MASTERCLASS: Credit Markets - December 2019

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  • 01 hr 01 mins 00 secs
This Exclusive TCW Masterclass examines the overall fixed income environment, looking at the macro factors and central bank decisions impacting the asset class. The panelists evaluate corporate credit, high yield, and other areas, analyzing the trends that investors are watching closely. We hear from four credit experts at TCW: 

  • Stephen Kane - Fixed Income Portfolio Manager
  • Jerry Cudzil - Head of Credit Trading
  • Steven Purdy - Head of Credit Research
  • Brian Gelfand - Credit Trader



Jenna Dagenhart: Hello, you're watching an Exclusive TCW Fixed Income Masterclass, with a focus on credit markets. We'll cover monetary policy in the Fed, where to find yield in a low-yield world, and what matters most to bond investors heading into 2020. Joining us on location at the TCW Headquarters in Los Angeles, are TCW Credit Market Experts, Steve Kane who is a Generalist Fixed Income Portfolio Manager, and part of the team of portfolio managers overseeing TCW's array of fixed income products. Along with Jerry Cudzil, Head of Credit Trading, Steve Purdy Head of Credit Research, and Brian Gelfand, Senior Credit Trader.

 Thank you so much for joining me.

Stephen Kane: Thank you Jenna.

Jerry Cudzil: Good to be here.

Steven Purdy: Good to be here.

Jenna Dagenhart: So great to be here at your headquarters. And Steve, I want to kick things off with you. How does TCW view the overall credit market?

Stephen Kane: Well, let me start by saying that the way TCW approaches Fixed Income investing is to have a value discipline and a business cycle framework, where our core belief is that interest rates, the shape of the yield curve, credit spreads, move around, but mean revert over the course of the business cycles. So, the key point for us is where are we in the business cycle, and our view currently is that we are late cycle, actually very late cycle, in the business cycle, and that what feeds our thesis, is the excess buildup of debt. And we'll probably get into further discussions on that in the global economy, but particularly in the U.S. corporate credit markets, a declining economic growth rate across the developed market, shrinking corporate profit margins, and then just in general, increased downside risks for the economy. So, in short, if we were to use an, a much overused cliché about baseball, we would characterize the cycle as being in the maybe the bottom of the eighth, or top of the ninth, in terms of the cycle being over.

Jenna Dagenhart: Love the baseball analogy, and building off of that, would you say now is a good time to be investing in fixed income?

Stephen Kane: Well, it's a little bit of a mixed bag. And on the one hand when you get late cycle and recession risk build, as we've seen recently, you have central banks beginning to ease. And we've already seen that occur across the globe. And so as central banks are easing, that's a good thing for fixed income investors. You get a price appreciation. However, on the other hand, you get deteriorating credit fundamentals, and as that happens... At least our belief is you're going to see widening credit spreads and potentially significantly widening credit spreads at the lower quality area of the market. So, netting these two things out, I think the way we'd characterize it as high quality fixed income is still probably a good place to invest. You'll probably earn your coupon, maybe a little bit in excess of your coupon, if you focus on the high quality parts of the market.

Jenna Dagenhart: Yeah, you mentioned global monetary policy, and the easing that we've seen. What is your take on the Fed and interest rates?

Stephen Kane: Well, let's start with where we're at. So as I mentioned, the Fed has eased three times in the fall, and they sent clear signals to the market that they're going to take a pause and they're going to see how the trade situation develops with China, and also see the impact of what the three eases to date... insurance cuts, so to speak, have... do for the U.S. Economy. Our view is pretty much lined up with the market today. The market is expecting embedded in the current structure of the fixed income market, is one more ease in 2020, we'd probably lean to maybe two, maybe three eases next year, and likely a steepening of the yield curve. So short rates come down, longer rates stay put or maybe even drift a little bit higher.

Jenna Dagenhart: And to steal another phrase from the Fed, they talked about a mid-cycle adjustment. How does that impact credit markets?

Jerry Cudzil: Well maybe I'll start. I would say that we would push back a little bit and say we don't really think it's a mid-cycle adjustment. Actually, we think the Fed is responding to some real change in information. That changing information is, as Steve mentioned it, there's been a real compression in profit margins, and a real slowing in economic data. And we're starting to see that come through in some of the fundamentals, and we're actually getting confirmation of that in the credit markets.

We'll talk a little bit more about that, I think as we move through this panel, but what we've seen is a real significant under performance of lower quality credit. And we've seen that across the high yield and the bank loan markets, and I think our opinion is, this is exactly what you see at the end of the credit cycle. When you begin to see the weaknesses exposed in the most levered parts of the credit markets first. And so, when you see a little bit of a slowdown, that gets magnified in credits that have significant increases in leverage. And ultimately what happens, is lower quality credit begins to underperform at the late stages of the credit cycle.

Steven Purdy: And if you look at the last financial crisis, a lot of the leverage built up was on personal balance sheets with mortgages particularly subprime, and then also on the globally systemic investment banks. But in this credit crisis, or in this part of the cycle rather, as Steve mentioned earlier, the buildup is really focused on corporate credit. And so, we're seeing debt levels that are unprecedented history, at both the large companies and small companies. From the higher rated, all the way down to lower rated. And as we get to the new credit cycle, we're starting to see fissures start to occur from the earnings standpoint, which is impacting the lower parts of the credit markets as Jerry mentioned.

Jenna Dagenhart: And building off of that, I mean we've touched on it some, but does this global easing make you more or less constructive on fixed income?

Stephen Kane: Well, start by saying that there's an often used axiom in investing in general is, "Don't fight the Fed." Which is... or don't fight central banks I guess is the broader point, which is... As they're easing, investors are encouraged, or have been rewarded, I should say, by taking risk. And with the backstop, if you will, that central banks will ease, and help your asset prices go up in value.

                                                            At the risk of saying this time is different, this time might be different. And there's a couple of reasons why. I think there's two main considerations that one should think about today when buying risk assets with the idea that central banks are going to have your back so to speak and bail you out of the investment. The first is valuation. So, with stock, the stock market's near record highs, spreads in both investment grade and high yield, near cycle tights, the question one has to ask, is even if the central banks have your back, there's not a whole lot of upside. It's one thing at the end of previous cycles where credit spreads are a 100 or 200 wider than their average, or stocks are down 20% to 50%, and the Fed is easing. That's an entirely different environment than we have today.

