Masterclass: Fixed Income

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  • 58 mins 10 secs
The fixed income market has been in a state of low and/or declining interest rates for over a decade now, despite some short-term rises.
Two experts discuss strategies for finding income in the current environment, evaluate the riskiness of these investments, and look at how interest rates, inflation, and other factors are impacting the asset class.
  • Chet Paipanandiker, Managing Director, Fixed Income Portfolio Manager / Analyst - Barrow Hanley
  • Scott Mensi, Institutional Portfolio Manager - Fidelity Investments
Channel: MASTERCLASS

Jenna Dagenhart: Welcome to Asset TVs at Fixed Income Masterclass. Joining us now to look at how inflation and other factors are impacting the asset class, why a golden age of credit could be upon us and how to use different strategies and vehicles to find income in the low-rate environment, we have Scott Mensi, Institutional Portfolio Manager at Fidelity Investments, and Chet Pai, Managing Director, Portfolio Manager, and Analyst at Barrow Hanley. Well, great to have you both with us. And Chet, starting with you, loans are floating rate instruments settle sea, coupons expand as risk free rates rise. How is the retail demand for leverage loans impacting the loan market?

Chet Paipanandiker: Well, there's a pretty strong correlation between the 10 year and yields, as well as inflows into retail loan product. And so, if you go back in time and go back to the 2014 timeframe or 2018 timeframe, similar to today, effectively when yields started to rise, and you take a look at what retail loan inflows were actually doing, basically prime funds were taking in at their peak, probably in the 2014 timeframe, about 175 billion of total assets. You fast forward from there to about 2018, same thing was happening. Prime funds were probably close to about 185 billion or so of total assets.

Chet Paipanandiker: Then compare that to today, you're starting to see obviously talk of inflation, the 10-year starting to rise. And you're actually seeing prime funds at about 135 billion or so of assets. And that actually doesn't include ETFs, which are, if you take the top three or so, probably around 13 billion. So if you sum that up relative to your overall loan market, which you'll see is you're probably at about 12 [inaudible 00:01:52] of the loan market, 15% in 2018 and then today, maybe about 10%. And so I point this all out to just say from a technical perspective, for the loan market, I mean, there's definitely potential for tailwind there in terms of that retail bid as the 10 years starts to go higher.

Jenna Dagenhart: Scott, starting big picture here, where does fixed income fit into a portfolio?

Scott Mensi: So I think broadly when you think about fixed income, there's really two components to it. There's the capital preservation component, which is traditionally, treasuries, investment-grade bonds. They offset some of the risks that people might be taking in an equity portfolio. I think when we think about other parts of fixed income, where if you think about where we are today and rates that people should be thinking about are things like floating rate loans, high yield bonds, they've got higher coupons, a little bit lower duration. They can help mitigate some of the risks to get in a broader fixed income portfolio with maybe not adding as much risk as adding equity.

Scott Mensi: So these are diversifiers when I look at correlations to other asset classes like investment-grade bonds, treasuries, even equities, you're getting some diversification benefits by investing in whether it's high yield bonds or leverage loans. So they are income producing, they enhance yield, they lower duration. They also offer diversification benefits in a broader portfolio.

Jenna Dagenhart: And Chet, LIBOR is going away. How are you thinking about the change in LIBOR to an alternative rate and its impact on the loan and CLO markets?

Chet Paipanandiker: Yeah. So, I mean, basically taking a step back and thinking about what precipitated this with LIBOR, there was concern of course in the past that LIBOR itself was a manipulated rate, potentially, of course it was fixed by the banks. So the idea was to transition over from LIBOR to some other market determined rate. And so far, most of the commentary has been around SOFR, which is the Secured Overnight Financing Rate, basically based off of treasury repo. And so a little bit about timing, about how this could potentially work and play out.

Chet Paipanandiker: Basically, by the end of this year and actually starting into 2022, any new loans or any new CLOs are going to have to basically reference that new alternative rate. Again, it's most likely going to be so for avoidance of doubt, I think through June of 2023, you're still going to have publishing’s of one month and three month LIBOR for all those loans that were issued prior to 2022. Now, if we take the market separately, think about the loan universe and then separately, the CLO universe, the two are quite tied together. For the loan universe, credit agreements had been referencing some form of fallback language for quite a while now.

