By CHRISTOPHER A SHELDON Nov 02, 2020
For centuries humanity has embarked on many different types of journeys. The concept of a journey can vary by perspective, but all journeys share one thing in common: they begin with the process of finding a path to move forward. We parted ways last quarter noting that we were “on the road again” – a journey that will inevitably be long and winding, but also embedded with opportunities along the way.
Although it may feel as though life has stagnated since the start of the global pandemic, we do continue to make strides forward. Healthcare professionals have become more knowledgeable on how to manage COVID-19 and the race for multiple vaccines pushes onward. Like all trying times in history, we continue to be faced with challenges everyday as the world finds its footing in the midst of a thick fog of continued uncertainty.
We view this road ahead as our Odyssey – a continued long journey through evolving unprecedented times. The waters ahead may sometimes be calm or volatile, but we will continue to row forward. Sometimes we will move with the current, but regardless always striving toward our destination and desired outcome.
As we look back on the third quarter, the market continued to inch upward and onward as the U.S. Federal Reserve's ("The Fed") historic intervention continued to seep through the market’s pipes and corporate issuance continued to surge: S&P 500 returning +8.93%, U.S. High Yield +4.71%, and U.S. Bank Loans +4.14% for the quarter respectively. In a stunning reversal, U.S. bank loans experienced a robust rally and were almost flat for the year as of September 30th at -0.66% and returned +24.29% since the March 23rd lows. U.S. high yield returned -0.30% year to date as of September 30th, bouncing +25.515% since the March 23rd trough.
The U.S. bank loan market fully emerged from its winter hibernation in the last six weeks of the quarter as the asset class outperformed high yield in the month of August and September. The market welcomed back CLO issuance as demand for AAAs increased and spreads tightened, creating more compelling CLO arbitrage than we have seen for the bulk of 2018-19. This was a nice positive tailwind for the bank loan community. Primary loan issuance rebounded and increasingly stabilized market conditions revitalized investor and borrower demand. However, there continues to be negative net supply in the loan market which means despite the recent resurgence in primary, there was still more appetite than the market was ready for in Q3. Leveraged loan volume rose to $73.8 billion up from its four-year low of $44.5 billion in Q2.
On the other side of the risk spectrum, high yield issuers placed $126 billion which is the second highest quarter on record; right behind the second quarter of 2020, which printed $140.5 billion. With funding rates still at record lows and the capital markets wide open for business, we continue to see borrowers transition from bridging their COVID-19 liquidity gaps to extending out their maturities at attractive costs.
As we highlighted last quarter in The Twilight Zone, the market now exists in a unique middle ground state, - a place we often refer to as No Man’s Land, where it delicately balances structural fragility while continuing to ooze price appreciation off of strong technical tailwinds. As global credit investors, we believe there are a number of factors that have persisted in the market contributing to the insatiable pursuit for yield, income, and corporate credit.
It is important not to discount the perception of the market’s strength or weakness: we have seen how the market can move like the wind, which is abundantly evident in today’s environment where the shift in headlines can drive the market up or down. We were reminded of this in September with the debate of additional stimulus and the Supreme Court confirmation hearings. However, in bouts of volatility throughout the year we continue to see that dealers remain flat, volume remains thin, and when forced selling occurs – dealers are often not stepping in. This trend is highly likely to continue into the fourth quarter and year end, regardless of volatility. Conversely, the opposite also holds true: when there have been big inflows, prices can gap upward quickly. It is all to say, – the market is still fragile and the ripples are still forming.
Overall, we believe there will be a sustained fundamental long-term technical demand for yield, and we continue to observe a growing bifurcation between perceived risk assets and non-risk assets. This bifurcation is creating mounting dispersion across sectors as well as on the security level. We have used the market’s rebound to reassess our portfolio construction and monetize specific trade themes in order to be in a position to be prudent with cash balances going into the fourth quarter. Across the KKR Credit platform we continue to take advantage of leaning into volatility and seeking out attractive idiosyncratic risk that the market may not fully understand. This market Odyssey continues to prove that the journey is not linear.
