Episode 8: Why Good Credit Managers Like This Bifurcated Market

Federal Reserve’s liquidity bazooka ended the “doom loop” of lower funding market values and forced selling. But liquidity-driven euphoria creates a disconnect between prices and still-challenged fundamentals. The price gravity of bankruptcy.

Transcript

Why Good Credit Managers Like This Bifurcated Market

Danan Kirby: Hi. Welcome to another episode of Away From the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day. I’m Danan Kirby, Client Portfolio Manager at Thornburg, and today we’re joined by Ali Hassan, who’s a PM on a number of fixed income strategies. Now, Ali began his adventures in credit working at Citi Group’s origination and loan workout groups. And, he’s no newcomer to challenging credit environments with experience in distress credit and turnaround PE while at HIG Capital, and this makes him a perfect guest for today’s show in which we’ll cover Fed corporate bond buying, its effect on credit risk and high yield in the low market. And, Ali, welcome to the show.

Ali Hassan: Thanks, Danan.

Danan Kirby: The Fed’s corporate credit facilities began about 2 months ago with the secondary market corporate credit facility initially buying credit ETFs, and then adding corporate bonds about in, in mid June. Now the facilities have been on the minds of investors over the past 3 months and have dominated conversations that we’ve had with clients because the, the original announcement was just a, so much of a critical circuit breaker through the disorderly market price action that occurred in March. What’s your take on the Fed’s purchases and what it means for, for markets in general, Ali?

Ali Hassan: So, that’s a great question, Danan. Let’s talk about what it has meant for the market, and it’ll give you a clue of what it means going forward. So, you know we had a big shock event. It was kind of a 911 event, but for healthcare, and we, we didn’t know what the shape and scope of the epidemic would be, and we still don’t know what it, what it is going to be. And, what we, what we had was, you know, that shock sparking a, a fire basically in funding markets that increase liquidity concerns, as well. Weak hands, whose funding rates kind of went up, couldn’t hold paper, and stronger hands couldn’t jump in to the fire and, and fix things. And then what we had was a doom loop where we had force selling, and then those lower values resulted in bad marks, redemptions, margin costs, further lower values and force selling. And the Feds being able to step in basically and provide liquidity into the market that’s reduced funding rates, allowed weaker hands to continue to hold their paper and stay levered. It’s also allowed stronger hands some time to get organized and come into the market and lever, lever in into purchases. And, I think the most important thing is not the amount of buying that the Fed has done, but the signal. And the signal is that the Fed is prepared to move very quickly. I was very surprised about the speed with which they responded to the event, but they’re, they’re signaling that they’re a credible backstop and that they’ll move in speedily if there’s any more, any more issues in funding markets. And, so, that’s calmed things down a lot more.

Danan Kirby: So, I’ve noticed and the data shows to my count that the Fed’s ETF buy has been spread across 16 ETFs, of which I think nine are investment-grade and seven are high-yield focus. When I looked at the granular data, which showed that high ETF accounts for about 17 percent of all ETF purchases through the first week, which was May 12th through 19th, and since then, the percentage of higher ETFs has kind of fallen off. And on most days, it’s actually below 10 percent of the actual Fed buy. Since high is your specialty, has the Fed purchases affected your thinking on high-yield credit given the massive tightening that we’ve seen in spreads over the last few months?

Ali Hassan: That’s a great question, Danan. I think that the key point here is not parceling through the exactly what the Fed is doing, exactly where they’re buying, but it’s, it, but because, you know, funding markets are kind of fungible in a sense. If you’re buying an IG or high-yield, you kind of squeeze the balloon in one place and it pops out somewhere else. The, the broad signal for me is just that the Fed is willing to be creative and aggressive and do things unprecedented on a massive scale in order to calm markets, and I think that’s, that’s really the, the credible signal that’s been, been put as a backstop. In terms of what this means for credit spreads going forward, technically prices are, are being bid up. There’s a lot of liquidity and euphoria, as well. But on the other hand, you’ve got a disconnect from, from fundamentals, and, so, there’s still a strong link between economic activity. The more economic activity you have, the more the virus spreads. So that link between economic activity and the virus spread is still intact and unbroken. Secondly, you have pockets of the economy that are really depressed revenue levels, zero revenue levels, and you look at the cruise industry, hotels, airlines, and, so, that’s real stress in the market. And, of course, there’s, there’s unemployment, and it’s really unclear today how much of that unemployment is still temporary and how much is, is going to be permanent, and, so, how much permanent damage there is in terms of people’s behavior and permanent damage in terms of small and medium-size businesses and permanent damage to the employment picture. And, so, so with that insight, you know there’s real prospect for bankruptcy for many, many companies as liquidity is, is getting weaker as, as those companies burn cash to try to stay afloat. And bankruptcy is, is like gravity. It pulls crisis down to recovery levels, and, so, there’s a real opportunity for good credit pickers in this kind of environment. There’s, there’s a bifurcation, and, so, there’s some companies that are being priced like performing credits and getting bid up when, in fact, they, they will be nonperforming. And then there are companies that are being left for dead. Companies that are being perceived by the market as nonperforming credits that actually are much more resilient, and those companies shouldn’t be trading at recovery value. So, for good credit pickers, I think this is, this is a very rich environment still.