The second consideration where it may be different this time, is how effective is lower interest rates going to be on the economy today? And I think we're in a somewhat unique environment where we've had low interest rates, relatively tight credit spreads, and very available credit, particularly the corporate credit market, for almost 10 years now. So, it's not as though you're really giving much debt relief, or cafro relief to borrowers, given how low rates have been for such a long period of time. So, it's early to conclude today that interest rates aren't going to have the same stimulative effect, but we're not seeing much from the housing market, we're not really seeing much investing activity in the corporate area. And it looks as though there may not be the same type of stimulus or the effect from stimulus, the cycles we've had in the past.

Jenna Dagenhart: Any other thoughts on, "Is this time different?"

Steven Purdy: I thought the one thing I would say to Steve's point, is that we've seen CFOs have had a normal reaction by looking at these low interest rates and going on issuing these record levels of debt. Well it sits appointed from us, and the credit investors side, is that they're taking these new munies and instead of investing in the business, they're giving away to the equity shareholders. So, while we're having all-time record highs on the earning standpoint and free cashflow, they're not using those free cash flows to either invest in the business or pay down debt. And that's just put us on heightened awareness as a credit investor.

Jerry Cudzil: Right. And I think the further that point, there're two things. One is we're sitting at almost record levels of leverage and debt in the system prior to a recession. I think when we look back over time, what we see is that we're dangerously close to peak levels of leverage on corporations, except we suppose we're at a point where there's pretty strong economic growth, I'd say globally, and a supportive central bank policy today.

                                                            And I think the second thing is what's clear, is that the central banks can't fix a bad business model. When you have a bad business model, when you have companies that ultimately have issued too much debt, and either dividend that money to shareholders, or made some bad acquisitions, or just been too aggressive with their balance sheets, when the economy slows or they're earnings slow, that debt doesn't go away. And ultimately what happens is that company needs to restructure, and there's no amount of stimulus that will fix a bad business model.

Brian Gelfand: And you're starting to see some of those vulnerable business models begin to crack. Particularly in the more... The lower quality parts of the high yield market. So, when you think about the effect of central bank stimulus, what does that... What does lower interest rates do for an energy company that is just uneconomic, in terms of the production that it produces.

Jenna Dagenhart: And we'll talk more about energy sector in a little bit. But yeah, really interesting insights there about credit spreads being really tight, and where we are in the cycle. I know Jerry, you mentioned leverage. Are there any other risks that you'd like to highlight that you think are important to fixed income markets?

Stephen Kane: Well, we'll start with the obvious one that isn't going to. It's not noteworthy, but it's certainly front page every day, is trade and the issue surrounding trade. The markets reacting daily as a matter of fact, minute by minute, as we get tweets and new information out, and if the market's reacting because it is a real factor meaning. The market is assuming today that some sort of phase-one deal gets done, in whatever form that is. However, the risk is that a deal doesn't get done, or you know more significantly, if it goes the other direction, and terrorists begin to ramp up because given the weak economic conditions, the amount of debt and leverage we've talked about. If a trade wars were to escalate, you would get a further contraction and manufacturing, and likely a recession across the developed market.

Steven Purdy: And we spend a lot of our time talking to managers, and the adage goes that, "Markets don't like uncertainty, but management teams don't like uncertainty either." And so, what we're most focused on really, as credit investors, is getting our principal back. And that depends on free cash flows companies, free cash flows from companies. And so we really spent a lot of time stressing the downside cases of all of our investments, to make sure that if we do get a trade deal, or some other impact that causes the recession, either on the national level, on the global level, the businesses that we own, will be able to service their debt, and ultimately return our principal to us, at an attractive level of yield.

Stephen Kane: I would say another risk that is yet to. Well, rear its ugly head, so to speak in a big way, although we've seen bounce of it, is liquidity. The structure of the markets have changed significantly, and some of the folks here that trade on a daily basis, experience this.

It used to be that Wall Street banks and broker firms had significant capital, if you will, that they use to buffer the markets. Meaning, they take on risk as the market in general was shedding risk, and vice versa. With regulation coming out of the financial crisis, banks and broker dealers have largely withdrawn from the market. There's very little capital available for that trading. So, it's really been the ETF market that has stepped in and really been a significant source of liquidity of the market. By and large, the market has been fairly liquid, because flows in and out of ETFs have been fairly robust, particularly in. However, that environment could change significantly, if the economic climate changes as we anticipate. And that liquidity, which looks pretty good today, may end up being rather poor.

Jenna Dagenhart: Yes. Record in-flows as you've mentioned.

Stephen Kane: Right.

Brian Gelfand: Well I think you saw a microcosm of that in the fourth quarter of last year. Right when the market needed that liquidity, dealer balance sheets weren't there to provide that buffer. And so, you know, you saw pretty pronounced moves in prices in short periods of time, as a result of that illiquidity.

Jerry Cudzil: I would just add, that we've seen a real change in the ownership of the marketplace, and I think we're not really sure how that plays out yet. So, what's clear is that the ETFs own a larger percentage of the markets today. That's clear. And what's also clear, is that there's been significant flows into fixed income for various reasons. Whether you think rates have been manipulated lower, or they're just lower because of slower global growth, or just globally the market can't handle higher rates because of the amount of debt notionally that's been created.

So ultimately what we've seen, is a pretty low volatility environment with one way flows, and that hasn't precluded the market from experience. Some pretty significant bounce of volatility, and if you think about what happened in the third quarter... I'm sorry, excuse me... The fourth quarter of '15, or the first quarter of 2016, what happened to the fourth quarter of 2018. There were significant bouts of volatility met with significant spread widening.

And I think our opinion is that we're at the end of the credit cycle, but whether we're right about that or not, actually doesn't really matter, because I think what we do anticipate, is some pretty significant volatility in spreads as a result of the lack of liquidity and the potential volatility that's going to be created due to the way the market is owned today. It's different than what it was in the past.

Jenna Dagenhart: So that volatility is a bit immune to what inning we're in right now.

Steven Purdy: Look, I think it is. And I think from a value perspective, because we have defensively positioned portfolios, in those periods of time where prices are falling and dislocations are occurring, we have the ability to deploy capital with kind of clear eyes given that we've done the under underlying fundamental credit work, and we quite frankly see some good bargains in those periods of dislocation. So, for us, it's been a great period of time to go on offense, having been relatively defensive up to this point in the cycle.

