Q: What are the macro risks that might cause volatility in the credit markets?
As part of a $330+ billion investment manager, we have access to a great amount of data and the investment professionals to interpret the signals and signs conveyed. While we will be unable to predict the exact cause of the next recession, we believe that we will be pre-preemptively positioned to mitigate its effects.
Of primary concern in my group is the amount of US non-financial sector corporate debt outstanding, which is currently at a record high at approximately 75% of GDP (SOURCE – Federal Reserve Bank of St. Louis). Record outstanding leverage was a characteristic of the last three recessions, 2008 – 2009, 2001 – 2002 and 1990 – 1991, with each of these recessions followed by significant system wide de-levering.
Additionally, we are concerned debt is being issued with diminishing quality of covenant protection for creditors. According to LCD S&P Global, since 2014, over 70% of leveraged loans issued have been covenant-lite. Furthermore, we have seen a deterioration in the quality of EBITDA, a fundamental financial performance metric, used for leverage measurement and covenant tests over this time period. This deterioration has largely been driven by issuers getting credit for in-process or identified EBITDA improvement initiatives whose benefits are yet to be realized.
When considering the potential for credit market volatility, my group looks at the percentage of the leveraged loan market and high yield bond market trading at distressed levels, generally demarcated by trading levels below 80% of par and 70% of par, respectively. These are bellwether indicators for us. As of September 2019, approximately 5% of both the leveraged loan and high yield markets were trading at distressed levels, these percentages having risen from recent lows earlier this year in May, a deterioration in market quality we are closely monitoring. (SOURCE – Bloomberg via JPM Morgan)
To abuse a cliché, the music is still playing in the credit markets, and everyone is dancing to this tune. However, we see a fundamental mismatch of facts along with largely sanguine credit markets for some time, and we believe it is time to increasingly weight portfolios towards a more defensive yet opportunistic makeup.
Q: What is the market in which you see opportunity?
We believe there is opportunity in the secondary market, taking advantage of short-term structural price dislocations in the market to purchase loans and bonds. Price dislocations are largely driven by the “sell first at all costs, ask questions later” mantra investors have largely adopted on any significant apparent or real changes in a company’s prospects.
Additionally, the diminished role that Wall Street brokers play as market intermediaries has challenged efficient price discovery of loans and bonds that are for sale, compounding the observed trend of sizeable, rapid drops in price levels. Illiquid, small high yield and loan issuances, less than $500 million and $200 million, respectively, where there is a relative dearth of investor interest in these issuances due to their size, and loans being sold by CLOs are most impacted by this price dislocation phenomenon. CLOs, structured levered vehicles that buy loans, buy approximately two-thirds of issued leveraged loans. CLOs are bound by strict portfolio construction rules and they tend to be indiscriminate sellers when their portfolios need rebalancing to stay in compliance.
Oftentimes, the collapse in trading levels, typically from frothy levels that reflected value we believe was not justified by fundamentals, overshoot to the downside. Opportunities to buy loans and bonds at levels indicating reasonable to sizeable discounts to their fundamental value may become particularly attractive and we are poised to capitalize on them.
We believe the good news is that we are fast approaching a time when an active manager may find mispriced opportunities.
Q: What do you need to take advantage of the downtown?
Access to locked-up capital provides a significant advantage for opportunistic credit investors. Hedge funds are the primary participants in the opportunistic credit investing arena, however their activities are constrained by being beholden to monthly reporting and the risk of redemptions. The redemption risk escalates into and during downturns, the very moment managers should be taking advantage of price dislocations. This limits managers’ willingness and ability to take advantage of under-valued investment opportunities. Locked-up capital removes this constraint, as quality assets can be held till the market recovers, with no risk of forced sales to meet redemption requests. Managers of funds with locked-up capital that charge fees only on capital that is called are better positioned to generate investor returns than those that charge fees on committed capital, as the investor is burdened with fees only when the manager is capitalizing on the opportunity set. Although the credit markets are poised for volatility, the timing is unclear.
Access to information flow from a trading perspective is instrumental to capitalizing on the opportunities provided during a downturn. An investment manager must have sufficient scale to be relevant to the Wall Street trading desks, to ensure they are offered the opportunities to buy attractively priced loans and bonds. This is particularly relevant for the smaller loans and bonds, where we expect to find the best opportunities, as these typically trade infrequently and in small size. The scale of the Neuberger Berman fixed income platform ensures we have the necessary relationships and critical coverage from the trading desks.1
Lastly, you need an information edge to maximize the return opportunity. In a world where comprehensiveness of disclosure to creditors by companies is decreasing, having increased access to Private Equity funds and the management teams of their portfolio companies, the primary issuers of the smaller loans and bonds we are targeting, is differentiating. As a loan or bond seasons in the market, the information and context obtained at the time of the new issue becomes stale, leaving potential investors with limited disclosure and access to the raw data—who, what, when, where of a loan or bond. The access we have to Private Equity funds and their portfolio companies across Neuberger Berman] is essential to ensure differentiating fundamental analysis, to facilitate proverbially picking up “the babies thrown out with the bath water” during the downturn.
We think the opportunity in this smaller secondary loan and bond universe is compelling, but timing is key. Investors need to do research on managers and their capabilities in anticipation of a change in macro environment.