By CHRISTOPHER A SHELDON Jan 29, 2021

There are some stories that have neither a beginning nor an end, but rather, a turning point in the narrative from which one can choose to look back or choose to look ahead. While we cannot say that the story of 2020 is completely over yet, the ink is now starting to dry on what is undoubtedly history’s newest defining chapter. As we look back on the year, it will forever be the time when a severe public health crisis evolved into global financial panic that definitively changed the course of our global macroeconomic environment as well as the behavior of our communities forever. With the start of the New Year, and the glimmer of brighter days ahead as the vaccine rollout begins, we acknowledge that there is still outsized hurt in heavily impacted sectors, small businesses and capital structures. We believe it is going to take more time for these impacted businesses and sectors to recover on many deeper levels, and many may need liquidity and look for new capital.

Like many epic tales, whether tragic or triumphant sometimes words alone are not enough to express the moment. That is why great soundtracks exist – to communicate the poignant points in a story. In 2020, the market composed a new score. Unknowingly at the time, it created new movements as events unfolded, to accompany its new rhythms, drops, tones and spikes. We believe the year cannot simply be summarized into one piece, but rather a collection of new melodic dynamics. This new symphony had the effects of a scattering burst of raw elements, in the form of historical Federal stimulus, record downgrades and issuance, Fallen Angels, and increased dispersion – ultimately creating a compilation of different market themes that we have discussed before, but have never manifested this way. This is what we have come to call Symphony No. 2020 – a market composition like no other before its time. As Leonard Bernstein once said, “music can name the unnameable and communicate the unknowable” which is exactly how we would distill the last four quarters.

Upon the spark of initial chaos in the first quarter, we shared our thoughts in V for Volatility that this was the time to start getting comfortable being uncomfortable. As we learned from our last go around in 2008, markets have a symbiotic way of navigating through crises, and it is important to focus only on what we can control – and that is what KKR Credit strived to do. We leaned into dislocation, we swam with and against the market currents, identified pockets of idiosyncratic dispersion, and we protected our downside. Through the quarters and progression of the year, we also started to see the composition of the market begin to evolve and change. Similar to the market, we also saw our own investment theses turnover as we quickly pivoted from one market pocket to another deploying, monetizing, and re-investing. This is particularly evident in our credit strategies where the turnover increased dramatically year over year. KKR's Credit platform remained nimble and innovative across capital structures, sectors and developing situations acknowledging that we were now in a new investing paradigm as we deployed capital across our credit strategies in the public markets. In the first quarter it is was almost unthinkable to imagine that the market would be able to generate the type of returns 2020 ended the year with: U.S. High Yield +6.17%1, U.S. Bank Loans +3.12%2, S&P 500 +16.26%3, and Dow Jones Industrial Average +7.25%.4 Ultimately, as we look back on the performance of corporate credit across the risk spectrum, we still believe many of the themes we have highlighted in the past are still at play. After all, the velocity of the 2020 drawdown and recovery is unparalleled in history. And as we have said in the past, as vicious as the market was on its way down, history has taught us that the snapbacks can be equally fast and furious.