Chet Paipanandiker: And that documentation has become a little bit more robust over time. So much so even now, as you see new issue under the market, something like 90% of new loans are coming out with some of the best practices from a fallback language perspective. Now, as it relates to the CLO market, of course, what we care about there is that simply the underlying loans effectively match what is within the CLOs. So as the loans go inside of the CLO portfolio, we just want to make sure that CLOs actually match that underlying reference rate.

Chet Paipanandiker: And so the way CLOs had been documented in the past and this year, we had a very good refi reset year this year for CLOs. That language basically says you've got a threshold as soon as all of the loans and the portfolio, I should say, as soon as 50% of the loans in the portfolio reference that new rate, then the CLO trips over onto that rate. So, our expectation going forward is, is that as long as this transition occurs relatively quickly, that that mismatch potential between rates and CLOs and rates and the underlying loans won't become any sort of an issue.

Chet Paipanandiker: And if you think about where banks sit in this whole process, banks don't want to have to deal with the amendment process loan by loan. The expectation is that there's going to be a push as you head into 2022, that a lot of the underlying corporate loans are going to simply refinance out straight into SOFR versus waiting for some type of fallback. So, we think ultimately this process will work relatively smoothly.

Jenna Dagenhart: The fixed income market has been in a state of low and/or declining interest rates for over a decade now despite some short term rises. At the end of August, a decade ago, the 10-year treasury yield was around 2.2% low, of course compared to long-term history. Then 10 years later, that yield is even lower today at under 1.5%. Scott, how can yield starved investors survive in this kind of market? What options do they have?

Scott Mensi: Well, I think those are good points and as demographics change, there's always going to be a demand for yield I think going into the future. And I think the options that folks have really depend on how much risk they're willing to take and go out on the risk spectrum, because with increase in yield, there's always going to be some risk that you're taking on. In the investment-grade world that can mean going longer duration, but in the non-investment grade world like high yield leverage loans, that means taking on some element of credit risk.

Scott Mensi: So getting comfortable with the fact that there is credit risk in some of these asset classes, which means a little bit more volatility relative to an investment-grade portfolio, you can go out there and get around 4% from a high yield bond portfolio or leverage loans. Emerging market debt is another one where you can also find some opportunities, but again, there maybe you take on a little bit more duration risk. So, I think it really depends on what risks investors are willing to take.

Scott Mensi: There's also the option of going into things like private lending, small and mid-market loans, things like that where you really have to have a long-term view and be able to deal with liquidity that becomes another risk as well. So, when you think about what options folks have, they really have to understand what the risks of the different options are, whether it's duration, credit risk, liquidity risk. And from there, you can fine tune to where exactly you want to be.

Scott Mensi: Now, you can either have a standalone strategy, which you have just high yield bonds or leverage loans. There are some portfolios that you can mix the two together. And then there's even more opportunistic portfolios that you can potentially mix in some of those other things, like stressed and distressed credits, middle market and small market loans where liquidity becomes the bigger risk in terms of not being able to maybe access your money immediately, but certainly if you have a long-term root view, can get that enhanced yield over time.

Chet Paipanandiker: I think that makes a lot of sense, Scott. And I think it's interesting, if you look back in time, I think you go back 40 years and you take a look at sovereign returns, I think if you look back on a five-year rolling return basis, basically you've got negative real returns after inflation in a number of sovereigns. And so, it wasn't enough that you got the call right to be in risk free paper and that you didn't get hurt by rising yields. I think that what you actually ended up getting hurt by was inflation. And so, I think that's right. I mean, basically from the standpoint of how you combat that for carry is with spread.

Chet Paipanandiker: And Scott covered a lot of those items. I mean, whether it's leverage loans or high yield bonds. One I would add to that, that I think is quite compelling actually, and there's now more retail product out there to address, it is effectively CLO tranches. Basically, tranched out liabilities that pretty much referenced the underlying leverage loan market, which is a 1.3 trillion-dollar market. And remember that CLOs are effectively about 63% of the loan universe. So, it's a pretty healthy representation of the loan market.

Scott Mensi: Chet, reports about the risks in the loan market grab headlines. Are credit agreement documents that govern individual corporate loans in worse shape now in terms of permissiveness than they were in 2019?