Jenna Dagenhart: And we've talked about a lot of macro risk factors, and liquidity leverage. Building off of all of that, how does this impact your current credit allocation?

Stephen Kane: Well maybe I'll start from a high level, and then let you guys fill in with the more important details.

So, at a high level from a... As a general's portfolio manager, we're concerned with sort of sector allocations, and how to shift risk, and we are being very defensive with our corporate credit allocation. And at the highest level, that means the allocation is underweight, or low relative to our benchmarks are relative to our average exposure in the cycle, both by market value it's low and then by spread duration, which is sort of a measure of price sensitivity. But probably the most significant part of our credit allocation is not only is it low, but it's up in quality, meaning we're at the very low end of our risk budgets on high yield and emerging market debt, and particularly within each of those sleeves, kind of the lower quality area where when you get in these end of cycle periods, bonds don't just move by one or two points. They can move by 10, 20, 30, 40 points, and we want to be very careful, very disciplined in that, and the allocation to that part of the market.

Jerry Cudzil: Yeah, and as Steve mentioned, I think that when you look at, I would just emphasize when you look at our credit allocation, it is meant to reflect our entire cycle view. That means we have a defensive posture; it means we're up in quality. And then I think that the way we've digested that and the way that we have positioned ourselves is we try to protect the portfolios as much as we can from downside. I think we view considering our view of late cycle investment, we view protecting principle as our primary role and then how do we do that? And there are different ways we can get defensive and I think we try to use as many tools in our credit toolbox so to speak, as we can. I'd say we... The first is we look at sectors that are regulated. So, when you have protections of a regulator, whether it be in the banking sector or in the utility sector, there's a regulator there.

It as a meant to protect the depositor and the rate payer. It's not that that's a governor on the amount of leverage companies can put onto their balance sheets, which is, which is helpful. I need, the second way is we look for companies that are... That have assets or covenants. And I think when, what, why do we look for that? Well, there's fewer situations where covenants, we'll talk about maybe some of the weakening of covenants that we've seen, but when we have situations where there's multiple ways out, I think we feel more comfortable with making that allocation. And lastly, we prefer non-cyclical sectors over cyclical sectors. Clearly given our economic view, you've heard from Steve that we think we're late in the cycle. We'd much rather have a little bit of an over levered non-cyclical company than maybe a less levered cyclical given, given our economic view.

Steven Purdy: And just to flush Jerry's last point out, I mean, we've really focused on those nonsensical sectors. The obvious point being when we do get an economic, a turndown, we know that we feel like the cash flows remain robust. So, in sectors like healthcare, or pharma, or telecommunications, or utilities, you're not going to make any major changes or see any real volatility on either the top line or the bottom line with a recession, which makes us feel good about the securities that we own.

Jenna Dagenhart: So Steve, you talk about quality. Brian, I wonder, is there anything that you'd like to add from a high yield perspective?

Brian Gelfand: Yeah, so one of the principle themes that is occurring within the high yield market is this degree of dispersion that we're observing. You're seeing double B high yield up about 14% this year, outperforming triple C bonds by about a thousand basis points, so 10%. An interesting byproduct of that bifurcation is that capital is being crowded into a what the market has deemed to be high quality bonds. And so today double B risk, really is a rather risky proposition in our opinion. You have spreads compressed in absolute terms, as well as relative to investment grade debt. The basis between a double B spreads and triple B corporate spreads, is that the tight... tightest it's been in the last 20 years.

Jenna Dagenhart: Interesting point too, about the double B spreads, because we are going to go into more detail later about triple Bs.

Jerry Cudzil: Yeah. I would just make one other comment too, and that is when you look at the high yield market, and you see this bifurcation really makes it difficult to choose. We're going to have to pick our poison. Triple Cs are obviously, dangerous late in the cycle. We talked about potential under-performance and we have 8% of the triple B market. I'm sorry, a triple C market, that trades outside of a thousand basis points currently, and when you think about, okay well that's potential future defaults, that 8% cohort and that's its own risk. And then we have this 40% of the high yield market that currently trades that... That's a double B portion of the market currently trades inside a 200 basis points over treasuries, which clearly doesn't have a lot of upside from spread tightening perspective. And so really, you're just dealing at a vulnerability, both from either a default scenario or a potential, a spread widening scenario, as it relates to the higher quality parts of high yield.

Jenna Dagenhart: Any final thoughts from a high level? Steve-

Stephen Kane: Well-

Jenna Dagenhart: I'm picking up on-

Stephen Kane: The higher level standpoint is all this informs the overall allocation, which is there's not a whole lot to choose from. I mean we are finding opportunities Steve mentioned, but it's more rifle shot type approaches where we're seeing unique credits that we have a high conviction that they're going to perform well in a variety of environments. But buying the market today, even segments of the market, is fraught with a lot of risk. So, it informs from a high level standpoint, best look elsewhere to allocate within a fixed income portfolio than the high yield area, at least in our opinion.

Jenna Dagenhart: And you mentioned staying away from some of those cyclical areas. Building off of that from a credit sectors perspective, where are you finding risks as well as opportunities right now?

Steven Purdy: Sure. I mean, I guess I'll kind of take-off for what Brian just mentioned, in the fact that this spread between the double Bs and the triple Bs, or is that kind of all-time tights? And we've quite frankly found a lot of interesting investment opportunities in the triple B space. Obviously, there's been a lot of writing has been done about this bubble we have in triple Bs, and we think it's fascinating as both a risk and opportunity.

On the risk side, we currently have the triple B segment of the market is twice the size of the high yield market. So, if you looked at history and just made a projection of how many of these names might be downgrade, it would be a massive component of about 60% of what the current high yield market is. So that's quite concerning.

                                                            But on the positive side, there's a number of these companies that we actually think do have a path to do leveraging. So just take a moment, to talk about how we got to this bubble. It really starts with the rating agencies. A number of businesses went out and made large MA transactions and took their leverage up with the promise that they would bring the leverage down over time. So, the rating agencies have extended an investment grade rating to a company whose balance sheet is not investment grade, but they've made promises to bring that leverage down over time. We think it's a great opportunity to really do the deep dive fundamental analysis to figure out do they have the capabilities in both a robust economy and a declining economy to achieve that de-leveraging, or they at risk of becoming a fallen angel, because they simply can't keep up with the de-leveraging they promised the rating agencies.