THE MARKET'S CRESCENDO

From starting the year at almost record tight spreads – to widening out to distressed levels with high yield and leveraged loan spreads +1,000bps during the depths of the first quarter volatility, the credit markets ultimately ended a wild ride of a year on a strong note. As of 12/31/20, high yield spreads tightened back to 386bps5 and leveraged loans to 452bps.6 What felt like a 10 year market roller coaster resulted in high yield essentially returning its coupon +6.17% on a total return basis and almost unchanged on a price return basis -0.02%.7 Meanwhile, U.S. bank loans ended the year down on a price return basis -1.77%8 with CCCs presenting the greatest opportunity for convexity and showcased an exciting story for the fourth quarter returning +9.21%9 and +4.35%10 for the year on a total return basis, but still down -3.32%11 on a price return basis as of 12/31/20. The fourth quarter was an amalgamation of the market themes we have been discussing all year coming to an inflection point. The strong market momentum was further catalyzed by the announcement of the success of efficacy of multiple COVID-19 vaccines resulting in an even bigger appetite for risk assets. In the bank loan market, leveraged loans welcomed back a bustling new issue pipeline off of the vaccine optimism and continued pent up demand, rising 9%12 from third quarter levels and printing $80.513 billion in new issuance for the fourth quarter. The new issue volume in the loan market signified a strong surge in buyout and acquisition activity illustrating the private equity and the sponsor backed industry’s increased confidence in the market. On the other hand, corporate M&A activity remained subdued at $5.114 billion, which is the lowest level since the fourth quarter of 2012. However, we do expect the M&A market will be reinvigorated in 2021 in large part due to the pent-up demand in 2020 leading to the initiation of new product. The revival we saw in primary loan activity was supported by the gaining momentum in CLO vehicles after large repositioning in the first half of the year as well as CLO issuance offsetting outflows from retail loan funds.15 We anticipate an increase in the number of repricings in the first half of 2021 in the loan market and will be interested to see if the pipeline can keep up with the flows back into the asset class, which if it does, would mitigate the number of repricings.

As we highlighted in our third quarter note, The Odyssey, the net negative supply in the loan market coupled with growing CLO appetite for institutional bank loan paper extended the rally in the asset class and flexed pricing tighter into year end. As of December 31st, leveraged loans were bid $96.1916 representing a 164 basis point increase since November 9th. Additionally, with an increased number of dividend recapitalization deals, the market saw the number of B3/B- rated deals reach its highest level yet: 36%17 of total 2020 loan volume. As we have noted in the past, we believe the growing credit risk in the loan market is greater than that of a newly composed high yield market thanks in large part to the high volume of 2020 Fallen Angels, which we will discuss further. In total, institutional leveraged loan issuance ended the year at $287.818 billion, only down 7% from 2019 levels, solidifying the third consecutive year of lower market supply after peaking in 2017. The year also closed with floating rate assets looking a lot like fixed rate assets given all time low interest rates and LIBOR. We highlighted last quarter how LIBOR floors became an en vogue pricing staple this year with suppressed LIBOR levels: 60%19 of new loans in 2020 included a nonzero floor compared to 32%19 in 2019. We believe this trend is here to stay given the likelihood of potential future interest rate volatility as well as the LIBOR transition. In addition, while inflows to fixed rate products increased in 2020 so did outflows for floating rate products signaling to us that the investor profile of leveraged loans was migrating back towards more institutional hands. This trend is also significant as the loan market shrank for the first time in its history by $178.420 million while the high yield market grew by 18%.21 Although, the bank loan market only decreased ever so slightly and still stands at close to $1.2 trillion, this is the first time since 2011 the loan market has declined in size after averaging ~10.5%22 growth year over year for the last decade.

On the corporate bond side, the high yield market told a different story in 2020 largely in part to the Fed. We view the Fed as the market’s conductor of 2020 – whisking its baton through the darkest days of the first quarter’s allegro and then signaling through its Secondary Market Corporate Credit Facility (“SMCCF”) and Primary Market Corporate Credit Facility (“PMCCF”) that corporates would be dancing to a different tempo – presto. As a result, the high yield market transformed completely through the course of the year creating an even larger asymmetry between it and the investment grade market. As of 12/31/20, the SMCCF held ~$8.823 billion market value of exchange trade funds (“ETFs”) and $5.223 billion in individual corporate bonds.

