By CHRISTOPHER A SHELDON May 14, 2021
Considered one of the most complex and historically significant films of our time, Alfred Hitchcock’s Vertigo portrays the story of the delicate and often blurred balance between deception versus reality. In the film, Hitchcock follows the journey of John “Scottie” Ferguson as he tries to combat his acrophobia while straddling the world of illusion and fantasy. We can draw many parallels to Hitchcock’s realm of distortion to the market and its evolution through the COVID-induced drawdown of 2020. We feel as though we are swimming though a blurred market reality today. While it may seem as though the first quarter of 2021 was mildly uneventful, the last twelve months have dramatically shifted the foundation of the market, and investors will need to dig beyond the surface to understand this new landscape. As we discussed in our Q4 2020 letter, Symphony No. 2020, the market’s composition has definitively changed, and investors are now re-entering an even more complex paradigm. Looking back on the market one year ago: high yield spreads spiked to +1,000bps amidst a global shut down as the world succumbed to a new unknown virus and investors flocked to the exits in pursuit of instant liquidity, while the world tried to grapple with the day-to-day news developments of COVID-19. In contrast to where we stand today: high yield spreads are near their historical tights at 336bps1 as of March 31, 2021, the vaccine roll out in the U.S. has been robust, and the re-opening rally has shown no signs of slowing down. It is remarkable to see the powers of fiscal and monetary policy at work, and the vigor and speed in which a market can snap back. As we have noted before, as vicious as the market is on its way down, history continues to remind us that the snapback can be equally fast and furious.
We now stand in a market where spreads have not only reverted back to pre-COVID tights but they are also approaching pre Global Financial Crisis “GFC” tights. High yield has in essence become low yield, and the sea of great dispersion we saw on a sector and sub sector level has become muted. That begs the question: what does this market consider good yield? As we have referenced before, the yearn for "good yield hunting" has only grown stronger, valuations are richer, and liquidity runways have been extended as a result of the historic Federal stimulus in 2020. As we look across our platform at KKR Credit, it has become clear to us that we are in a market that is ripe for re-imagination and primed for active management. We believe there is a compelling story building in the private capital solutions space, complex idiosyncratic secondary opportunities, relative value inter-capital structure plays, and agile pools of capital that have the ability to invest across multi-asset credit products, but also possess the qualities to be nimble and flexible in their portfolio construction.
THE BALANCING ACT
Early on in Vertigo, we learn that Scottie has a theory that may help him combat his fear of heights – if he can get used to climbing up a stepladder just a little bit at a time, step by step, he can get comfortable with being up at elevated heights. However, he does not get very far, and as far as metaphors go, it reminds us to take the market’s exuberance with a grain of salt. Acknowledging the record amounts of dry powder, fiscal stimulus, historically low borrowing costs, and insatiable thirst for yield it is not surprising that both leveraged loans and high yield issuance and performance to date continue to be strong.
We saw a flurry of activity back into floating rate assets on the heels of rising Treasury rates in the first quarter in both the retail and institutional channels. Global leveraged loan new issue volume reached a record total of $263.92 billion between institutional new issuance and pro-rata activity as of March 31, 2021. The U.S. loan market experienced more than 2x the volume it saw in Q4 2020. The movement in rates coupled with the growing optimism around vaccine roll-out spurred strong technical tailwinds setting U.S. leveraged loans up for a record quarter of issuance at $180.83 billion, which exceeded the prior record of $171.44 billion back in Q1 of 2017.
We also continued to see strong momentum in the CLO market, which saw its highest quarterly issuance in the CLO 2.0 era with a net $39.25 billion (excluding refinancings and resets). The CLO machine has been fueled not only by an abundance of assets in the system but even more so by the sinking liability costs, with the tightest triple-A print at 98bps6 versus 120bps7 in Q4 2020.
Despite the high volume of activity, we do not believe that liquidity across the market has been uniform and as robust as it may seem. Long duration paper trading inside or at 4% is not attracting the deepest bid, and while there continues to be infinite demand for good yield, we have witnessed a number of fairly valued tranches of debt struggle to obtain consistent liquidity across the market. We believe this is a poignant indicator that while the market appears to be “la vie en rose” there is a bit of fragility lurking underneath the surface.
For most of 2020, leveraged loans trailed high yield in the snap back. We started to see a slight shift in sentiment in the fourth quarter of 2020 with further spread compression in corporate bonds and as the relative value spectrum began to lean towards leveraged loans as a result of the dispersion created by fiscal stimulus between the two markets.
