By CHRIS SHELDON Jul 30, 2020
THE TWILIGHT ZONE
The first quarter of 2020 will go down in history as the highest velocity market drawdown investors have seen to date. It will also be remembered as the entry point of a devastating global pandemic that we continue to learn how to navigate. As we noted last quarter, as vicious as these drawdowns can be on the way down, history has taught us that the snapbacks can be equally fast and furious – and we would describe the second quarter to be following a swift snapback trajectory albeit not fully recovered.
As we published V for Volatility last quarter, we were reacting in real time to the events COVID-19 had catalyzed in the market. Our view in closing the first quarter was that it was a time to get comfortable being uncomfortable as we believed every investment would have a unique credit story going forward. Today though there remain many unknowns, we all have more insight on COVID-19 and we continue to believe there will be market uncertainty lurking close by with a second potential wave of infections, federal aid slowly rolling off, and liquidity runways shortening.
In the first quarter, we witnessed the immediate net effects of the pandemic on the economy, and now we are seeing the second and third derivative effects on companies as the economy learns how to recalibrate and adjust to a new era of everyday social distancing amidst the search for a vaccine. It is also important to remember that the economy and the market have moved asymmetrically – meaning, we are seeing a much more rapid market rebound with the S&P returning +20.54%, US bank loans +9.70% and US high yield +9.61% for the quarter, in large part thanks to the backstop provided by the Federal Reserve (“Fed”), versus an all-encompassing broad economic recovery. While we do believe there are a number of defensive and compelling ways to position a portfolio to take advantage of lingering dislocation and relative value opportunities, we would note that the coronavirus has greatly impacted consumer behaviors and has forced a shift in business models for many impacted sectors. As a result, it is incumbent upon investors to truly understand the health of the balance sheet, liquidity forecast, and potential revenue impacts.
In the second installment of our quarterly V for Volatility series we explore how the second quarter of 2020 has morphed into a bit of a market Twilight Zone as we have seen a tremendous rally across equity and credit instruments, while straddling a fragile market backdrop. Although investor sentiment has tempered, it continues to display a cautionary risk tolerance with mounting cash balances continuing to grow on the sidelines indicating to us that there continues to be a moderate reluctance to fully deploy into the market as uncertainty grows.
After all, we are still sitting at high yield spreads of mid 600bps, which a year ago most investors would have considered high and an indicator of heightened stress and volatility. From a spread perspective, the market still appears attractive but it is key to look under the hood with secular declining portions of the market pressuring spreads higher. Across the KKR platform, we continue to lean into opportunities of dislocation that position us to capitalize on simplicity, liquidity, and market leading businesses with strong fundamentals.
We navigated the Keynesian animal spirits together last quarter and we will now take another step beyond the surface together into new unchartered territory. In the words of Rod Serling,“[This] is the middle ground between light and shadow, between science and superstition, and it lies between the pit of one’s fears and the summit of their knowledge.” So, in the Twilight Zone, investors must remember that everything is relative and nothing is as it seems. While disconcerting, that is also where we believe the opportunity set lies.
THE SHADOW MAN
The old adage of “don’t fight the Fed” lives on. The Fed first announced it would step in to support the credit markets on March 23rd, which now appears to be the bottom of the COVID-19 induced market drawdown. The first term sheet for the Primary Market Corporate Credit Facility (“PMCCF”) and the Secondary Market Corporate Credit Facility (“SMCCF,” and together with the PMCCF, the “CCFs”) were released subsequently on April 9th. It is important to acknowledge the significant role the Fed has played in the credit markets recovery to date. Investors pulled $73.6bn from investment grade funds in the last two weeks of March and high yield saw $49bn of outflows for the month of March. The announcement of the CCFs injected risk appetite elixir back into the markets stabilizing credit markets on the pure notion that the Fed would be a buyer of eligible corporate debt and exchange traded funds (“ETF”) securities. As we learned from the Global Financial Crisis (“GFC”) – buy what the Fed is buying.
The Fed’s wizarding effect has trickled through the market ecosystem creating a powerful technical amongst credit assets while also inspiring new flows back into high grade and high yield products. Since the Fed announced it was going to provide liquidity to the credit markets on March 23rd, high yield is up +19.87% and investment grade +16.45%. As they say in the land of Oz, pay no attention to the man behind the curtain. The SMCCF began purchasing eligible ETFs on May 12th and eligible broad market index bonds on June 16th, however the majority of the outperformance in bonds occurred prior to the Fed’s first purchase on May 12th illustrating the emphatic headline power the communication of these programs have had on the market versus actual dollars spent. As of June 30th, the SMCCF has purchased $7.9bn of assets and the PMCCF had not commenced its purchases of primaries, only becoming operational at month end.