Jerry Cudzil: And then ultimately, we always ask ourselves, "What risk are we being compensated to absorb?" And that is really a function of where do these securities trade, and what spread volatility, what default assumptions are priced into the marketplace today. And as we look, as we look at the market today, there are certain triple B securities that Steve talked about some of these situations that we're seeing, they're really organic. It's really micro. It's really a bottoms up buildup of the portfolio.

Broadly speaking, I would say we think there's a lot more risk in the marketplace then opportunity. Although I would say we're seeing our fair share of, because of the increased dispersion in idiosyncratic opportunities as well. But I think for some of the triple B cohort, some of those securities are attractive and we think they'll deliver, and we think they're spread tightening potential. And we think other parts of the other parts of that market and other securities, actually represent a pretty significant amount of risk. And there's probably a lot more downside in those securities. And so hopefully, our job, and I think the job of the marketplace is to figure out which securities are going to re-mediate, which aren't, and what are the risks and what are the opportunities. And that that's hopefully that'll be a lot of fun.

Steven Purdy: And it's exciting for us as active managers, because this is a market that really, as Jerry mentioned, the dispersions increasing and that makes it a credit picker's amount market. And so, we're taking more concentrated positions to our portfolio than we have in recent history. So, we really think it allows us to capitalize on our fundamental credit research to take advantage of this dispersion in overall tight market.

Jenna Dagenhart: Going back to that conviction.

Stephen Kane: Exactly, exactly. It's... And that's why, maybe tying back to the ETF, I think investors have to be careful just buying the market, buying the index, buying an ETF where you're getting the good with the bad. We think it's... Just like we mentioned, that triple C dispersion from double Bs, well within triple Cs, we think there's going to continue to be dispersion. Same with triple Bs, so it is upon picker's market. We think it's active managers are going to be well rewarded, at least the ones that do a good job we think.

Jerry Cudzil: Yeah, I think that's a really interesting point. I think we talked a little bit about the investment banks, and their lack of balance sheet. And I think the way we like to term that is, you have a middleman who is agnostic as to where the price clears, which is they really are incented to find a source, a buyer, or seller, and source liquidity. As similar to the ETF, you have an agnostic buyer, or seller of securities. All they're responding to is flow, and really, they're just giving you exposure to a segment of the market or a part of the marketplace where the flow is coming, or where the flow is leaving. And it is not a function of price, and it is a function of the mechanics of the ETF so we actually think that will be an opportunity as you move forward, because that will magnify volatility potentially, as we see weakness in the marketplace, we do think the ETFs will be involved magnifier.

Steven Purdy: And I know I'm speaking from my own perspective here, but it's also about the role of the investment banks is interesting. It's not only as their balance sheet being curtailed, but their head count from the financial crisis down about 40%. So, it's 40% less human beings on trading floors. A lot of them were research analysts, and so you have less research analysts on the investment banking side, you have active managers under stress as assets flow to ETFs. There's just fewer people doing the credit work out there, and we think that this really collapsed the triple Cs, is really kind of a by-product of that, and so we really think that you need to be protected and do the bombs at research at this point in the cycle.

Stephen Kane: And to pile on further, to sort of be the challenges to liquidity in the market.

There's a lot more private companies issuing debt today, both in 144A and the larger market. But then, we haven't really talked about the bank loan market. When you get into the bank loan market, there's a significant portion, certainly by number of issuers, that are private companies that don't put out 10Ks and 10Qs, and the same amount of information. So, when these credits get into trouble, not only do you have the lack of Wall Street capital there to provide liquidity, you don't have information for new sponsors to come in, learn the credit, and put a value on the debt. So again, we think these things can compound in the next downturn.

Jenna Dagenhart: And we'll talk more about public markets being impacted by that in a moment. But going back to our conversation about triple Bs, I just wonder in a nutshell, would you say that this concentration is overall risk?

Steven Purdy: I think for the market overall, definitely. I think as investors that have limitations on what they can hold in certain investment portfolios, are really going to be impacted by a shift to high yield. But we think it's also a great way to pick up companies that are trading high yield, which ultimately have a path to remain as investment grade.

Jenna Dagenhart: Anything you'd like to add on that, Brian? In terms of high yield?

Brian Gelfand: Well, I think when you take a step back, and you look at the quality of the credits within the triple B space relative to those that are rated double B, these are much larger companies. They've got a lot more levers to pull. They endogenously generate free cash flow, to a much greater degree than the double B high-yield companies. So, you know, to the extent that you do see that rounded downgrades, when you're sifting through the opportunity set, looking at these newly minted high yield credits, versus the existing stock, the relative risk reward looks far more attractive, favors the investment grade company. And so that could really create a dislocation within the existing stock of double B credits.

Jerry Cudzil: Yeah, I think the analogy we would use is, probably a little bit overused, because from my standpoint... But what you do is you think about the size of the triple B market, and we've talked about it being about $3 trillion, which is a... It's larger than the bank loan market, and the high yield market combined. It literally would if you get the pace of downgrades you've seen in the past, it would be like dropping a bowling ball in a bathtub. You would literally displace a lot of this risk if a lot of these triple Bs got downgraded. Now there could be some mitigating factors, and maybe some of those credits would be higher quality, but there would be a lot of securities that need to be sold, to purchase those securities, and we do think that displacement factor might be pretty high.

Jenna Dagenhart: How do you protect yourself from that bowling ball in the bathtub?

Stephen Kane: Well, I'll hand it off this ride, by saying good credit work is your first line of defense. Is really knowing the company's backwards and forwards and picking the ones that aren't going to be part of that bowling ball, that stay out of the bathtub and the sink, go somewhere else in the bathroom. But that's really the work. And I think to Steve's credit, and his team of research analysts, that has been a huge focus of the team, is focusing what companies, as Brian alluded to have the levers, have the cashflow, and the sustainability of cash flow under stress to be able to maintain leverage. Or actually even de-leverage in a tough environment. And so, I think it really starts at the company credit level.