Closing out the year we believed we would start 2021 with an eerily similar feeling to how 2020 started: increased repricings and a supply-demand imbalance across CLO creation ensuing. In line with our expectations, the loan market experienced an influx in repricings in the first quarter with $148.58 billion of institutional loans repriced, which is the most we have seen in four years, further accelerating a strong rally in the secondary market and muting the tone on new issuance overall. In total, there were 1299 repricings during the first quarter, 33%10 of which were deals papered during the pandemic, and deals where the soft call protection rolled off. The repricing trend was heavily concentrated in issuers with a single B credit rating, accounting for 77%11 of the quarter’s repricing activity. Another notable trend is the delicate supply-demand imbalance in the loan market with investors getting more comfortable with riskier Single B- borrowers supporting the issuance of a record $67.612 billion, representing 37% of total issuance during the quarter.13 As borrowing costs remain suppressed falling to their lowest levels since the GFC, new issue yields on single B- term loans compressed to 4.81%14 in January and February which is the first time they have dipped below 5% in over ten years before ultimately rising back to 5.34%15 in March. All of this is to say – loans had a strong quarter returning +1.8%16 outperforming high yield, which returned +0.9%17 as of March 31, 2021.
RATES AND RIPPLES
The high yield market also showed no signs of slowing down printing $149.118 billion in issuance in the U.S. market and a total combined volume of $198.419 billion globally for the first quarter of 2021. This is the fourth consecutive quarter with more than 20020 bonds issued and a smashing $136.221 billion issued to refinance debt. With this level of activity, it is no wonder the high yield market has grown in size by +21.3%22 since January 2020 and is now sitting at $1.4723 trillion. As we discussed last quarter, the market’s composition has evolved as a result of a number of record fallen angels, ripple effects from the global pandemic, and the Fed’s historic backstop in the credit markets. What we know now for certain is that the market paradigm has truly shifted.
As borrowing costs remain suppressed and liquidity runways now extended, even rising Treasury rates could not completely deter the high yield market from pressing onward and upward. Daily liquidity vehicle ownership in the high yield market is now approaching ~50%24 of the market and with the ten largest core bond mutual funds making up approximately ~1.5%-2%25 of the market, that could make for a bumpy ride when the Fed begins to taper, which they have indicated could be in the fourth quarter of 2021. We have previously noted the growing share of daily liquidity vehicles in the market, which are susceptible to equity volatility and potentially rate volatility, ultimately causing gap risk across the market in security pricing as investors typically, flock to sell the highest bid and most liquid security in times of stress. We also believe that the structure of the high yield market is poised for volatility given the equity linked concentration, the growing retail holder base, and simply due to dealers being conscientious of balance sheet risk taking post GFC. As a result, having a nimble active manager who can pivot with the market to help absorb any potential shock in real time will be integral to future dislocations.
Moreover, we believe the driver in the move up in rates is more significant than the rate backup itself. Overall, credit held up during the slight rate volatility during the first quarter of 2021, and we believe the market was anticipating this movement and thus had already started to price it in. With strong growth expectations ahead and stable corporate earnings, we believe future upside in high yield will be mostly predicated in credit selection given the high beta to the upcoming reopening “boom”. We are also mindful of what an inflationary economic backdrop may look like with increasing costs, wages, and potential margin compression for corporations. There will likely be an uneven recovery in COVID-impacted sectors as time goes on and the public slowly reverts back to life post lockdown. We believe the backdrop will remain active with strategic M&A as companies look to achieve their growth objectives and diversification over the next several quarters. The first quarter already brought forth the highest M&A levels the market has seen since 2007, and there is still a tremendous amount of dry powder on the sidelines indicating to us that the landscape will be active but it will shift back into investing in complexity over simplicity as we saw in the last twelve months.
From a fund flows perspective, U.S. high yield net fund outflows exceeded more than ~$11.826 billion through March 24, 2021 which is a stark reversal from the 2020 trend where high yield fund flows totaled $3827 billion for the year. Many issuers were spooked by the prospect of a rising interest rate environment and "rang the bell" to term out maturity profiles at low costs. As such, 2021 refinancing activity is higher than total high yield issuance volume for any pre March 2020 quarter at a staggering 79%28 of total volume this year – another record.
With the market grinding tighter and yields further compressing, investors have been pushed to take longer-dated bonds to take advantage of the macroeconomic background with 60%29 of the number of deals done carrying maturities of eight years or longer. We believe it is important for investors to understand that we may be in a world where high yield sub 4% is the new normal and may continue to grind tighter. With the economy positioned for growth, we will see the rate story continue to take center stage. If we look at high yield CCCs specifically, the group returned +5.2%30 and 59%31 are trading to call as of March 31, 2021.
This dovetails into the lack of visible distress in the high yield market now hovering at ~2.1%32 vs 22%33 in March 2020, but we believe that the liquidity runways borne from the Fed’s intervention have possibly obfuscated many issuer’s reality, but not eliminate stress completely from the future.
VERSIONS OF REALITY
The first quarter continued to display many of the themes we have previously discussed in the credit markets: risk on rally with record amounts of debt issuance, unrelenting yearn for yield, an anticipated movement in rates, and spreads continuing to inch tighter. However, we do not mistake this market backdrop as a sign that there no longer is an attractive opportunity set. In fact, our thesis is quite the opposite: the lack of obvious and visible opportunities is key, as no detail is too small in this market. We believe this is now the time to become even more creative, reach across capital structures to find relative value, structure private capital solutions, and be prepared to move quickly as we know all too well this market does not wait for anyone to catch it.