Chet Paipanandiker: Well, I think first things first, I think what I would want to say is that, look, when we take a look at credit and when anyone takes a look at credit, we think that it's important to underwrite credit for cashflow and Porter's Five Forces. What it comes down to is you want to make sure that the company is in a good position and has the ability to cash flow appropriately to service their obligations, to pay for their maintenance cap backs at a minimum. But that said, thinking about the market from the standpoint of covenants, whether that's bond indentures or loan credit agreements, want to back up a second, just talk about how the market has progressed over time.

Chet Paipanandiker: First of all, bonds have something called incurrence tests or incurrence covenants, I should say. Similar to loans. Loans also have incurrence tests as well. Loans in the past actually had maintenance covenants too. Now tackling them one by one, for incurrence tests, basically what that is, is a company gets tested to determine whether or not they want to take an action. So, they have to pass the test to take an action. With regards to maintenance covenants, that's something that's tested in the past on a quarterly basis. And for that, it's not a matter of incurrence and it's not a matter of doing an action. It's just a matter of getting tested quarterly.

Chet Paipanandiker: Well, maintenance covenants over time have generally fallen away, but I oftentimes get the question if covenant light means there are no covenants whatsoever, and that's simply not the case. Across bonds and loans, you still have incurrence tests. Now, one thing I want to point out, in terms of how covenants have progressed over time, basically the market will ebb and flow with supply and demand. While you have seen maintenance covenants fall away, you have seen incurrence covenants still remain in capital structures, in credit agreements, in bond and dentures.

Chet Paipanandiker: And the important point is, is as that supply and demand ebbs and flows, you'll see some variation in what sponsors can put into documents. So, for example, there are times when particular provisions are taken away. At times like in today's market, for example, I'm seeing plenty of opportunities where some of those provisions have been put back and those protections have been put in place. And so that's a moving ebb and flow in the market.

Scott Mensi: Yeah. Chet, those are great points. And I think when we think about investing in leverage loans and covenant protection and indentures, I think the ultimate risk factor for us is really the fundamental trajectory of the business. So, what we typically say to investors, if we're relying on covenants and indentures to protect us in the case of a business falling apart, meaning the fundamental slowdown and the company goes into distress, we're not doing our jobs right. You really need to be focused on the underlying fundamental trajectory of a business when you're investing in whether it's high yield bonds or leverage loans.

Scott Mensi: Given the evolution of the market that Chet alluded to before, in terms of the growth, these markets are becoming very similar in terms of some of the investors that you see in there. And I would say because of that, you're starting to see leverage loan agreements look a little bit more like high yield bond agreements. And I think for us, it's just a matter of really understanding what the fundamental trajectory of that business is. And that is really the best risk mitigator when it comes to the weaker documentation you've seen over the last few years.

Chet Paipanandiker: Yeah. I think that's exactly right. And I think one thing I try and point out to people, looking back in the past example I gave is think back to the 2014, 2015 timeframe, think about an oil prices fell apart. I mean, you could have had a full slate of covenants and that wouldn't have necessarily saved you from the fundamental degradation that occurs in the business. In that case, you cared about cashflow and asset value.

Chet Paipanandiker: And so I think what I'd point out is you still, ultimately, you have to underwrite the credit. The rest are generally nice to have. Certainly, with the maintenance covenants, we certainly take a close look at the incurrence covenants to make sure that we're comfortable with the risks that we're taking.

Jenna Dagenhart: I love that you brought up Michael Porter's Five Forces, Chet. Always a good masterclass when that comes up. No, Scott, a lot of investors, particularly those looking for income and who are more risk averse, maybe scared off when they hear high yield bonds. Isn't that the same thing as junk bonds? Is this asset class too risky?

Scott Mensi: So, yeah, they are the same thing. So, anybody, a high yield bonds or a junk bonds reference the same thing. And what that really means is bonds that are rated below triple B. So double B, single B, and triple C and below, that's what's classified as high yield. So, the reason why we see high yield bonds, there's a couple reasons. One, there are some companies that might fall on hard times and get the rating agencies will downgrade them as a result of maybe higher than expected leverage or business fundamentals deteriorating. There might be a situation where you have a company that just stays in the high yield universe. Meaning they use debt for financing purposes and to grow their businesses.

Scott Mensi: There will also be situations where companies might be bought out or financed through debt. Those things are called LBOs. And those leverage buyouts, typically, you're putting a lot of leverage on a business with the hopes of it improving and paying down that leverage, but ultimately, that comes with a high yield bond rating. So, is it too risky? I think it really all depends on what the risk appetite of the investor is. In the high yield market, the average, when we think about the worst-case scenario, it's default. The average default rate is a little less than 5%. It's certainly lower than that in the loan market, given they're more senior in the capital structure.

