Credit Market, The New Equilibrium
Jonathan Berger, Chief Executive Officer and Chief Investment Officer at AS Birch Grove, is hosted by Naji Nehme, Chief Investment Officer at Petiole Asset Management AG, to discuss the credit market, its outlook and the new equilibrium.
After a brief summary of Jonathan’s long track-record in the investment business, he started by highlighting some of the lessons he has learned during the last decade which helped him refine the investment processes. As a person who’s been through bankruptcies for both the companies he has bought going through bankruptcy but also watching companies he’s invested in go through bankruptcy, he has learned to manage liquidity and risk, highlighting that this was very important for investors who venture into the world of illiquid investments. Jonathan mentioned that they should ensure that they are getting compensated, have the appropriate return profile, and understand exit time frames and mechanisms.
Credit Asset Classes
In terms of the asset classes or sub-asset classes within credit that Jonathan would consider, he mentioned primarily companies, i.e. corporate capital structures in North America and to some degree Western Europe but he would caveat that by saying that for European credits he would probably verge more towards the liquid side, as opposed to North America, where he’d look at both liquid credit and private credit across the capital structure. In other terms, he’d look for leveraged loans, floating-rate secured loans, secured and unsecured bonds, be it investment grade or high yield as well as corporate structured credit; so collateralized loan obligation liabilities and equity
Jonathan believes in previous environments where rates were higher, credit quality amongst the different asset classes was very different. If we look back to 2022, the first half of the year, when interest rates were increasing, there were fears of inflation, the war in Ukraine was breaking out, and energy prices were rising; we witnessed a very large drawdown in fixed rate credit, particularly in both investment grade credit and high yield credit because not only were they connected to the rates market, but investors also had concerns for the underlying fundamentals and what a hyperinflationary environment would mean for the underlying credits, particularly in the non-investment grade segment of the market.
Jonathan added that if one took a step back to think about the high yield market, which would be the non-investment grade segment of the fixed rate market, one would see that the credit quality of that market has actually been improving over the last 10 years since the Financial Crisis. Jonathan concluded by saying that today he would focus on individual situations where capital structures and balance sheets can be sustained through a recessionary environment, whether in the leverage loan market or the investment grade market.
Sectors to Favor and Sectors to Avoid
Answering a question about the sectors he favors and those he avoids, Jonathan named the tech sector. For example he has avoided many tech companies which were financed through both equity and credit markets but were not profitable or were in the early stages of profitability. They have also avoided parts of the healthcare market where there were either labor shortages or high costs. In contrast, the insurance market did well, as did the business services market.
Jonathan mentioned that high-end consumer businesses that are more about experiences than goods, have done well even in a high inflation environment and that he has more concerns towards the lower-end consumers where high food prices or high gas prices have had a greater impact on their wallets. The housing market has started to take a hit with higher mortgage rates and increases in the rental market. There's also been an acceleration in the secular changes in the consumer market due to COVID-19 which has obviously accelerated the practice of buying online. Restaurants and gyms are generally doing well even amid high labor costs as well as high food prices, with people going to restaurants and returning to gyms.
Playbook for the Upcoming Years
Jonathan shared his playbook for the upcoming years highlighting that they have implemented phase one of their playbook in the second quarter of last year, when a very large drawdown in all markets took place. They recognized that inflation was not transitory, and that the Fed would act. In phase one, they focused on companies that had very little impact on their underlying businesses from an inflation or rate perspective. Phase two included affected businesses that had sustainable balance sheets and phase three involved businesses impacted without sustainable balance sheets. He stated that at the moment he is avoiding restructurings due to a secular change in the distress market over the last 10 years, because of weakness in documentation which might lead to lender on lender violence. They prefer to provide new capital to a company undergoing restructuring or bankruptcy. On the private credit side, which can be distinguished from the liquid credit side; solution capital is a very interesting place to be because the private credit market is valued now at one and a half trillion dollars and default rates are going up. Thus, providing solution capital to this market is attractive. Jonathan said that they were finally seeing spreads widen in the private credit market, whereas last year there was a lag between the liquid market and the private market.
On his side, Naji also spoke about Petiole’s playbook laid out in the summer of 2022 where phase one was overweight credit, underweight equity, because the credit market was much more attractive on the public side versus the private side. Phase two is more overweight credit but also starting to go neutral on equities. Private debt is becoming more attractive after the pendulum swung from a borrower friendly environment to a more lender friendly environment. Petiole invested more in private debt as well as private equity, even though a homogeneous valuation across the board have yet not been witnessed but security selection and finding businesses that have repriced similar to the public market was possible.
Collateralized Loan Obligations
On the topic of CLO debt and equity, whether secondary CLO or primary issuance, Jonathan mentioned that CLOs represent around 80 percent of the buyer base in the North American leveraged loan market. In the last quarter of last year, there was a move in rates with a sort of a risk-off approach, making it very attractive to step in both utilizing CLOs and just unlevered accounts. With the move in leverage loans seen along with other asset classes in the first month and a half of this year, leveraged loans are still trading at a very attractive level relative to the fixed rate market. A big discount persists in the overall markets which means there's a lot of opportunity even within this market to construct portfolios that are very attractive.
In terms of convertible bonds, they are assessed like any other credit asset class. They are a gateway to invest in a particular idiosyncratic credit. Last year a lot of the convertible bond market or converts financed many of the unprofitable tech companies with very high stock prices. In the first half of 2022, those stocks got hit and converts had a perfect storm situation. They were traded off because the underlying equities were down, the rates market and the spread market moved up, and they became a credit product that was based on spreads. Their buyer base disappeared overnight because many of those buyers had bought bonds at very high dollar prices. By July 2022, the convertible bond market was actually trading at a three to four hundred basis points of a discount to comparable high yield bonds, even in their own capital structures. Birch Grove stepped in and added more exposure to converts. During the first month and a half of this year, those converts have traded in line with their high-yield counterparts. Now, the company has reduced its position because the converts have moved up too much, so their current yield is no longer as attractive as the equivalent high yield bond or a leveraged loan.
When asked about the person he has considered a mentor throughout his career as well as the guidance he’d provide to a young person venturing into this sector, Jonathan said that a young investor or somebody getting into the businesses must develop a mentor rather than just wait for him or her to appear. He suggested that young people be agnostic when thinking about investing, not to be biased against any asset class and not to fall in love with it, but to have an open mind. Being a good investor is not just about the business part, one must understand everything that is going on in the world.
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