We know we can’t fight the Fed, so the guidance presumably becomes, follow the Fed. The strong technical created from the Fed’s backstop is real and has provided attractive momentum for fixed rated products relative to leveraged loans given the low rate environment. This is evident by looking at how much the ETF market has grown since the announcement of the CCFs: almost 2x.
Additionally, the Fed is now one of the largest holders of many household name ETFs: it has become the second largest holder of $54bn iShares iBoxx Investment Grade Corporate Bond ETF (LQD) with 16.8mm shares as of June 30th, which is the largest investment grade corporate ETF, demonstrating to the institutional and retail investor that there will be healthy tailwinds continuing to support the bond market. The Fed is also the second and fourth largest holder of the $29bn Vanguard Short-Term Corporate Bond ETF (VCSH) and the $36bn Vanguard Intermediate-Term Corporate Bond ETF (VCIT), respectively.
The Fed began purchasing individual corporate bonds in mid-June in addition to ETFs, and Chairman Jerome Powell noted that the central bank would reallocate purchases of ETFs toward debt securities going forward. On July 28th, The Fed announced it would be extending its lending facilities through year end, illustrating to us that the original 9/30 expiration date did not give the market enough time to digest the Fed potentially stepping away. The original third quarter sunset date could have triggered a new knee jerk reaction depending on how the Fed communicated the end of the program. Either way, given the Fed’s role in stabilizing the market we believe there is now a market floor that is above the March 23rd lows. A tremendous amount of capital has been raised during the dislocation that is focused on deploying into volatility. Not only do we think the Fed will not let the markets fail and that they are committed to success, but that there is also too much thirst for yield and credit roaming the sidelines and still not enough current supply.
Although the SMCCF has generated an alpha bounce in the corporate bond market, we would like to highlight that the Fed’s eligibility parameters may be contributing to the growing dispersion in the credit markets. Should the Fed begin to unwind its ETF and corporate bond program at the end of the third quarter as currently scheduled, investors should be prepared to see a bit of the technical tailwind in fixed rated assets subside, but it will not fully deteriorate given we are still in a low rate environment. Additionally, the federal stimulus has had outsized benefits on very large capital structures and we would caution that there could still be longer term effects for medium and small sized business that have yet to surface and should not be discounted with the recent rally. In the near term, the stimulus is lifting asset prices, but when we look at small and medium sized business across main street, where a large portion of jobs reside, we can see that the real economy is not on the same path as the market. The Fed solved a critical issue by opening up capital markets but that only benefits companies with access to capital markets, not everyone. As a result, we believe the Fed has potentially gone too far in one direction and has now indirectly perpetuated a growing bifurcation in the market: big versus small.
While we found it encouraging to see companies have access to capital during the volatility and throughout the second quarter, the issuers who benefitted the most were large companies, many of which were in the eye of the COVID storm, such as Boeing, tapping the market and raising more debt. The critical question is: how much more corporate debt can be raised in this market before we reach a precipice? Leverage is creeping up and we continue to increase risk in the system. As such, credit selection and asset allocation remain paramount across the credit spectrum and it is important to remain agile so a portfolio can pivot with the market.
In addition, the Fed has communicated that we will likely be in a low rate environment for the foreseeable future which prompted borrowers to utilize capital markets for debt issuance and refinancings, leading to a record shattering issuance boom of nearly $1.4 trillion across investment grade and high yield for the first half of 2020. As of June 30th, U.S. investment grade corporate issuance for the first half of 2020 was 99% higher at $1.27 trillion than the first half of 2019 and already exceeds the total for all of 2018 and 2019. The willingness to borrow has arrived and the issuance frenzy continues to drive pricing tighter as demand for yield continues to be ubiquitous with pensions, insurers, and income driven pools of capital striving to find their good yield hunting. With the PMCCF only becoming operational on June 29th – what happens when the biggest buyer of them all, the Fed, steps in? Or do they even need to now?
The surge of bond issuance has also prompted a reversal of a long standing market trend with approximately 50% of leveraged finance activity in bond only transactions versus 44% in first lien loan placements. Further, bond for loan takeout activity over the quarter spiked 80% from the first quarter to $26.7bn illuminating the heightened bond issuance. In June alone, proceeds from 25 out of 28 high yield tranches priced backed the repayment of pro rata facilities.
On the other hand, bank loans had a more muted quarter with the majority of issuance coming in June on the heels of the hopes of the economy reopening for a total of $44.4bn in issuance for the quarter – a four year low, but year over year only down 8% compared to 2019. CLO origination and leveraged buyouts (“LBO”) make up a large portion of the bank loan market’s primary demand and given the abrupt pause in the first quarter at the onset of the crisis, it is not a surprise to see the bank loan market lagging behind. It is hard to buy a company when you can’t visit in person. However, we did see a welcomed bid for loans in the second quarter and CLOs starting to sprint and print once again.