In a letter to Treasury Secretary Mnuchin dated November 20th, 2020, Fed Chair Powell notes the success of the lending facilities and notes the 12/31/20 expiry date of the corporate credit facilities under the CARES Act, but does not detail how they plan to unwind the current positions. It will be important to watch out for further messaging on this given the Fed actually did not utilize the majority of its buying power in the Corporate Credit Facilities (“CCFs”), a combined size of $750 billion. We are hopeful the liquidation of these vehicles, if messaged appropriately, will not disrupt the market. However, given the power of the Fed’s voice in this market, we are weary of the moves a sheer announcement could provoke, similar to what we saw when the Fed announced it would step in on the darkest days in the first quarter. If anything, we would see it as a potential buying opportunity. Further to the Fed’s influence on the evolving composition in the corporate bond market, we had been carefully watching the growing share of BBBs in the investment grade market for some time. We noted in the fourth quarter of 2019 the technical tailwinds that could occur if a tidal wave of downgrades from investment grade to high yield, also known as Fallen Angels, could cause in the market. Fast forward to year end and we now see what a newly purified, higher quality, extended duration high yield market looks like: BBs comprising of +54% of the high yield market, of which 72% are trading above their call price, while CCCs account for a mere 13% as of 12/31/20.24

The high yield market also waltzed into year end with fervor – December saw $29.525 billion of primary issuance smashing another long standing record of $27.625 billion from December 2012. High yield set a record each quarter with issuance bringing 2020 total volume to $43526 billion, +60% increase from 2019. With the continued economic uncertainty and low borrowing costs, we would not be surprised if high yield continued to grind a bit tighter in the near term given cost incentives for borrowers and an accommodating Fed. We do worry about the rising duration and interest rate risk across the high yield universe as demonstrated with eight year maturity deals accounting for more than 50%27 of the primary supply in the second half of the year.

In addition, the strong market technical catalyzed by the Fed’s buyback program in the second quarter propelled corporate bonds to the tightest levels we have seen in years. As of 12/31/20, 62%28 of the high yield market yielded below 4% on a yield to worst (“YTW”) basis making high yield resemble what an investment grade bond looked like just two years ago.

Despite the tight levels in the high yield market and recent rally in leveraged loans we do not believe the continued hunt for income and yield will subside. As we think about our portfolio construction and asset allocation going into 2021, we remain constructive on high yield, but we currently view leveraged loans as more attractive than high yield on a relative value basis, subject to our credit selection and underwriting process. As such, we have increased our allocation to loans in our comingled strategies. We did this being mindful that this market symphony moves swiftly and can reverse course at any moment – so we remain opportunistic and laser focused on identifying accretive areas of value. In fact, the large technical tailwinds we have seen in the corporate credit market has been more impactful on a broad sector level vs. a sub-sector, intra-sector or issuer level. What does that mean? Essentially, with the changing composition of the high yield market due to its new Fallen Angels members and record issuance, and the loan market’s freeze earlier in the year, certain sectors have grown while others have shrunk. For example, in the high yield market, autos grew to account for 5.2%29 of the index, which is an increase of 3.34% year over year, in large part due to Ford Motor's large capital structure being downgraded from investment grade. With the growth of specific sectors as well as changing consumer and business trends, there were stronger rallies in specific areas of the market. In our eyes the real story will continue to lie beneath the surface on a credit by credit basis. Going forward, it will be very important to understand the credit fundamentals on the issuer level given the broad rally that has transpired on the surface. We are no longer in a market where one can rely on passive top level bets; we believe you have to look at the micro credit view based built upon credit selection given the bifurcation between storied names and perceived high quality credit.

Symphonies consist of multiple distinct sections called "movements" – and we believe we are now in a movement of dislocation amongst sub-sector dispersion. It is clear that there is real dispersion between the perceived high-quality names in the market and the credit vagabonds who tend drift about in No Man’s Land. Now, we know we have talked about this intersection before, and while it is not a new concept, the dispersion has become much more significant and the span of No Man’s Land zip code has widened. The pandemic has sped up many secular decliners and while the Fed’s stimulus may have extended the runway for a cycle, it has not eliminated the possibility of more stress to come. If anything, the Fed’s involvement has pushed the quality tighter as demonstrated by the majority of high yield trading now being inside of 4%. Absent the Fed’s CCFs, as well as quick liquidity injection upon future market dislocations, there will be cracks that will surface, and there will be issuers who will struggle to adjust their business models to accommodate the new way of life post pandemic. That said, we believe this presents a compelling market opportunity in 2021.