The ripple effects of The Fed's corporate credit facilities (“CCFs”) to support the flow of credit to large employers continues to permeate the market. The Fed announced on July 28th it would extend its lending facilities through December 31, 2020, (revised from the original September 30, 2020 expiration date), reiterating to the market that their commitment to keeping the flow of credit would not subside. Before the deadline was revised to year end, we were concerned there could be a potential knee jerk reaction to the sunset of the CCFs if the market felt that the deadline was too premature. The Fed beat us to that one, but they will eventually have to wean the market off of their backstop – that will never be an easy breakup. In a similar vein, we continue to be concerned with the longer term net effects of this stimulus on smaller issuers who cannot readily access capital markets, resulting in the growth of disparity between the haves and have nots in the market.
Without a doubt the Secondary Market Corporate Credit Facility (“SMCCF”) has played a pivotal role in the credit market’s performance to date and has driven high yield spreads tighter. We noted last quarter that the ETF market grew almost by 2x since the announcement of the CCFs – with the majority of growth coming prior to the program even beginning their purchases. As we look at the SMCCFs activity over the last quarter there have actually been no new ETF purchases since July 23rd. Similar to the sentiment we saw at the onset of the CCFs, the momentum in the high yield market carried on despite the Fed slowing its pace of ETF and corporate bond purchases by almost 64% quarter over quarter. As they say, a rising tide lifts all boats, and in this case, the Fed seems to be holding onto some extra punching power.
We also see that the Fed is sticking to its blueprint of buying large individual corporates and is not deviating away from an index sector construction whereby Consumer Cyclicals, Consumer Non-Cyclicals, and Utilities account for nearly half of the portfolio. As of September 30th, the three aforementioned sectors accounted for approximately 47% of the SMCCF Broad Market Index. If we peel back the onion a couple of industry classification layers further, it becomes evident that there is an asset allocation roadmap being applied to the Fed’s CCF schema. We believe that this fact pattern has contributed to the growing intra-sector and security level dispersion we saw brewing last quarter. Despite the strong rebound in the credit markets there are longer term implications to stimulus as well as growing idiosyncrasies that manifest asymmetrically across the risk spectrum. The CCFs have revitalized the credit markets with the inertia they provided for capital markets, but it will always be difficult to support the credit markets evenly across the spectrum of ratings, industries, and or pre-existing stresses on capital structures. As such, we believe there is a growing opportunity set for compelling relative value between asset classes, sectors, and intra-sector investments. This is going to last for a bit.
Although the breadth of global stimulus in response to the pandemic has been staggering, our house view is that there is likely more to come. As such, we will continue to watch closely how the Fed positions the CCFs going into the fourth quarter, fully realizing that they have yet to tap their full spend capacity. Ultimately, we do not foresee the Fed letting go of the steering wheel and will need to see how the fourth quarter unfolds to determine if they can truly unwind by the current year end facility maturity date.
TWISTS AND TURNS
Homer describes Odysseus as a man of “twists and turns” in his epic poem alluding to the common motif in Greek literature of disguise, or assuming alternate forms. We discussed last quarter the Fed’s outsized benefit to issuers that could readily access capital markets creating a big versus small dynamic, which as a result has set the loan market on a different journey than the high yield market. Loans are on a journey of twists and turns and have taken on many forms throughout the 2020 market evolution. Despite the rebound in leveraged loan primary for the third quarter, total issuance remains well below the norm due to a dreary M&A market. Year to date institutional volume of $204 billion is a five year low and total M&A volume is down 25% year over year. The bulk of volume we did experience in the third quarter was attributed to refinancings and dividend recapitalizations which hit $15.8 billion in the quarter - the most we have seen since the first quarter of 2017. The risk spectrum shifted late in the quarter as the loan market became more receptive to perceived riskier borrowers with Single B issuance doubling in the third quarter to $53.4 billion accounting for 72% of total issuance compared to 49% in the second quarter.
Bank loans turned ever so slightly positive +0.03% on a year to date basis on September 16th only to reverse course and give back approximately half of their gains to the late September bout of volatility. Overall, the third quarter was a strong resurgence for the asset class as we saw CLO creation pick up in both the U.S. and European markets as a result of significant tightening in CLO liabilities and AAA spreads. September had the largest volume of CLO issuance and deal count at $11.47 billion and 26, respectively. Despite the overall surplus in supply for bank loans in 2020, we saw a distinct reversal in the late third quarter creating a negative -$12.2 billion of net supply going into September in the loan market. With the CLO machine back on and stronger demand to deploy into CLO warehouses, there was a visible technical shift in the market. This shift represented a nice opportunity to lean in and add paper trading slightly below par to bank loan portfolios and also benefitted our multi strategy accounts by offering exposure to ~50% senior secured floating rate loans.
