, rising dispersion. I'm wondering if spreads are largely unchanged, why is it that risk has been rising in this environment?

Ashok Bhatia: If you take a step back again, credit spreads, as you noted, they're pretty much unchanged on the year. If you look at the index levels for investment-grade credit, they're maybe 10 wider. There is a lot of dispersion. I think the biggest area that we've seen the pressure has been the BDC market, business development corporation. Those spreads against a largely static credit index, they're about 50 to 80 basis points wider on the year.

I'd note that some of this pressure, it's become very visible, and we're all talking about it right now. It really started back last September with the Tricolor and First Brands defaults and issues. That's when we started to see this weakness in some of the softer, higher-risk sectors of the credit market really develop. I think this year has been more just about general recognition of these risks, discussion of the macroeconomic elements of these risks, but it remains very bifurcated. This is a market where some of those software companies and BDC debt under pressure, at the same time, we're seeing stability, tighter spreads in a lot of the big banks, and energy risks. A lot going on underneath the surface.

Anu Rajakumar: Maybe sticking with the BDC's theme, if you don't mind, just give a quick primer. What are the BDCs? Again, just digging in a little bit more, what does this year's spread move suggest on a greater scale?

Ashok Bhatia: The BDC market, the name of what it stands for is business development corporation. The rationale for them is Congress was like, "Look, there's a lot of small, mid-sized businesses that don't have the same access to capital that the biggest issuers have. Maybe these small, mid-sized issuers can go to a bank, but let's give them access to the public markets effectively." Business development corporations (BDCs), they'll own a range of debt instruments. They'll also then often put some leverage, so they'll borrow money so that they can buy more loans and own it and operate it so some of those investments can be sold, new investments bought, but think about it largely as a static type of investment.

Then if you're an investor into one of these BDCs, and there's private ones and then public ones, so ones that will trade on a secondary market where there's the daily moves. There's some that are private, and you don't have those same liquidity features. The real idea here is that these are intermediate-dated loans in the investment structure. Then there's often some liquidity provisions where investors, if you want your cash back, you could redeem, and maybe you can get 5% back a quarter.

What's happened is that if we look at this market, and it depends on the exact structure, but call it anywhere from 10% to 20% of the loans have been made to software companies. If you think about technology a little bit more broadly, higher numbers. With the advent of or with the introduction of AI, and we see this happening with what's happening with all of the software companies in the market, the bond market and the equity markets are saying, "Look, these BDCs, are these loans good? Are they going to be able to pay us back?"

What we've seen is that the BDCs, which you would think that they're inherently tied to and would trade at the book value or the value of the loans, they've started to trade at discounts. The message from the bond market and the equity market has been, "Look, not all of these are going to be money good. Maybe they'll have to get modified or some sort of structure like that." That has led to fears of either rising defaults, maturity extensions, haircuts, all those kinds of things.

We are seeing that, and that's why spreads have moved. To put this in context, this is not a 2008-style move. It's not a 2008-style event. I would characterize the pressure and the widening as significant. It suggests there is something brewing there, but it is not, I think, some of the extreme negative versions that we've all heard or read about.

Anu Rajakumar: Maybe just to follow up to that, do you find that the BDCs are a useful indicator of funding stress and liquidity? Whether yes or no, what other indicators are you looking at as we go through this year?

Ashok Bhatia: I do think there is certainly information value there. I think it is corroborated by a range of things we see in the public markets. Listeners will know that software companies, the multiples that software companies are getting for their earnings have come down maybe 10 multiple points. Why is that? There's concern that if you're a software company, your revenue stream may not be quite as recurring. Maybe the price increases you'll get aren't quite as strong. That's for some of the biggest, most powerful software companies.

If you then zoom into what is in a BDC, that is going to be a smaller software company. Maybe not as broad based of products. Maybe a single-use type of feature. Obviously, more fear of disruption there. There is definitely, I think, a very consistent message that the revenue stream coming from a range of the software companies, but then for us as bond investors, what does that mean for our capital structure?

Just very simplistically, if a company is going to have a lower equity multiple, certainly suggests that its steady state debt level should be lower, or it's going to have to pay a higher cost of capital. What the bond market is, I think, with a lot of the BDCs and things that we see in software debt that might be traded in the loan market, is really the market trying to find an equilibrium level for what a capital structure for a software company looks like two to three years from now. That is the big event that's happening, and we do think we are starting to find a little bit more stability in that near term.

Anu Rajakumar: Okay, great. Then just broadly, how are you thinking about quality and sector exposure at this time?