Although the dispersion of 2020 has tightened, we believe there will be future idiosyncratic risk to lean into. We also believe that gap risk remains a constant factor for investors to be wary of especially when the Fed begins to taper. Furthermore, there has been tremendous pent up demand as the world sat on the sidelines for the last twelve months of the pandemic and we may first come out of the gates with gusto – demonstrating higher growth appetite than potentially warranted, and then evening out as more time passes. As credit investors we are thinking about our portfolio positioning and how the impacts of higher costs may filter through issuers balance sheets. We also believe it is prudent to price in the COVID recovery and know when there is compelling risk to take versus taking risk for the sake of doing so. This market will continue to test investors’ patience as opportunities become harder to source. The other side of this story will be for investors’ to prudently determine when it is appropriate to de-risk and monetize successful investment outcomes.
THE NEW ACTIVE
The world and the fundamental investing landscape shifted dramatically with the onset of the COVID-19 pandemic. We related to the film Vertigo this quarter as the market seems to be floating in a bit of a blurred fog that can be confusing. On one hand, there has been a very strong snapback and asset prices have rallied on the heels of the Fed stepping in and many projecting a strong rebound in economic growth. On the other hand, there is still an unsettling feeling that lingers as we have yet to see all the long-term consequences of the global shutdown. It often takes multiple years after the initial dislocation and drawdown for all the downstream net effects of a market shock to permeate through the system, which is why now is the time for the new active. The new active is an extremely hands-on, agile, creative and proactive asset management style that capitalizes on: proprietary sourcing, creating your own issuance and liquidity, curating a portfolio embedded with downside protection that has equity-like upside potential while pivoting with episodic market events and de-risking to secure excess alpha. KKR's Credit platform continues to lean into partnering with sponsors to creatively structure capital solutions, identify compelling secondary and idiosyncratic opportunities despite the tightening corporate credit backdrop, and work in partnership across all the KKR core competencies to capitalize on a truly unique and proprietary sourcing channel, which I believe is unlike any other in the market.
On May 1st KKR celebrated its 45th birthday, a milestone for the firm and our firm’s history. The Firm was founded on the important principles of what a trusted partnership should look like, with a steadfast and common vision based on trust, integrity and partnership. Our four plus decades of experience, strong values, and culture of collaboration have enabled us to source and invest into unique opportunities for our clients. In my almost seventeen years at the Firm, I have learned first hand that collaboration is in our DNA and we will always bring all of KKR to everything we do.
We want to thank our investors for your continued trust and partnership. As always, we welcome your feedback on our letter and are grateful for the opportunity to discuss our market views with our readers.-Chris Sheldon
1 ICE BofAML as of 03/31/21
2 S&P LCD and KKR Credit Analysis as of 03/31/21
3 S&P LCD and KKR Credit Analysis as of 03/31/21
4 S&P S&P LCD and KKR Credit Analysis as of 03/31/21
5 S&P LCD and KKR Credit Analysis as of 03/31/21
6 S&P LCD and KKR Credit Analysis as of 03/31/21
7 S&P LCD and KKR Credit Analysis as of 03/31/21
8 S&P LCD and KKR Credit Analysis as of 03/31/21
9 S&P LCD and KKR Credit Analysis as of 03/31/21
10 S&P LCD and KKR Credit Analysis as of 03/31/21
11 S&P LCD and KKR Credit Analysis as of 03/31/21
12 S&P LCD and KKR Credit Analysis as of 03/31/21
13 S&P LCD and KKR Credit Analysis as of 03/31/21
14 S&P LCD, S&P LSTA LLI, and KKR Credit Analysis as of 03/31/21
15 S&P LCD, S&P LSTA LLI and KKR Credit Analysis as of 03/31/21
16 S&P LSTA LLI as of 03/31/21
17 ICE BofAML as of 03/31/21
18 S&P LCD and KKR Credit Analysis as of 03/31/21
19 S&P LCD and KKR Credit Analysis as of 03/31/21
20 S&P LCD and KKR Credit Analysis as of 03/31/21
21 S&P LCD, ICE BofAML, and KKR Credit Analysis as of 03/31/21
22 ICE BofAML and KKR Credit Analysis as of 03/31/21
23 ICE BofAML and KKR Credit Analysis as of 03/31/21
24 Barclay's Research, Bloomberg, Morningstar, and KKR Credit Analysis as of 03/31/21
25 Bloomberg, Morningstar, publicly available sources, and KKR Credit Analysis as of 03/31/21
26 Refinitiv Lipper, S&P LCD, and KKR Credit Analysis as of 03/31/21
27 Refinitiv Lipper, S&P LCD, and KKR Credit Analysis as of 03/31/21
28 S&P LCD and KKR Credit Analysis as of 03/31/21
29 S&P LCD and KKR Credit Analysis as of 03/31/21
30 S&P LCD and KKR Credit Analysis as of 03/31/21
31 ICE BofAML and KKR Credit Analysis as of 03/31/21
32 ICE BofAML and KKR Credit Analysis as of 03/31/21
33 ICE BofAML based on par values and KKR Credit Analysis as of 03/31/21
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.