Leisure and transportation are stark examples of this growing trend: bank loans in leisure returned -2.63%30 while high yield leisure was +0.78%31 on a year to date basis. In a similar fashion, transportation in bank loans returned -2.02%32 while high yield transportation returned +4.79%33 year to date as of 12/31/20. We believe this is a poignant example of how the Fed’s stimulus, while very well intended and the reason why capital markets were able to function again, impacted the corporate bond market in a much greater way than the bank loan market. As we highlighted in our second quarter note, The Twilight Zone, the Fed solved a critical issue by opening up the capital markets spigot, but that only benefits issuers who can access the capital markets, not all issuers, especially the smaller ones which typically occupy the loan market. Could the dispersion between the bank loan market and the corporate bond market be the result of that big versus small dynamic? Further, the Fed support, or lack thereof, coupled with the number of defaults, downgrades, and Fallen Angels, has contributed to the growing sector composition changes and dispersion in high yield and leveraged loans.

Energy and telecoms alone accounted for 78%34 of defaults in 2020. In telecom alone, two issuers, Frontier and Intelsat accounted for 32%35 of total defaults, given their large capital structures, resulting in overall telecom exposure being reduced by -3.7%36 in the high yield index. Defaults and downgrades were really the two driving forces of change to the market composition this year. While the overall default rate started to decelerate in the third quarter, individual issuer defaults continue to rise standing at ~9.5%37 by December, a signal that the recovery is still far from over. On the other end of the spectrum, leisure’s exposure in high yield grew by 1.48%38 as a number of issuers tapped the capital markets to raise more debt and shore up liquidity to weather the storm of the pandemic. Notably, we saw the cruise lines Norwegian, Viking, Carnival, to name a few make a couple of trips to the debt capital markets as they extended their maturities and borrowed at attractive incentive levels to fortify their liquidity positions. All of this is to say – when we look at the credit markets today versus one year ago, there is a drastic difference in terms of its overall composition and in its constituents.

As the market continued to pivot quickly throughout the year, so did the opportunity sets. What may have been considered a top performer in 2019 could have turned over to be a bottom performer in 2020. That is why we strongly believe that being flexible and agile despite the tune of the market that day is a significant value add. In 2020, we realized the power of trigger and contingent capital available during a dislocation. Market drawdowns tend not to announce themselves before crashing the party. On March 23rd, the trough of the 2020 drawdown, over 80%39 of the market yielded greater than 7%, but that entry point was short lived. Many investors started to chase the market at this point trying to catch up – but they couldn’t. By the end of the second quarter, just three months later, only 27% of the market yielded greater than 7%. As of December 31st, only 16% of the market yielded greater than 7%.40

THE CHORUS

The fourth quarter’s appetite for risk carried on to the very last trading day of 2020. The quarter brought forward one of the strongest rallies we have seen in CCC rated leveraged loans and high yield, returning +9.21%41 and +12.19%42 respectively on a total return basis, outperforming both BB and B rated loans and bonds. The strong performance helped narrow the average bid gap between B and CCC to approximately 8.943 points, compared to a 10-15 point range in the preceding nine months of the year. While CCCs in high yield and leveraged loans ended the year positive on a total return basis at 2.86%44 and 4.35%45 respectively, they were still negative on a price return basis at -5.32%46 and -3.32%.47 You might be asking yourself now, why the dichotomy between total return and price return? The answer: not all CCCs and, more generally, credit, is created equally despite rating classifications. For example, we have discussed in prior quarterly notes the misgivings about judging a rating by its letter, and that it is incumbent upon investors to truly understand the credit fundamentals in order to make a determination. What we would like to emphasize through the lens of the risk on rally is – don’t be fooled by quarter over quarter moves as a rising tide often lifts all boats. There are many credits that were massively oversold in the first half of the year, some deservingly, others not so much.

Often the lack of liquidity exacerbates the actual move whether up or down. While the rally has been strong, there are many credits that still ended the year down on a total return basis across a myriad of industries. This is why we cannot emphasize enough the level of dispersion that now exists in the credit markets has truly upped the ante on credit selection. As long term credit investors, we always stick to our credit 101s and across the KKR Credit platform we wanted to ensure we stayed true to that principle despite various areas of the market appearing cheap this year. That discipline paid off as KKR’s credit strategies all outperformed their respective benchmarks in 2020.