Steven Purdy: And I would just say, at any point in the late cycle, investors that get FOMO in there, trying to search for yield, or chase yield, they do so at a cost. And that cost is asking tough questions about covenants, asking tough questions about free cash flow. And free cash flow has been out of vogue for a while now.

Although some of the recent technology companies having some hiccups, people are starting to remind themselves that if you're not generating free cashflow, and the market won't support their business model, the music stops pretty quickly. And so, while it's not as fun not to invest, we found that being patient has allowed some really interesting opportunities that avail themselves where we can deploy capital, where we're getting paid for the risk.

Jenna Dagenhart: Given all this conversation about late cycle, what are you seeing in terms of covenants?

Jerry Cudzil: Clearly, we're seeing a loosening, or a weakening of protections, on the investor standpoint, and we think it's a real vulnerability that has presented itself in the marketplace. High yield market has largely done away with maintenance covenants, many years ago. But the bank loan market's really over the past five years, has started to lose what we call maintenance covenants. And really those are protections that we used to get the investor to the table sooner and as you look today, we think it's a real vulnerability that has presented itself in the marketplace.

Where what happened is, there's been a significant amount of competition for investors, and we'll talk a little bit about the growth of the private markets and maybe some of the capital that's flowed in. And what's happened is, there's been more demand for these loans than there has been issuance, and so that's done a couple of things. One, it's increased valuations, but the second is greater real vulnerability in the loan market from an investor standpoint. And what we've seen, is in allowance for companies to take out capital a lot faster to distribute that capital to shareholders, and even sell assets without returning those monies to the lenders, which is a real problem as we think about defaults and ultimately recoveries as we move forward through the cycle.

Steven Purdy: I mean over time, it'll come into been very key protections for investors. One, they allow you to attach your bond to a specific asset that you know is yours. But secondly, it allows you to stop a company if anything is going wrong, to make sure that you can protect the business. You know, if there's a mortgage, if a bank couldn't come in and repossess the house for three years after you stopped paying your mortgage, it might be dilapidated. So, we want to make sure as an investor, to make sure we can get to the management teams and make them take changes as a company is starting to go through a downturn.

The second aspect that's really coming on, beyond just the covenants, is there's been a lot of focus on alternate EBITDA usages, or free cashflow usages, or a number of adjustments have been proposed by management teams, that they're asking the market to look at. And in a bull market, when people are reaching for yield, they're willing to take add backs that may or may not ever come to fruition. So, even though it might say it's a four times levered company on the face of it, when you do the real work, and figure out what you think true cash it has, it might look more like five, to five and a half times, which we think is just another vulnerability for the credit markets.

Jenna Dagenhart: So what are some of the risks, and opportunities that we're seeing in leverage finance, high-yield, bank loans?

Brian Gelfand: So we've talked a little bit about the emerging dislocation in lower quality parts of the market. And our investment process naturally pulls us in the direction of dislocation, and to a degree, the point of our defensive positioning today is to enable us to get aggressive when prices dislocate and when valuation improves.

Now we've level set a little bit, but to contextualize that opportunity set, and to maybe temper some enthusiasm about it. Trailing default rates in high yield are at cyclical lows at 2%. The distress ratio, in the high yield market, which is the percent of high yield bonds that are trading wide of a thousand basis points, is mid to high single digits. It's been increasing, although in the context of a full cycle, it's still rather benign.

At the bond level, we've been tracking about 150 high yield issuers that have seen the price of their bonds drop by 10 points or more over the last year, and in many cases,  you've seen these air pockets where bonds have dropped by 50 points or more. So, beneath the surface you're starting to see a little bit of that risk aversion. That fundamental deterioration begins to manifest.

                                                            The drivers have been credit specific in nature, but they've also been thematic as well as sector wide in the case of energy. Some of these themes that we've been underwriting, include opioid litigation, impacting some of the pharmaceutical names. Balanced billing legislation impacts a subset of healthcare credits. You have regulatory headwinds within the telecommunications space, and so that's an area where we've identified some opportunities recently. One in a satellite operator that we believe has a significant value in its spectrum assets, is looking to monetize. We've been focused on the unsecured bonds of the most senior credit box within that capital structure. So, where we think the risk reward profile is the most attractive.

Among the idiosyncratic opportunities, we've invested in a retail pharmacy that we believe is misunderstood by the market. We believe there's underappreciated asset value, and we like where we create the enterprise at the current price of the bonds. Ultimately, we've been pretty selective up until this point, and that's really a byproduct that a lot of these first movers, despite the new price points, we still think they represent poor investments. The analogy we could throw around is that we're constantly looking to identify babies being thrown out with the bathwater. At the moment we're just seeing a lot of bathwater.

Jerry Cudzil: And I think what you heard from Brian there, is a lot of themes that we're constantly digesting, re-underwriting, trying to make sure we're gravitating toward that dislocation. And as a value manager, that's what we view our job as. We want to make sure that we're looking at dislocated parts of the marketplace for opportunity. We've identified a handful of organic opportunities, really micro as you've heard, but from a macro perspective, when you're staring at almost post-crisis tights on high yield spreads and investment grade spreads. Largely we view this as slim picking, so to speak, in the credit markets today.

Jenna Dagenhart: And that kind of goes back to the concentration, as we discussed.

Steven Purdy: Yeah, I think if you look at some of the parts of our portfolio, we have big concentrations in the credit side, particularly in the more risky side, they kind of fall into three buckets. One, there's a de-leveraging story that we really believe in. Two, there's some sort of asset complexity. Either we have the specific entity within a capital structure that we think represents good value, or there's something about the company where there's disparate businesses. But cumulatively they look like they have free cashflow. It's negative, but it's really just one bad business that we think we can shut down.

And the last is a business or an entity that's going through disruption. Brian had mentioned opioids before, but you look at opioids, or vaping, or quite frankly, electric cars, and EV, AV. All of these disruptions are not only impacting the equity markets, but they're also impacting the credit markets, and creditors sometimes really struggle to get their arms around these concepts, and sometimes overreact to potential liability. And so, we try to roll up our sleeves, do some real analysis about the size of potential opioid litigation, or vaping costs, and really make sure that we think we're protected and we kind of come to opportunities through that lens.

Jerry Cudzil: And I would just say lastly, as we look at the high yield market, Brian referenced it, but you know the 150 plus names, that have seen 10 plus point drops. I think what we're observing is that the pace of decline in some of these names, is increasing in a real way, and how quickly they're losing access to the capital markets, particularly this lower quality segment of the marketplace, is really informing our view as well.

