By Chris Sheldon Jan 10, 2019
Yesterday, we released our Global Macro Annual Outlook for 2019. Authored by the CIO of KKR’s Balance Sheet and Head of Global Macro & Asset Allocation Henry McVey, the annual outlook, widely read by institutional investors around the world, reflects Mr. McVey’s view on how asset allocators should be thinking about their portfolios. The title of the piece describes the overarching view quite simply: The Game Has Changed.
Some headlines implied that KKR was making a negative call on investing in Leveraged Loans because after being overweight on Leveraged Loans for the past two years, the team shifted its asset allocation model from overweight to neutral for Leveraged Loans. Moving an asset class from overweight to the benchmark is hardly a cautionary view and KKR is not “sounding an alarm” on Leveraged Loans. Given that the team shifted equities up as part of the new outlook, it’s clear that we aren’t exactly bearish on Leveraged Loans since they are senior in the capital structure to equities.
While it is true we have favored the 'pure play' loan asset class in the past, the call we are actually making related to corporate credit is how to get exposure to it. Instead of a pure play, we are moving to consolidate our liquid credit positions into an opportunistic credit strategy that allows portfolio managers to respond to the current market dynamics. That’s why the same asset allocation model tilts to a greater overweight in Opportunistic Credit at 7%. This shift, up from 6% last year, reflects our belief that, in dislocations and increased volatile markets, having a more flexible and opportunistic approach to below investment grade credit (Leveraged Loans, High Yield bonds, and Structured Products) is the better way to generate outsized returns in the asset class.
The technical picture in the loan market has changed. Today there is lower overall liquidity than historical levels (as there has been a 75% decline in broker-dealer inventories since 2008). In addition, a higher proportion of market participants comprise ETFs and index-tracking mutual funds that may have to buy and sell based on sentiment-driven inflows or outflows. This combination of factors makes higher market volatility inevitable.
And, to put an even finer point on it, we have and will continue to invest in Leveraged Loans. In fact, today, approximately 50% of KKR’s Opportunistic Credit strategy is exposed to Leveraged Loans and CLO liabilities (structured products collateralized by loans).
Looking ahead in 2019, expecting continuing volatility, we believe allocators should look for managers who have the capabilities and track record to be nimble and flexible across all of the below investment grade asset classes given the current market dynamics. Since credit selection will be even more crucial in this part of the cycle and we continue to see value in parts of both bond and loan markets, manager selection will be an important factor to consider.
This view is consistent with what we expressed to fund investors at our annual meeting last fall. Specifically, we noted:
- Volatility in the credit markets should be the new norm
- There has been a growing asset and liability mismatch in the credit markets given the growth of daily liquidity credit vehicles, particularly the 'equity-linked' vehicles like ETFs and listed mutual funds
- Today there is higher correlation of index performance to retail fund flows and equity volatility
- The growth in passive funds (ETFs and index funds) has resulted in a significant 'flight to quality' and many individual credits are either 'priced to perfection' or 'over-sold' when they are perceived as too risky
- Credit dispersion and manager dispersion have and will continue to widen
Given the above market dynamics, we think active portfolio management and being able to understand broader relative value and risk reward, coupled with a hefty bottoms up credit selection is the way to win and generate good returns in credit in today’s volatile market.
The views expressed in this blog reflect personal views of the writer and do not necessarily reflect the views of KKR or the strategies and products that KKR offers or invests. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. This blog is prepared solely for information purposes and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. This blog contains projections or other forward-looking statements, which are based on beliefs, assumptions and expectations that may change as a result of many possible events or factors. If a change occurs, actual results may vary materially from those expressed in the forward-looking statements. All forward-looking statements speak only as of the date such statements are made, and neither KKR nor the writer assumes any duty to update such statements except as required by law.