Turning our attention to the year ahead, we believe there could already be a new technical forming in the loan market. As a result of the high volume of defensive downgrades we saw in the first and second quarter, which not only caused CLOs to temporarily freeze as they were approaching their weighted average rating factor (“WARF”) and over collateralization (“OC”) concentration limits backed up against a 7.5% CCC limit, but it also prevented CLOs from purchasing much of the investible loan universe for many months. Towards the end of the third quarter and into the fourth, we started to see other side of this CLO technical. Rating agencies began initiating upgrades from CCC back up to B3/B- status enabling CLOs to purchase a wider array of assets again. We think this could be a great opportunity to invest in senior secured paper with a pull to par opportunity. In fact, Moody’s updated its rating methodology in December, which would put 26%48 of loans up for upgrade consideration as well as 188 securities issued by 114 CLOs.

Overall, credit has held in strongly this year and we think the backdrop is even more interesting going into 2021. As seen most recently with the modest movements in rates and steeping of the curve, longer dated credit has held in well. As the market evolves, we are seeing credit become more equity correlated as opposed to rate correlated particularly as a result of the continued strong demand for income. Good yield hunting is not only still hunting in the public markets, it is exploring all markets, including private ones, to quench the unrelenting appetite for continue yield amidst a tightening credit backdrop.

A CLOSING SONATA

F. Scott Fitzgerald concluded The Great Gatsby with these powerful words: “so we beat on, boats against the current, borne back ceaselessly into the past”, communicating the novel’s significant theme of the past always being with you and the power of future endeavors. Similar to the year 2020, we will continue to remember the past year for many years to come and the new challenges that arose along with the rise of a global pandemic across humanity, the economy, and our markets. More importantly, at KKR, we will continue to beat on, with our boats against the current, ready for whatever is to come, and strive to deliver exceptional results for our investors, shareholders, and portfolio companies. As we begin to navigate the New Year, we recognize that there is still a great deal of uncertainty and no doubt will be more challenges ahead. We will be eyeing how the new stimulus gets spent as stimulus is not always a guarantee of automatic good results. In fact, it could create even more dispersion in the market depending on where it is deployed. We anticipate that the second and third derivative effects of shutting down the economy will begin to permeate to the surface resulting in many issuers who may be in need of new capital solutions, on both the public and private side.

With the continued pursuit for income and yield in a tightening corporate credit market, the onus, now more than ever, is on agile and creative active managers to continue to identify idiosyncratic investment opportunities across the debt and equity markets in a very fast moving market environment. The average high yield mutual fund gained +5% versus the index that returned +6.17% resulting in approximately 66%49 of mutual fund managers underperforming the market for 2020. As such, we believe the time to be invested in flexible pools of capital that can invest up and down the capital structure and lean into future market dislocations is now.

As a firm, KKR had an extraordinary year across all our core competencies including Private Equity, Real Estate, Infrastructure, and Credit. We challenged ourselves every day to be better as we worked remotely across the globe to continue to connect dots and find new creative ways to invest through the market disruption. We leaned into the market when others were fearful and sidelined. We cross-pollinated across our many strategies to tap into synergies, capture return, and contribute alpha through public market dislocation. And even now, we are seeing new opportunities arise across our platform providing us with more bespoke sourcing opportunities. In my sixteen years at the firm, I can say with great pride and certainty that KKR’s values and culture is what makes the firm a truly unique place and investing environment. I believe this is more evident today than ever given our global connectivity and ingenuity in investing for the long term future. We want to thank our investors for your trust throughout the 2020 year. We know it was a long hard one for all of your communities, and we feel fortunate to have such a deep partnership with you all across our platform. As always, we welcome your feedback on our letter and are grateful for the opportunity to discuss our market views with our readers. And with that, happy new year, and we beat on, boats against the current and face towards the sunshine.