And the cost of being wrong, especially in leverage finance, is very high. And so, when you're staring at dollar prices on the high yield index, very close to par, even triple Cs still in the mid to high eighties, and spreads of post-crisis tights, I think again, we ask ourselves a question, what are we being compensated? What risks we're being compensated to take? And I'd say we still think there's a lot more downside than there is upside.

Jenna Dagenhart: Yeah, protecting yourself as you mentioned. Those risks are amplified, and you also talked about your toolkit for protecting principal. What tools do you have in your toolkit to protect against your principal?

Jerry Cudzil: Well, there's a lot less today. I mean the honest answer is when you're staring at covenant packages as weak as they are, when you're looking at the buyer base, being indiscriminate. You have in the leverage loan market, you have 60% of the market owned by CLOs, the... They purchase 80% of the flow, much larger percentage of flow is purchased by CLOs. That's largely indiscriminate buyers, dedicated capital that needs to be put to work. And in the high yield market as you... As we've mentioned, you know ETFs are a bigger part of the marketplace as well, and there are indiscriminate buyers as well.

And so, as we think about competing with that, I think the what... We can only... All we can do is our organic work. All we can do is try to buy the companies with that we are fundamentally supportive of. That we think have multiple levers to pull. Maybe it's asset coverage, not going to be a situation most likely, where we have covenants in the leverage finance markets today, because they largely don't exist. But ultimately, we have to buy good businesses at this point in the cycle.

Stephen Kane: And then I would say, and maybe switching things a little bit, I think Jerry, Steve, and Brian, are answering that question with respect, to if you have to invest in corporate credit, what are the protections you can get from the macro kind of fixed income perspective.

  The other way to get protection is to, as I said earlier, under allocate to corporate credit, and look for other areas where you get much better protections, and much better risk return. And in general, we see that in the securitized area. So, whether it's CMBS, or non-agency mortgages, or certain areas of the asset back area, that's where the structure of the security can often give you significant credit enhancement. Can really afford you to get much more significant protection than you can in the unsecured, or even secured corporate bond market with a little bit of yield sacrifice. There’re no free lunches so to speak, of getting more protection, and more compensation for that, generally speaking, but the securitized market for us, when we look at broad multi-sector portfolios, is really where we see the better late cycle risk return.

Steven Purdy: The only thing I'd add to that is, obviously we're in markets that shift quickly, and we continue to tell our teams, "Do the work, do the work, do the work." Because in the fourth quarter of 2018, that risk budget quickly reversed, where a corporate credit was getting an increased allocation, given the opportunities we were seeing in the market. As credits have compressed, and spreads have compressed, that risk budget has flowed back to securitize. But we are eagerly awaiting the day when we see prices remark lower, and we can really deploy capital.

Jerry Cudzil: Well, I think that's an interesting point is when you're staring at marks, we'll talk a little about illiquidity. When you're in this environment, spreads can move very quickly. In the fourth quarter of 2018, high yield spreads moved to 150 basis points in a matter of weeks. And I think what we did was, we opened our risk budget, and we got aggressive about allocating to credit during that period of time.

And so really, we're when we reference the lack of relative value, that's really a point in time. And I think the good news about the way we're set up, is we're defensively positioned about Steve being the credit allocator. These decisions happen real time. And so, I think if we had this conversation in December of 2018, we'd be having a different conversation about opportunities in the credit markets. We were allocating in a pretty aggressive way during that period of time.

Jenna Dagenhart: Yes, certainly a very different conversation. And to hone in on bond liquidity, how are you... How is this impacting portfolios? And going back to your point about ETFs, I mean ETFs are bringing liquidity to parts of the market that aren't that liquid.

Jerry Cudzil: So I'd say the first thing is the markets are less liquid than they have been in the past. I mean, it is more difficult to transact in the marketplace. The markets are larger than they have been, and our counterparts are committing less balance sheet than they have been historically. And so, if you just think about a crowded movie theater, and you've shrunk the door, and you've added more people into the movie theater when people want to get out, it's just harder to get out.

And we've heard all different kinds of analogies about the marketplace, and the growth in the marketplace, and the lack of balance sheet. But what we would say also, is that you can't manufacture liquidity if there's an ETF. If there's liquidity in that ETF, and then you can find a buyer and a seller. Sure, there's another source of liquidity. But ultimately, when you see flows out of credit, and you see flows out of the ETF, well then there's no manufacturing of that liquidity. If there's no buyer of that ETF, and the underlying is not liquid, there's no liquidity to be created by that ETF. And that's what we mean, when we say that the ETF has the potential to be a volatility magnifier in those situations, because you just have another pocket of selling that's taking place in a market that's dealing with outflows.

Stephen Kane: Yeah, another way of putting it is an ETF, it's just a conduit to buy the underlying securities, just like a mutual fund. And so, there's not magic to an ETF having liquidity that the underlying securities do not, it's just a vehicle to get access. So, when the demand for those, that ETF dries up, the demand for the underlying securities is going to dry up, and your left in that dire situation.

Steven Purdy: And from a credit research perspective, we're just constantly, as Jerry mentioned before, we unwriting these businesses, because if a bond, a new issue comes apart, and you don't think it represents good value, is held on, because then a couple of quarters it might be trading down to 90, and at that point in time you might be find it more attractive for your portfolios. And so, the amount of communication that's required between a research team, and a trading team, and then up to the senior management, to allocate across portfolios and markets, is really critical on that active management component, at these types of markets, with this liquidity, at this part of the cycle is really important.

Brian Gelfand: And I would add, in thinking about just the growth of the ETF, and its presence in the market, this is real time in 2019, particularly in high yield, you've seen, near 30 billions of capital flow into the marketplace, and the majority of that has been through the ETFs, rather than the mutual funds. So, we've seen the impact of that indiscriminate buying take place in terms of re-pricing the high-yield market, to the extent that capital isn't sticky, and it reverses the potential impact on the way out, is what might create the next opportunity.

Jenna Dagenhart: So a lot of the acute stress is concentrated in the energy sector. Building off of that, what are, do you see any opportunities there right now?