Scott Mensi: So understanding that there's a possibility that you could see about 5% of your portfolio over a full cycle potentially default, is something that investors have to understand, but ultimately, you can have some of these situations when it comes to risk, can result in great opportunities. So, it's a matter, like I said always before, it's a matter of balancing your risk appetite with the type of investments that you're making. So, in today's environment, I would say, from a default rate perspective, distress is very low in terms of the amount of bonds and loans that are trading at the stress levels. Default rate outlook is pretty good, just given all the liquidity we've seen.

Scott Mensi: And Chet mentioned refinancing activity that we have seen are already in the loan market. We've seen the same thing in the high yield market. So, there's not much in terms of maturities due over the next two years, and that creates a pretty good liquidity runway for our issuers and the companies that we're looking at on a day-to-day basis. So, when we think about what the ultimate risk is, when we think about high yield bonds and anything that's below investment grade, it's default risk. And for the near to medium term, we tend to think that risk is relatively low, just given the fact of all those factors I mentioned earlier.

Scott Mensi: So maybe the yields reflect that with yields that are a little bit tighter than the long-term average. Certainly, in the high yield bond market and maybe slightly lower in the loan market, we still think that's fair in the fact that it's reflecting this strong fundamental backdrop for much of the market that we see today.

Chet Paipanandiker: I think that's absolutely right. I mean, expected default rates are going to be low. And from a fundamental perspective, the high yield universe is actually looking relatively clean in terms of balance sheets. And Scott had mentioned runway as well as liquidity coming off of COVID, a lot of companies had puffed up their ability to get liquidity. And I think there are a couple of other interesting points to note.

Chet Paipanandiker: Now, I'm not going to claim that in any way I focus solely on the ratings agencies, but if you were to just simply look at it from the standpoint of ratings and go back to the 2000 timeframe, and then fast forward to generally today, what you'll find is, is for all those credits that are rated double B or split double B, basically just a shade below investment grade, the upper end effectively of the high yield universe, you're probably about 30% of the market back then. Today you're closing in on something like 57, almost 60% of the market.

Chet Paipanandiker: So if we were to simply use the ratings agencies as a proxy, you can get to a pretty happy place in terms of the quality level of the overall high yield universe. The other thing worth noting is for a lot of the fallen angels that you saw post COVID, those are companies that have a lot of levers that they can pull from a cash flow perspective. From a burn perspective, I mean, they have capital structures with coupons that are a lot lower because they're PBC investment grade. And with those extra levers, perhaps dividends that could be cut, that they could use to focus on paying down debt, you can get an acceleration of de-levering as they try and move back up into investment grade status. So, we think that's another potential positive.

Chet Paipanandiker: And then finally, just looking at it purely from the standpoint of growth of debt, just a generalization, but if you take a look at the investment grade market, take a look at high yield as well as leverage loans, you've got an interesting dynamic that's played out with regards to lows in gross leverage to call it today's levels. And which you'll see is interestingly, the investment grade universe is actually raised leverage by about 80% or so. A highly universe only about 30, 35%, the loan universe about 60, 65%. So on a relative basis, you can see that if anything, probably investment grade is taken on a little bit more risk throughout COVID.

Scott Mensi: And here's a good point on the investment grade world. And I think folks have to understand too, as the leverage has gone up, the yields have gone down, and the duration has been extended. So now when we think about that relationship and typically between yield and duration, you're stretched in the investment grade bond market. And not that interest rates tend to drive performance necessarily in the high yield universe or the leverage loan market correlations to tenured treasuries, to both of those asset classes are negative, but I think ultimately, you have to take into account where we are from a rate perspective today.

Scott Mensi: And that mismatch between duration and income leaves, I think investment grade investors a little bit exposed. So in order to do maybe offset some of duration risk, it might make sense to look at things like floating rate bond or loans where you have no duration and a 4% income and high yield bonds where you have a much lower duration around 4% and a 4% yield. So, you're matching that yield and duration in a way that you can't do in the investment grade world and with rates so low and the talks of potentially seeing rates move higher. Those investors that are just in investment grade bonds or treasuries are somewhat exposed to a duration risk today.