We believe this was a critical, although short, technical shift going into Q4 as CLO managers were eager to issue CLOs prior to the unknowns of the U.S. election. We believe the CLO machine will continue to churn, albeit at a slower pace should volatility arise going into year end, but do not believe the CLO market is at risk of freezing as we saw in the first quarter given the Fed’s anchor in the investment grade portion of the market. We continue to be constructive on CLO BBs and selective BBBs as we believe the sentiment is definitively more bearish than the corporate market and the investment grade (“IG”) portion of the stack is tracking IG corporates and thus - not going anywhere anytime soon.
Furthermore, over the next twelve months the CLO market is due to have ~$90 billion of deals come out of their reinvestment period, which will be a technical conducive to AAA tightening. The key takeaway here is that managers will likely be looking to reinvest those prepayment proceeds across the leveraged loan market.
With the Fed indicating that it will be keeping rates lower for longer and LIBOR at anemic lows since the March volatility, leveraged loan investors will have to think about how to maintain yield in their portfolios. We saw the painful reality of LIBORs plunge in late March amidst the spread of the global pandemic and market volatility. Leveraged loan and CLO investors had to rebalance their portfolios given the domino effect of a swath of loan downgrades which had severe implications to CLO concentration tests and resulted in forced selling driving loan prices lower.
A theme that emerged from the first quarter was the significance of a LIBOR floor. A floor is a provision in the credit agreement that establishes a minimum base floating rate to be paid by the borrower before the fixed spread. As LIBOR has retained its suppressed levels, floors have re-solidified their importance in providing certainty of cash flow for floating rate instruments. All of this comes at a perfect time as the publication of LIBOR will no longer be guaranteed beyond December 31, 2021.
Moreover, this is all to say, there is still a lot of healing going on in within the market and there are simultaneously many extraneous factors that continue to take form which investors should be mindful of as they head into the fourth quarter.
DECEPTION AND DISPERSION
The credit markets are intrinsically interconnected and as a result we are seeing the byproducts of differing effects of 2020’s exogenous events across asset classes. We discussed last quarter the encouraging signs of recovery in the high quality segment of the high yield market but that investors should not ignore the distressed tea leaves forming. The investment grade portion of the market has tightened by 64.1% and high yield by 50.2% since their respective peak wides. What this means is that, while the fixed grade portion of the market has experienced a robust snap back, there is still potential for additional yield.
As we look across the relative value spectrum, high yield CCCs were still at distressed spread (ie: greater than 1,000) levels at 1,152 and +752bps wider than BBs as of September 30th. Essentially, we believe there are two key themes unfolding: deeper bifurcation between the perceived high quality credits and lower quality paper vis-à-vis ratings; and a deeper level of dispersion as a result of capital being deployed in specific areas and sectors, as well as the second derivative of the economic impact due to COVID-19.
We worry about the growing price and gap risk at the higher quality end of the market in the event of volatility. Equity-linked products like Mutual Funds and Exchange Traded Funds have a disproportionate amount of higher rated names, and as we have seen in the past, the higher quality cohort is usually the first to sell off during volatility as investors typically seek the most liquid and highest dollar price in the midst of a sell off.
Further, the growing dispersion we have alluded to in the past is a byproduct of this bifurcation. As institutional and retail asset allocators shift their portfolios, there has been a migration intra-sector that reflects the macroeconomic effects of the pandemic. For example, within the high yield transportation sector, air transportation returned -29.38% for the quarter while trucking and delivery returned +5.58%. Both air transportation and trucking and delivery fall under the broader transportation classification but tell very different stories. Airlines continue to suffer a rout from the abrupt stop of global air travel while trucking and delivery have benefited from the nesting theme as a result of shelter in place, social distancing and work from home. Similar to most periods of volatility, there will be winners and losers and secular decliners and gainers. We have just mentioned a few and continue to believe there is more to come.
While blended top level sector performance may have seemed more muted this quarter with the high yield market returning an overall -0.30%, we see that dispersion is growing in troves beneath the surface. It is increasingly important to recognize the deception across the top level of the market. While we may sound like a broken record, investing for the longer term requires keen credit selection. What we have experienced this year is only the precipice of what potentially could come further down the road: increased defaults, consolidation of businesses, and a societal and macroeconomic shift that could take years to play out.