Danan Kirby: So, it sounds like while a rising tide may lift all boats, there’s gonna be some boats that end up at the bottom of the ocean regardless of what the Fed is up to, and the real key is gonna be trying to separate those ones for adding alpha for portfolios. One of the things that I wanted to, to also touch on too, which is sort of related to, to the volatile that you, you had mentioned, you know, earlier is loans. And loans were hot on the minds of investors that were simultaneously looking for some protection against rising rates, while also getting attractive yield. But during like the depths of the crisis, it seemed like loans experienced some serious volatility, which I believe went beyond investor expectations. But today the loan market has recouped out. Approximately 80 percent of the spread widening that took place between February 21st and the date the Feds stepped in or March the 23rd. Are there any thoughts that you have for the loan market today, and is it attractive, is not attractive?

Ali Hassan: No, the, the loan market in general wasn’t providing as much great value in terms of flows. Flows have returned into that market, and like credit spreads in general. Those have been bid back in. In terms of new supply, you know a lot of the leverage loan market was there to fund M&A activity. That M&A activity has ground to a holt. A lot of the buyer base that had been funding the explosion in the leverage loan market was the CLO investor base and the formation of CLO, UCLO creation has, has, has slowed down quite considerably. I think, you know, there are still some, some more legs to go potentially. You know we see weakness with second and third quarter financial reporting that’s gonna be coming out. That could result in confirmation of weaker run rate performance, higher leverage, and that will have to result in rating agency downgrades. Those rating agency downgrades, a lot of the holders of bank loans, like CLOs, are sensitive to certain concentrations. So if you look at the vehicles that own leverage loans, a lot of them are, are very credit sensitive. So, they have met, they have, as part of their governing documents that they can’t have a certain amount of CCC paper or certain concentrations in very low rated leverage loans that also triggers potentially issues related to having to take marks and then creates problems for them in terms of their over-collateralization tests. So, so, what that means is that these buyers are kind of handcuffed to a specific investing mandate and requires them to be for sellers in the market, and, so, we may see that ahead. And there might be a better opportunity going forward in terms of entering the leverage loan market if we see recovery prospects dim and the expectation of a more of a V shaped recovery get a little bit more grounded.

Danan Kirby: So, Ali, you’re known for being a, a pretty much a, an international character on the fixed income desk. Being from Sudan, having grown up in England and Saudi Arabia and Canada, what do you miss most about your, your home country or countries?

Ali Hassan: Yes. So, yeah, that, that’s actually right, Danan. I, you know I did, I did grow up in four different countries. It really helped me in terms of getting a unique lens for multiple perspectives. You’re going through multiple different education systems that are teaching you history from multiple different angles and lens. My childhood in Saudi Arabia was idyllic and, and I think many would be surprised about that. And it was idyllic in the sense that it’s a very secure country. Even at 5, 6 years old we could go and, go outside, play, and there wasn’t any sense of any insecurity or, or fear for us. So, we could go out and explore and, and that was, that was really fun. You know living in Canada, I think the thing that I appreciate there is, is kind of the unique culture, and it’s a, it’s, it’s a really open society. And, and it’s, and it’s that way because they have a deep embrace of multiculturalism because of the francophone and Anglophone history. There kinda has to be a, a deep respect for and an understanding of multiculturalism as a strength. So, I think that’s something that’s potentially an example for the world, and I’m not sure if there are many other countries that really do embrace so strongly all the way from, from the bottom all the way to the elite levels. And, you know, maybe Singapore would be another example country like that. And, so, you know, that’s, that’s interesting, and then, you know, obviously I’m here in the U.S., and the U.S. is my home now. It really is the land of opportunity, and I’m really grateful to, to be here and in Santa Fe and at Thornburg working with people who are, who are at the top of their game. So, you know, if you want to be at the top of your game, I think this is, you know this is the country to be in.

Danan Kirby: That’s excellent, Ali, and I, I wholeheartedly agree that the U.S. is probably where you, where you want to be if you’re looking to be at the top of your game when it comes to business specifically. Thank you for joining us on today’s episode. And today’s episode was produced and edited by Michael Nelson. You can find us on Apple iTunes, Spotify, Google or wherever your finer podcasts are sold. You can also find us at Thornburg.com/podcasts where you can subscribe, rate us and also leave a review. Please join us next time on Away From The Noise.

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