Even though overall issuance is lower, individual loan demand picked up as CLO portfolios repositioned their risk to cure their Weight Average Rating Factor (“WARF”) and Over Collateralization (“OC”) test concentrations after the wave of downgrades in the first quarter. We discussed in last quarter's V for Volatility the technical pressure that loans would face as a result of increased selling of CCC assets and have seen that although downgrades have slowed in the second quarter, the growth of CCCs has almost doubled to accommodate about ~10.7% of the bank loan market, which is approximately 5x the size it was during the GFC. This truly emphasizes the tremendous evolution of the bank loan market as it was not nearly as large and mature during the GFC. The portion of Single B- to CCC and below assets in the bank loan index has now reached 34% up from 25% at the start of the year.
This is what creates an interesting dynamic in the loan market as we know bank loan primaries are intrinsically tied to CLO origination and yet CLOs are inherently capped at owning no more than 7.5% CCCs in their portfolios. With CCCs now accounting for approximately 10.7% of the bank loan market, new warehouses and CLOs are entering the scene with a tailored back opportunity set, and yet bank loans were up +9.70% for the quarter. In this twilight zone reality, the appreciation of price in loans has actually benefitted issuance as CLO portfolios now appear less distressed. Managers have been able to offset losses with gains and/or buying new loan positions at a discount below par, and they are being mindful of leverage levels across the structure – often times de-risking deals and obtaining lower liability costs. We recognized the growing pressure on Single B/B- rated loans in the first quarter and leaned into the opportunity to identify credits swimming through the pandemic induced fog in COVID adjacent sectors such as transportation and leisure that we believed had sufficient asset coverage, liquidity, and were overly punished as a result of the CLO downgrade technical.
EYE OF THE BEHOLDER
They say beauty lies in the eye of the beholder, and time after time we have learned and seen that the market and the opportunities therein also lie in the eye of the beholder. There will always be multiple perspectives on what we find attractive and we may not always conform to others. We believe this is also true for the credit markets and how investors should navigate perceived risk going forward. While the market has certainly experienced a robust snapback, as of June 30th, high yield spreads were at 644 peaking at 1087 on an 18 month lookback and the median spread sitting at 409. On one hand, it appears you have ~235bps of room to run, but on the other, with interest rates staying lower for longer and growing defaults looming, investors really need to understand the risk they are buying and not gravitate to what seems cheap. We believe high yield still appears cheap and attractive on a spread and relative value basis; however, when looking at on an absolute yield basis with high yield at 6.85% as of June 30th and a 2019 median of 6.23%, now there is only ~62bps of runway. With rates lower for longer, the US 10 Year Treasury hovering around 60bps, and 3 Month LIBOR at 30bps, the compression event may have shorter runway as you become capped much sooner. When looking from that vantage point it is clear the market has moved away from the cheap trade to more of the idiosyncratic trade. Everything is not what it seems. All aboard the idiosyncratic train.
During the quarter, we took advantage of the Fed technical by rotating our asset allocation to be more heavily weighted in bonds for our opportunistic and multi strategy accounts. We invested in credits where we saw additional runway for attractive risk adjusted returns by capitalizing on the spread compression event building in the fixed rate portion of the market. Across the spread compression theme, we leaned into credits ranging from investment grade/BBB rated to Single B rated in non-COVID impacted sectors providing a defensive layer to our portfolios. With low rates and the over exuberance in issuance in high grade corporate debt we saw companies taking advantage of borrowing costs; however, there continues to be downgrade movement within the investment grade arena: Disney, AbbVie, Marriott, and Hyatt are all large structures that were downgraded in the second quarter but still maintain IG ratings. As we discussed last quarter, the growth of the BBB market has almost tripled in the last ten years creating a very large and thick looming murkiness of corporate debt ready to flow right into the high yield index. While the credit quality of the high yield index may have seen improvement over the years, we are growing warier of the ability for corporate borrowers to continue to issue debt at these tight levels while EBITDA continues to decline. We have also seen new fallen angels notably Carnival Corporation, Macy’s, Occidental Petroleum, and Royal Caribbean Cruises – all of which tapped the hot issuance market this quarter.
As investment grade issuers become fallen angels, market duration is extended given investment grade issuers are seen to be more credit worthy and as a result have the ability to issue longer dated paper. What has transpired in the fixed rate market with the Fed intervention has been a favorable asset allocation preference towards bonds, paired with low rates, and longer maturity given the new members of the fallen angel community, as well as new issuances, have resulted in extended fallen angel duration. Longer duration in a low rate environment should outperform shorter duration paper. That is why investors should not underestimate the power of call protection especially with tightening spreads. While being longer dated has paid off in the current market environment, we would remind investors that the longer extension also creates the potential for elevated gap risk. Despite high yield being attractive in the near term, we believe this road will become much more treacherous down the line with gap risk concealed as the hidden snake in the grass. This market will continue to test investors stamina through portfolio construction and security selection given the constantly evolving macroeconomic backdrop and we continue to believe investing in simplicity i.e.: credits with strong fundamentals and healthy balance sheets continue to provide attractive tailwinds to the portfolio.