Scott Mensi: And that's something we haven't really heard about in terms of risks. That's usually we focus on the downside from defaults, but I think today just given where things are trading, you have to think about what will happen to my bond portfolio if we do see a small uptick in rates. And you've seen this year with returns on the investment grade world being slightly negative while high yield and loans are up mid-single digits. And I think that's a function of those factors I just mentioned.

Chet Paipanandiker: And Scott, I think you mentioned this before, but duration in IG at eight years, roughly half that now in high yield, even if you dip down from IG down into say double B, which will probably be some of the longer debt out there, include some of the fallen angels, there's still a shade below five years. So to your point, you can pick up some extra spread, but markedly reduce that duration risk. And of course, that's not even including going into single B credit, given those good balance sheets that we're talking about and good credit metrics, we can cover more about that, but you're basically you're benefiting, you picking up carry without taking that interest rate risk.

Jenna Dagenhart: Yeah. Chet, how would you sum up your view of the current quality of the loan market in terms of credit risk?

Chet Paipanandiker: Yeah. I mean, I think coming off of COVID, some interesting things have happened here. EBITDA growth has been great. EBITDA margins have been great, and this is specific to the loan universe. If you think about what happened, we entered an environment that no one really thought was going to happen. We had basically zero in revenues. Companies went through a phase of cost cutting. And what I'm seeing just anecdotally in some companies now is as revenue comes back, management teams are finding a way to effectively do success-based cost and currents. What that means is revenue comes in the door, then they incur the cost. It's not done proactively.

Chet Paipanandiker: And so I think that's really helping EBITDA margins out quite a bit, but then fundamentally, just taking a look at the loan space, if you look at those public filers that are out there and just look at enterprise values, think about that cushion that sits below the leverage loan, which is senior secured nature of course, that couldn't also include a cushion of unsecured bonds, basically those enterprise values have risen materially heading into the fourth quarter of 2020 and into 2021 as well. And then a slight proxy for that. If you were to take a look at something like say the credit fees, leverage equity index, and take a look at market cap per issuer, what you'll see is over time, effectively the same things happen.

Chet Paipanandiker: Market cap per issuer has generally risen. So you're getting a better cushion behind loans. So that's been a definite positive for the loan market. There's a couple of other factors I think are equally surprising. Basically stats around short-term debt. If you look at short-term debt as a percentage of total debt, we're at record lows right now. Roughly at about 3%. And I say record, going back about a decade effectively. And then if you take a look at the metric in terms of cash relative to short-term debt, basically measures of liquidity, we're at about 300%. Same concept. Go back 10 years, those are stats that are extremely positive for the loan universe.

Chet Paipanandiker: But then take a step back, I mentioned the ratings agencies. Again, we don't necessarily look at credit purely from the standpoint of ratings. You do have to keep in mind though the large part of the loan market is controlled by CLOs, about 63% or so of the market. And they are to some degree ratings driven. But if you take a look at the loan universe, what you're going to find is we've been in this pretty large upgrade wave that's been lasting for a while now. And as that credit quality improves, companies have the ability to basically up tier from a coupon perspective, reduce some of that fixed cost if there's.

Scott Mensi: And Chet, you made a mention a couple key points that I think are worth maybe expanding on a little bit. You talked about the credits with leverage equity index. And if you look through the names in that index today versus the names, let's say 10 years ago, there's a lot more household names. So, when we think about credit quality, we can talk about ratings, but I think if you think about the underlying businesses themselves, 10, 15 years ago, if a company from the high yield universe or the loan market defaulted, they might be the fourth or fifth player in a specific industry.

Scott Mensi: Today we've got some well-known names in these industries and in these markets. So within the high yield market, you have a brand like Kraft Heinz, T-Mobile, Charter Communications. In the loan market, you have some of the same names there as well. So these are companies that are big, that have, in some instances, global reach, very viable businesses. So I think when you look at the overall quality of both the high yield loan markets, if you take a step and look the quality of just the underlying businesses themselves, the types of companies, it's certainly improved over time.

Jenna Dagenhart: And Scott, for investors looking to add some high yield to their portfolios, what's the best option here, individual bonds, ETFs, or mutual funds?