Brian Gelfand: Yeah, so importantly, the emerging dislocation, while it has been concentrated within the energy sector, and by that, really the producers and the service providers less so than the midstream operators, yet credit stress really has begun to increase, both in frequency and sector reach. However, focused on the energy sector, we're constantly underwriting and re-underwriting the situations as they're evolving real time. You're seeing some very dramatic dislocation within those producers and service providers. The short answer is that no, we're currently observing very little opportunity to invest in energy right now.

Candidly, we actually find it a very difficult sector to invest in, particularly given the fact that you have a very volatile underlying commodity. The growth and the fracking industry have really been a feature of this cycle, and that many of the marginal producers and service providers over the last 10-years have financed themselves in the high yield market. And so many of these companies really don't have a path to free cashflow generation, and probably don't need to exist in their current form. That being said, the aversion to the sector is quite pronounced right now, and so should we continue to see selling pressure, we will step in, identify those credits that we believe have the better assets. Currently the risk reward profile, we just don't find as compelling at the moment.

Jenna Dagenhart: So you mentioned this aversion to fracking, how is ESG impacting your portfolios?

Steven Purdy: Look, I think when we underwrite businesses, we do it on a holistic basis. We look at the financial aspects from revenues and margins, and free cash flow. We look at the security level, what's your covenants? What is your security? What's the yield? But we also focus most of our time on the business, and that's complete.

So that means, what are the structure of the industry? Who are my competitors? Who is my management team? And importantly, within that are the ESG factors, the environmental, the social, and the governance factors that play a key role in that business's success. It's always been a part of our analysis. What's been really exciting, is in the last five years, the U.S. has really caught up to the rest of the world, which is way ahead of us in terms of focusing on those issues. And we're seeing the three legs of the stool really kind of coalesced, provide a lot more information.

 The first is the company side. I mean, you can now engage with companies, and get information with them about their carbon footprint, or their water usage, or their thoughtfulness around their social aspects of their workers, in a way that you can never have a dialogue a few years ago. The second aspect is policymakers. A lot of it starts in the local level here in California. You can't really get a plastic single use straw, or a single use basket, a single use bag at the shopping center. That's really happened over night, and we're seeing that bottoms up kind of ground movement push into the national discourse as well. And then the last bit is investors, both a younger generation of investors really kind of quote unquote, "Putting their money where their mouth is," and demanding more of their investors, and therefore the companies they invest in. So, where does that bring TCW? The one disappointing aspect about ESG, is we haven't coalesced around a true definition.

Everybody has a different perspective, a different definition, a different way of tracking ESG. We think it's important that anyone, when they're talking about ESG, make sure that they're doing something that's consistent with their fundamental investing principles. So, what we've done, is we've gone through all of our businesses, we've created a specific scorecard for each of them. We try to figure out which factors are the most important for a given company or sector. We think about the severity of those factors, and then ultimately whether we think there's a high probability of those playing out or not, and if those factors are not in the price, is really something that we have spent a lot of time talking about, and we'll avoid them.

A great example here, is opioids. We've been talking about opioids for a number of years, because our analysts are very concerned about the potential liability that could arise once these addictions really played out on a national level. And unfortunately, it's occurred, and it's now played through, and we're seeing the policy backlash occur now. We haven't been invested in that sector for a number of years, because that social aspect which was caught as a part of our process.

Jenna Dagenhart: And Steve, you mentioned regulation, and how it's impacting opioid investments, so I do want to talk about as we've discussed 2019, 2020, and the election that's approaching, how does that and potential policy changes in Washington impact your portfolios?

Stephen Kane: Maybe I'll start at the macro level, and let my colleagues again fill in the important details. At the macro level, so fixed income, that's how it affects our duration, our yield curve, our sector allocation. Quite honestly, there's really not much for us to do, or much information today at the very high level of a portfolio. At this point, there's not a clear picture whether there's going to be a political change in Washington 2020, nor it's even less clear what the policy implications may be. And furthermore, how that's going to impact growth and interest rates and sort of the big macro pictures. I think that is very opaque. I think, and again passing the baton here, when you get into individual industries, that might be shaped by shifts, I think there's sort of more considerations to be made there. But I would say at the broad picture, we're focused on growth, inflation, the economy, and at this point, there's not much clarity in terms of what the election will mean, not on those factors.

Jenna Dagenhart: Wait and see.

Stephen Kane: Wait and see.

Steven Purdy: You know, I would say from the fundamental credit perspective, I mean what's interesting is now, is the country bifurcated? The policies that are being proposed by two dominant parties, are very extraordinarily different. We can't think of a time where we've seen some of this radical change from current policy being discussed at such a high level. From our standpoint, we try to do a few things. The first is understand what policies are being floated in which sectors, and quite frankly individual positions that we own would be impacted by those positions, if that candidate would become the president. The second thing we talk about, is the fact that we have a long time to go here. We have to get through the primaries, and then we have to get the Democratic National Convention, then we have to have a National Election, and then once the President is in place, they have to go through the legislature.

Things can change. So, while we're aware, and constantly following the planks of each of these large, each of these prominent politicians, we also want to think about what an ultimate outcome might look like, and how policy might be watered down. And that leads us to the last point, which is in positions that you like, or excited about, where you're convinced that the business model will not be eroded or evaporated by any given policy. There's going to be a lot of volatility and noise. And what we've seen is on every election night, healthcare stocks react the next day. And so, we want to be thoughtful about the sizing of our positions, and make sure that we're taking advantage of some of the dislocations that come along with the ins and outs, and the daily news cycle that goes along with an election.

Jenna Dagenhart: Great. And going back to our discussion about the growth in private credit, as well as CLOs, I wonder how does this impact public bond markets?

Stephen Kane: Maybe I'll let Jerry handle that one.

Jerry Cudzil: Sure. Well, what I'd say, is the growth in private markets and CLOs is real. I mean, we've seen estimates of upwards of a half a trillion dollars added in private credit. I would say three to five years ago, really wasn't even a segment of the marketplace. It was created... There was distress credit, and there were maybe... There were BDCs, and now there's private credit, as a function of a or its own sub-segment of the marketplace. But from our standpoint, what it means, is it just means further distortion of valuations, and it means that there's more competition for credit. And, so ultimately, it means two things. One is, you push valuations tighter. And so, what we've seen from a private credit standpoint, is crowding out some of the other investors, and that they're lending at tighter and tighter spreads, because of this dedicated capital.