Prior to the onset of the economic shock of the pandemic, many businesses have already amassed growing debt levels. Eight months into the pandemic, many issuers have already accounted for the urgent liquidity bridge needed in order to extend their liquidity runway. Larger issuers have been able to tap the capital markets to raise incremental debt while smaller and medium sized businesses continue to struggle and tread water in survival mode.
Eleven issuers in the bank loan market defaulted on $10.6 billion of term loans in the third quarter, down from $23 billion in defaults across twenty seven issuers in the second quarter. The second quarter of 2020 was the highest quarterly volume since first quarter of 2009. The year-to-date default volume came in at $49.3 billion, a +254% increase compared to the same period in 2019.
The number of companies that have defaulted this year is on pace to be the highest since 2009. In March and April we saw a large volume of downgrades across bank loans and corporate bonds. On the corporate bond side this included an elevated quantum of fallen angels ie: issuers who were issued at investment grade ratings and subsequently downgraded to high yield as well as issuers who were in the eye of the COVID-19 storm, some of which experienced multiple sequential downgrades through the year.
We will continue to see the intersection of skewed security dispersion and future correlated defaults. The playing field is not equal on this front and we believe that smaller issuers who have not been able to take advantage of the Federal stimulus or have not been on the receiving end of the Fed’s CCFs program may lag behind in the economic recovery.
KKR Credit had a strong third quarter clawing back performance and outperforming in a number of our credit strategies against each respective benchmark. Our quarterly performance reflects choices we started to make in the darkest moments of the March volatility when we embraced dispersion instead of shying away from it. We leaned into dislocation and utilized our fundamental credit tool box to assess credits that we believed were overly punished, identified market themes and disparities as they were forming, and also moved with agility as the Fed stepped in recognizing nothing was impossible.
In the first and second quarter, we identified COVID-19 adjacent sectors and invested in simplicity – companies with fundamentally good businesses, resilient balance sheets, strong asset coverage, and or access to hard collateral. Our investment theses in a number of these credits played out across leisure, building materials, chemicals, and consumer goods. We also rotated our asset allocation to align with the low interest rates and the Fed’s pivot into corporate bonds, but maintained a healthy exposure to bank loans in multi-strategy portfolios which benefited from the ballast of CLO formation in September. Our CCC exposure demonstrated the resilience and power of individual credit underwriting during the March volatility. During the third quarter, our net allocation effect to CCC credits provided positive alpha across various strategies. On a yield basis, U.S. high yield CCCs are now a mere 10% away from their tights and up +7.68% for the quarter.
We also continue to constantly assess relative value across our credit platform. We are always on the hunt to identify relative value in existing positions and individual capital structures: we discerned where we could shorten our duration, pick up or maintain the constant yield and pay the same dollar price.
Ultimately, we continue to be prudent as we head into the last inning of a year that undoubtedly goes down in the history books as one full of extraordinarily unprecedented twists and turns.
As much as we would like a crystal ball at this point, we still haven’t managed to invent one and for that we sit in the same boat as the rest of the world – adapting with each day. There are many unknowns which we will get through together as we look towards closing out the year, including an election in the midst of a global pandemic that has caused global market fragility.
As the Fed continues to hover over the market with their excess capacity, we believe there will be more punch to come from them and that lends itself well to risk assets. However, we do believe there will be long-term implications to the Fed’s backstop and, as a result, a longer tail for these effects to surface. The tide is shifting and the growing number of issuers will present more opportunities to begin to weave complexity back into asset allocations vis-à-vis rescue financings and workouts.
We continue to see attractive opportunities in this market that span the credit realm. We believe there will be second and third derivative effects of the dislocation which may not be overly obvious today. We also believe investors should consider a multi-asset credit allocation that enables a curated portfolio of credit selection layered across a blend of credit products truly affording the opportunity to be agile and more flexible in future dislocations and take advantage of differing dispersion across the board. Overall, we view the current environment as an attractive one to translate thematic macro views into executable micro level investments across our various strategies.
