Great Market Expectations

Originally published in serial form in 1860, and released as a book in 1861, Great Expectations by Charles Dickens remains today a brilliant and relevant depiction of the passage of time, growth, and the role that socio-economic dynamics plays in our pursuit of prosperity amidst the ultimate tempering of expectation.

As the protagonist Pip learns over the course of his journey, the intangible takeaways of life’s lessons learned often paid a greater dividend in his knowledge portfolio than the ephemeral triumphs. Ultimately, Pip’s journey portrays a struggle we all know too well: the eternal balancing act of managing a fleeting euphoric high and the gravitational pull back to earth. Dickens reminds us that we should “Take nothing on its looks; take everything on evidence.” As fundamental credit investors, we could not agree more with that sentiment, having watched as the markets closed out 2021 on a high, but then experienced a reality check when volatility made a comeback and spiked in January 2022.

There is no doubt that the past 24 months have been a memorable ride for the credit markets as demand for yield and income met record levels of issuance against a continuing conducive monetary policy backdrop. The market has continued to flourish off of the seeds sown by the Fed in March 2020, and as we have seen with the recent January volatility, we continue to be squarely operating in a Fed inspired market. The January volatility is also a prudent reminder that market expectations are not always what they seem and that as vicious as the volatility can be on the way down — the snap back can be equally, if not more, destabilizing given the speed at which the markets move. There have been many instances in history where expectations have diverged from reality, but in today’s market there is no longer the same amount of white space between chapters. Today’s market roars in a different tone, which underscores the value of having a robust bottom up credit investment process and seamless integration of flexible multi-strategy capabilities across the market and capital structures.

Key Themes

As one looks across the market landscape today, the differences between expectation and reality seem clear, we believe:

1. Incognito Investment Grade (“IG”); You Can’t Hide from Duration : IG experienced a rollercoaster year and a half as the Fed stepped in and corporates leaned into historically low borrowing costs to extend their liabilities. But what we have started to see is that IG is no longer “core” and while the asset class has been known to be stable and positive during good economic times, as of the end of January 2022, IG posted its second worst monthly total return since the end of the GFC, -3.13%, with yields re-approaching spring 2020 levels. High yield (“HY”) also experienced a robust run over the course of the market’s recovery. However, we would remind investors not to discount duration risk given the extended maturity profile HY inherited as a result of 2020’s “fallen angels” and new issuances.
2. Beware Judging a Credit by its CCC Cover : We have always believed one cannot fully judge a credit solely by its rating; it is also about relative value and the fundamentals. Both HY and leveraged loan CCC have outperformed their constituents in 2021 and continue to offer compelling risk reward profiles in a world of tight yields.
3. Duality in Credit : We have begun to see the decoupling of bonds and loans in the market. In January, leveraged loans posted the largest outperformance, 300bps, over high yield, the first time we have seen that occur since the U.S. downgrade in 2011.
4. Goodbye LIBOR, Hello SOFR : For over a decade, whispers of LIBOR’s demise was merely contemplated to be a rumor. The market faced a reality check in Q4 as the no new LIBOR clock officially started its count down to 12/31/21 cessation and the market began to navigate pricing risk in the Secured Overnight Financing Rate (“SOFR”).
5. Captain Capital Solutions : Despite an increasingly competitive backdrop, lenders remain open to a diverse array of financing solutions — small, medium, or large. With elevated levels of dry powder still on the sidelines, there has been a shift to offer more creative structures and a desire to differentiate product offerings with a wider range of solutions.
6. Creative Canvas Asia Credit : Given many domestic financing providers may be policy constrained, this less mature market has broad potential in need of creatively structured capital solutions. The supply/demand pendulum has drastically swung as a result of the pandemic and with the region being the largest contributor to global GDP, we believe the time to lean in is now.

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