And the second is, you're losing some of those protections. We've talked about it a lot, but I think you can't say it enough that the lack of covenant protection or the removal of some of the protections that we used to have, it's hard to argue that's not a function of some of this new capital that's pushed into the marketplace, and we think that's creating a real vulnerability in the marketplace. And so, when you think about the growth, I'd say that's private credit. When you look at CLOs, that's its own opportunity, and risk at the same time. And you've added... So now we've talked about how the low market is owned 50 to 60% by CLOs, but they're buying about 80% of the newly issued loans in the marketplace. To the extent that a loan is not fit into a CLO, there's a significant dislocation in that price.

And so, we like to talk about this a lot, because I think it's worth spending time on. It's worth the market. Understanding this, the low market has seen significant growth. More so than even the high yield market. The loan market is just as big as the high yield market now. A big portion of why that has grown is because of the CLO. So, you have a loan market that's $1.3 trillion, and as Steve mentioned, a lot of those issues are private. It's really hard to get information on these issuers. So, what happens is, if the CLOs are no longer a buyer of that security, you can see a dramatic fall in the price of that security. There's not a lot of information. There's a lack of transparency, and there's a lack of liquidity that follows through on the other side of that.

Steven Purdy: And this is an obvious point, but because there are private markets, there's no signal. I mean, if you think of the end of the dot-com era, all these companies had gone public in a very short period of time their stock prices collapsed, and people became unemployed.

In the private markets being so large, we just don't know. We don't know if these companies are performing well, or not well, we don't know if they're hiring people, or laying off people. It's a lot more difficult to figure out what is happening at the end of the credit cycle, and we think it just could be a more abrupt ending, because you don't know until the whole company goes under, as opposed to seeing bond prices we can track every single day. And that will probably have an impact, as we get to the end of the credit cycle.

Brian Gelfand: I also think importantly, that these private credit markets, the leverage loan market, and the high yield market, they're not really siloed. A lot of the issuers within the loan market, are also issuers within the high yield market. And so, if you think that there's some vulnerability, do the excess, create in the loan market, there is a transmission mechanism toward to the other parts of the credit markets, specifically high yield as well.

Jerry Cudzil: Yeah. One of the ways you used to say you get defensive, is you move up in the capital structure, and you buy bank loans. And you get covenants, and you get a floating rate product, and you push up higher in the capital structure, and really what's happened is, the bank loan market. Yes, there's overlap with the high yield market about 50%, but then there's another cohort which is 50% of loan only issuers. And I think what we've observed, is a real significant abrupt decline in price in those issuers when their earnings change, and when their earnings decline. And then what we would say is, there's a real potential vulnerability presenting itself. When you look at the loan market, and the high yield market, there's a higher percentage of the loan market that trades at distress valuations in the high-yield market today.

And you wouldn't think that's the case, if in fact you're talking about a higher quality cohort of the leverage finance market. And so, I think what we've observed, is that there's been a weakening of credit quality across the leverage finance markets, and maybe even a more pronounced weakening of credit quality in the loan market.

Jenna Dagenhart: Given some of these risks that we've discussed, where are you putting your money to work?

Jerry Cudzil: Well, we are seeing a few areas of opportunity to say, one is at the micro level, and that's really kind of agnostic to sector. But there are some companies that have dislocated, maybe they were too aggressive with their balance sheet, or they levered up for merger and acquisition, or maybe even a dividend. But we're confident that they have the ability to organically deliver. And there are a few of those situations in consumer non-cyclical space, maybe in food and beverage, maybe in healthcare as well. And certainly, in the pharmaceutical industry that we think are prime candidates for that.

And second, is from a sector standpoint, I think we definitely have identified opportunity from a sector. I think Steve mentioned some of the areas that healthcare, some of those in the the opioid space we think are too risky, and we don't think are attractive. And actually, we can't get our arms around some of that. And there are others where other parts of the healthcare space, that we do think are attractive, that we do think are, have widened because of some of the concerns over policy standpoint, and I think we are putting our money to work. And to kind of put it all together, Steve mentioned some of the volatility, and some of the pricing.

What we do is, as a value investor, we always dollar cost average into our positions, and so what we have begun to do, is dollar cost average interest that we like, recognizing that this could take a long period of time to play out, and we could have 6, 12, 18 months of volatility, where we're going to be able to add to our positions over time.

Stephen Kane: And then I would say away from the corporate sector, we're actually seeing what I would describe, as pretty decent risk adjusted opportunities and securitized as I mentioned earlier, and I'll just tick through them real quick. Agency, mortgage backed securities have, in the case of Ginnie Mae and explicit government guarantee, Fannie and Freddie are implied backing by the government, but with recent interest rate volatility, and an increase in supply agency mortgages, we've seen spreads widen out to the widest they've been in some three or four years. And so, we're increasing our allocations there. We're seeing some attractive opportunities in non-agency mortgages. Mostly legacy paper from the last cycle, is still credit curing and still provides good total return and opportunity.

And another one I bring up, just because it provides an interesting contrast between the loan market and the securitized market, is we actually like the Triple A rated liabilities issued off of CLOs. So, we're very cautious on bank loans. The collateral in the CLO, and we wouldn't really buy down the capital structure, but the triple A's have high 30% credit enhancement, which if you figure a 30% loss on default, you can have over 90% losses in the underlying loan pool, and still have enough credit protection to protect your principal, and the triple A rated tranches, and you're getting libel, plus 130 to 150, in that area. So that's where the underwriting in the securitized market leads to the senior tranches is still very good, even though the underlying collateral might be a little dicey.

Jenna Dagenhart: So more safety in some of those senior tranches.

Stephen Kane: That's right.

Jenna Dagenhart: Well, gentlemen, thank you so much for joining me.

Jerry Cudzil: Thank you.

Brian Gelfand: Thank you.

Steven Purdy: Thanks.

Stephen Kane: Thanks a lot.

Jenna Dagenhart: And thank you, for watching this exclusive TCW Masterclass. I was joined by Steven Kane, Fixed Income Portfolio Manager. Jerry Cudzil, Head of Credit Trading, Steven Purdy, Head of Credit Research, and Brian Gelfand, Senior Credit Trader. From the TCW headquarters in Los Angeles, I'm Jenna Dagenhart with Asset TV.