While there are some encouraging signs of recovery in the high quality segments of the high yield market, there is a growing trail of CCC tea leaves forming that should not be ignored. High yield CCCs are underperforming BBs by 8.60% and ~14% of the high yield index is trading at distressed levels (spreads of +1,000) contributing to rising dispersion in the market. The increased amount of CCCs present a growing barrier to the credit markets attempt to avoid a high-default wave in the future but a lot of the CCC concentration lives within the Energy sector which skews the overall picture. The real story behind the tea leaves is that elevated levels of dispersion do exist within each sector and the disparity is not always obvious to the naked eye. We looked at the standard deviation of daily volatility between every name in the high yield index over the last two years to discern where the dispersion was brewing.
One would expect the daily volatility to be somewhat muted on the security level, but what we found was that the growing dispersion actually started to spike pre-COVID in the third quarter of 2019 and then tapered off ever so slightly until the start of the pandemic. Today, levels remain high and we believe that there will continue to be elevated levels of dispersion going forward, reinforcing our view that security selection and a bottom up analysis remains paramount to identifying strong assets even if they reside in challenged sectors.
ON THE ROAD AGAIN
Despite the growing uncertainty that exists all around us in the new COVID world, we have found inspiration in turning back to our roots: investing in strong fundamentals and identifying value. The market has run up quite a bit and we believe it is important to position your portfolio to protect for future downside risk going forward. Although we did experience the economy attempting to reopen in the second quarter, it is going to take more time to fully understand the full scope of the new day-to-day risks for society as well as business operations.
Given the Fed’s intervention and no end in sight for low rates, we expect the market to continue to follow the Fed’s path and believe corporate bonds and high yield offer attractive risk adjusted returns. As such, we will continue to pursue investing in simplicity over complexity and be on the lookout for compelling idiosyncratic opportunities in bank loans, bonds, and structured products. The public markets have diverted activity away from private capital solutions in the past quarter and we have seen rescue financings being executed at much tighter levels. However, we do think that the shift back into leaning into complex capital solution transactions will be knocking at the door before we know it.
As a firm, we actively leaned into the dislocation across a myriad of strategies, geographies and products and deployed approximately $18 billion gross from the onset of the February volatility. We will continue to seek opportunities where we can connect the KKR core competencies across Private Equity, Credit, Real Estate and Infrastructure to identify value accretive transactions across durable capital structures globally.
We want to thank our investors for their continued partnership, resilience, 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 investing in this new paradigm together.
Christopher A. Sheldon
1 Bloomberg (dividends reinvested) as of 6/30/20
2 S&P US LSTA LLI as of 6/30/20
3 ICE BofAML as of 6/30/20
4 KKR Credit Analysis, JPMorgan Research, Bloomberg as of 6/30/20
5 KKR Credit Analysis, JPMorgan Research, Refinitiv Lipper, as of 6/30/20
6 ICE BofAML as of 6/30/20
7 ICE BofAML as of 6/30/20
8 Federal Reserve Bank Board of Governors as of 6/30/20
9 Bloomberg and Federal Reserve Bank Board of Governors as of 6/30/20
10 Bloomberg and Federal Reserve Bank Board of Governors as of 6/30/20
11 S&P LCD, Bloomberg and KKR Credit Analysis as of 6/30/20
12 S&P LCD, Bloomberg and KKR Credit Analysis as of 6/30/20
13 S&P LCD as of 6/30/20
14 S&P LCD and KKR Credit Analysis as of 6/30/20
15 S&P LCD and KKR Credit Analysis as of 6/30/20
16 S&P LCD and KKR Credit Analysis as of 6/30/20
17 S&P LCD and KKR Credit Analysis as of 6/30/20
18 S&P LCD, S&P LSTA LLI and KKR Credit Analysis as of 6/30/20
19 S&P LCD and KKR Credit Analysis as of 6/30/20/p>
20 S&P LCD and KKR Credit Analysis as of 6/30/20
21 ICE BofAML and KKR Credit Analysis as of 6/30/20
22 Bloomberg as of 6/30/20
23 Bloomberg as of 6/30/20
24 ICE BofAML and KKR Credit Analysis as of 6/30/20
25 ICE BofAML and KKR Credit Analysis as of 6/30/20
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 Teams 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.