As a firm, we continue to lean into dislocation and seek out compelling idiosyncratic opportunities across our core competencies in Private Equity, Real Estate, Infrastructure, and Credit. We have deployed in excess of $40 billion gross globally year to date and that is in large part due to KKR’s truly unique culture where everyone works together and is always eager to connect the dots. This is a special characteristic of the KKR platform and one of the most important assets we have as it enables us to tap into global connectivity across our many strategies and deliver fulsome capital solutions to our investors, shareholders and Portfolio Companies. We believe this is what continues to differentiate us from our peers.
We want to thank our investors for their continued partnership, dedication, and support during this time. As always, we welcome your feedback on our letter and are grateful for the opportunity to discuss these topics and the market with our readers.
We look forward to closing out the 2020 chapter with you together.
1 Bloomberg (dividends reinvested) as of 9/30/20
2 ICE BofAML as of 9/30/20
3 S&P US LSTA LLI as of 9/30/20
4 S&P LCD and KKR Credit Analysis as of 9/30/20
5 ICE BofAML and KKR Credit Analysis as of 9/30/20
6 S&P LCD and KKR Credit Analysis as of 9/30/20
7 S&P LCD and KKR Credit Analysis as of 9/30/20
8 KKR Credit Analysis, S&P LCD, ICE BofAML as of 9/30/20
9 KKR Credit Analysis, S&P LCD, ICE BofAML as of 9/30/20
10 KKR Credit Analysis and Federal Reserve Bank Board of Governors as of 10/8/20
11 KKR Credit Analysis and Federal Reserve Bank Board of Governors as of 10/8/20
12 KKR Credit Analysis and S&P LCD as of 9/30/20
13 KKR Credit Analysis and S&P LCD as of 9/30/20
14 KKR Credit Analysis, Bloomberg, and S&P LCD as of 9/30/20
15 KKR Credit Analysis, Bloomberg, and S&P LCD as of 9/30/20
16 S&P LCD and KKR Credit analysis as of 9/30/20
17 S&P LCD and KKR Credit analysis as of 9/30/20
18 S&P LCD and KKR Credit analysis as of 9/30/20
19 JPMorgan Research and KKR Credit Analysis as of 9/30/20
20 Intex and KKR Credit Analysis as of 9/30/20
21 ICE BofAML and KKR Credit Analysis as of 9/30/20
22 ICE BofAML and KKR Credit Analysis as of 9/30/20
23 ICE BofAML and KKR Credit Analysis as of 9/30/20
24 ICE BofAML and KKR Credit Analysis as of 9/30/20
25 ICE BofAML and KKR Credit Analysis as of 9/30/20
26 S&P LCD and KKR Credit Analysis as of 9/30/20
27 S&P LCD and KKR Credit Analysis as of 9/30/20
28 S&P LCD and KKR Credit Analysis as of 9/30/20
29 ICE BofAML and KKR Credit Analysis as of 9/30/20
30 ICE BofAML and KKR Credit Analysis as of 9/30/20
The views expressed in this material are the personal views of Christopher A. Sheldon and the Leveraged Credit Team of Kohlberg Kravis Roberts & Co. L.P. (together with its affiliates, "KKR") and do not necessarily reflect the views of KKR itself. The views expressed reflect the current views of Mr. Sheldon and the Leveraged Credit Team as of the date hereof and neither Mr. Sheldon and the Leveraged Credit Team nor KKR undertakes to advise you of any changes in the views expressed herein. In addition, the views expressed do not necessarily reflect the opinions of any investment professional at KKR, and may not be reflected in the strategies and products that KKR offers. KKR and its affiliates may have positions or engage in securities transactions that are not consistent with the information and views expressed in this material.
This material has been prepared solely for informational purposes. The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this material has been developed internally and/or obtained from sources believed to be reliable; however, neither KKR nor Mr. Sheldon and the Leveraged Credit Team guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision.
There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. This material 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.
The information in this material may contain projections or other forward‐looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this material, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. The indices do not include any expenses, fees or charges and are unmanaged and should not be considered investments.
The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely.
Participation of, and discussions with, KKR private markets personnel, KKR Capital Markets and KKR Capstone personnel, Senior Advisors, Industry Advisors and, if applicable, RPM and other Technical Consultants, in KKR Credit’s investment activities is subject to applicable law and inside information barrier policies and procedures, which can limit or restrict the involvement of, and discussions with, such personnel in certain circumstances and the ability of KKR Credit to leverage such integration with KKR.