Ashok Bhatia: We have had our portfolios, and I think we spoke about last time. We entered this year with some of the most conservative defensive credit exposures that we've had. We've had it heavily concentrated in the financials, the biggest banks, the things that we've had. There's a lot of talk today about moats and what's the moat for your business. We've generally thought the best moat is a very high regulatory barrier, and that is the big banks by definition.

I would say we are starting to add some credit exposure in the last week across the range of our portfolios as we've seen some of these valuations change, and I think, importantly, these risks are now all out in the open. The fact we're having a podcast about BDCs today tells you that there's something that is getting better known. A lot of these risks, and we can argue about how the end game goes and how it all plays out at the end of the day, but I think you should conclude that there is a better pricing structure for the risks today than there was a couple of months ago.

Where we've actually found a little bit more interest is some in the emerging markets. Some of the things going on in the Middle East are creating some investment opportunities, we think, and even some of the technology names that have sold off this year on some of these themes. They're just a lot better priced from a bond perspective.

Anu Rajakumar: Sure. What about cash? How are you thinking about cash at this time?

Ashok Bhatia: Cash is still good, but the Fed is going to ease. Whatever you're getting on your cash today, we think that that is coming down. We’ll be paying a lot of attention to the jobs reports over the coming months, but our mantra for this year, and it's been the same, is the Fed's going to ease two times this year. Inflation is coming down. We remain very confident despite this movement in crude that we are still on a disinflation path for the US. The Fed will deliver two eases as inflation comes down.

There is the tail risk for more easing. There is more weakness in the labor market than I think people generally expect. If there is, say, three of these big risks are on the table now, a fourth risk is deterioration in the labor market. We do suspect as this year progresses, weakness in the labor market is going to become more visible, and also that's what can introduce even more Fed easing. Cash is fine, it's good, but recognize that rate that you're getting is probably going to move from 3.5% to 3% in pretty short order.

Anu Rajakumar: Yes, absolutely. That makes sense. Ashok, this is great. Thank you so much for jumping on to go through these important questions. Before you go, I do have one more for you, my-

Ashok Bhatia: A bonus question time.

Anu Rajakumar: -as you know, the bonus question. You know it. You're prepared. I love it. Ashok, I recognize you've navigated a number of market crises over your career. I am curious if there is one in particular that has really shaped how you think about risk more than some of the others.

Ashok Bhatia: I guess it's easy to say '08, but the one that actually, when you first ask, that comes more to mind is 2010, the European breakup crisis, where a couple of years after the financial crisis, the markets really priced for a reasonable probability that the EU was going to break apart and we were going to go back to single currencies. Those are harder. There are crises and problems that are financial market-driven. They're leverage, there's too much debt, there's revenue streams.

I would describe what's happening in the BDC market today, "private debt and AI." These are macroeconomic issues. There are ways to think about and model how they'll likely play out, and one can be wrong, but something like that European crisis is inherently political. It's really, do people want to stick together? You've got the financial analysis that would say, "Why would you ever consider this?" People do strange things. I do think, and I guess to tie in a little bit to what's going on in the Middle East, there's political realignment occurring, and that is harder to understand because it's not just the math and the spreadsheets. It's human nature and human psychology and human desires, and how that all plays out.

I took two lessons away from 2010, which is the tail risks on where those political crises can go are a little bit more extreme than maybe you think. I also, and hopefully this continues to play out, which is to be an optimist that at the end of the day, things tend to get a little bit better in life and the world, and that's a good backdrop to invest.

Anu Rajakumar: Awesome. Thank you very much for sharing those. We certainly want to be optimistic and hope for a swift return to a peaceful situation in the Middle East, particularly for our listeners who are based in those regions. I really appreciate you sharing those comments. To bring together some of the topics that we discussed today, Ashok mentioned key risk factors that you've been thinking about for some time, but AI disruption, BDCs and liquidity, the software defaults, the attack in Iran and how that affects markets, and then you added the fourth one as well, the deterioration in labor markets.

We spoke about some of the positioning you entered the year, cautious, defensive positions in credit. You talked about companies where there are moats, like the financials, the big banks. You also mentioned selectively adding to emerging markets, European credit, and just in general, starting to add to credit as valuations change as well. This was really great. Thank you so much for being on and sharing your thoughts, and look forward to speaking to you again soon.

Ashok Bhatia: Thanks, Anu. Talk to you soon.

Anu Rajakumar: Great. To our listeners, if you've enjoyed what you've heard here today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts, or you can visit our website at nb.com/disruptiveforces, where you can find previous episodes as well as more information about our firm and offerings.