Scott Mensi: So I think for most investors, individual bonds is really out of the picture. Definitely for the loan market, in the high yield market, there are some that are publicly traded that individuals can get access to, but because these markets are more over the counter traded and there's very few, if any really exchanges for them, the bid-ask spreads that individual investors will pay to get access to those bonds, makes it very costly to transact in those environment, or in that type of environment. So we recommend folks looking for a co-mingled pool or some sort of vehicle.

Scott Mensi: Now, if we talk about ETFs versus mutual funds, what I would say is, in particularly when we talk about ETFs, so I'll reference passive really more so than mutual funds. So, passive versus active. I think in the passive world, what we've seen is that because this is an over the counter asset class, what happens particularly in environments like this, where we see lots of new issuance and we see spreads tighten in very quickly, passive investors are forced to buy a lot of higher dollar priced loans and high yield bonds, whereas mutual fund or what's called the, not necessarily mutual fund, but active portfolios can be a little bit more selective in managing what they're going to purchase and don't have to buy everything.

Scott Mensi: And what we've really seen that happen this year in terms of the impact of having to buy into a very quick and rising market, in that a lot of those passive options have underperformed even the average for some of the active market. And I think part of the reason too, is ETFs tend to be in passive vehicles, tend to be more trading vehicles in terms of folks looking for short term exposure. So, you start to see a lot of trades and flows coming in and out of ETFs and passive vehicles. And what we've seen is you generally see three times the amount of flows coming into and out of a passive vehicle. And what that means is that vehicle has to go to the market three times that of a, what I'll call the active market. So, the mutual fund universe.

Scott Mensi: So just on transactions alone, whether it was a passive or an active strategy, if you're going out three times more to the market, that's three times more bid-ask spreads that you're going to have to pay. So, our view is that the best way to invest in whether it's high yield, leverage loans or plus sectors, generally speaking, is to use some sort of active vehicle where you can have managers who understand the universe, who understand the day-to-day function of the market and can manage liquidity in a way where they're not forced to sell things or forced to buy things.

Chet Paipanandiker: Yeah, I think that's absolutely right. I mean, I would reiterate that point about active versus passive. I think the evidence would show, and this has been an ongoing fact, that active management and fixed income, to some degree actually, you're not seeing the same evidence with equities, but in fixed income, whether it's high yield bonds or leveraged loans, active management does work. I mean, you think about the way some of these passive indices are created, oftentimes it's as arbitrary as how large is the tranche.

Chet Paipanandiker: And usually that's pretty much a proxy for liquidity, but you're inadvertently taking onto the risks, perhaps it's excessive leverage in that particular name, or perhaps you're concentrating a portfolio in a passive index of LBOs. And that may not be what you intent. In terms of other vehicles, I think are interesting to consider, and its true really across fixed income, is closed-end funds. That could be one other type of vehicle that would be interesting to retail investors.

Chet Paipanandiker: Closed-end funds are basically fixed pools of capital where the shares actually trade based upon supply and demand. And so, as a result, they can trade at a premium or a discount to nav. And so, I think that could also be interesting. You can oftentimes find, based upon changes in sentiment across the asset classes, some of these closed-end funds trading at discounts. And that can augment the yield that you're getting on the underlying portfolio. It can also help out with liquidity.

Jenna Dagenhart: Chet, any other thoughts around the types of investments and loans that you would recommend for investors?

Chet Paipanandiker: Well, I think it largely rhymes with what we talked about for high yield conceptually. I think the thought of staying in an actively managed fund matters. As I think back to some of the passive funds in the past on the bank loan side, I remember a couple of names, in particular, iHeartMedia and Toys“R”Us, which were actually in some of the larger passive indices that we use in some of the ETFs. And that was unfortunate, of course, some of those larger names. LBOs actually headed into bankruptcy. And any amount of active management could have probably pulled this out of the portfolio and optimized that.

Chet Paipanandiker: I think that the same thing is true, as I mentioned before in closed-end funds. I'd been interested in vehicle to consider. The other thing I would suggest, and it's rather new, in terms of opportunities on the retail side, is also a CLO tranches. We talked about that before, effectively as if you want to call it a derivative or a proxy to the corporate loan market. Interestingly, for the ratings there, you're actually getting potentially outsized yield.

Chet Paipanandiker: And as Scott had mentioned, sometimes, these funds could even be used as a trading vehicle. There are times with CLO tranches, depending upon sentiment in the market, that you can also use them to that effect. But generally, because of the floating rate nature of these products, whether it's loans or CLO tranches, and because of the availability to retail investors, they can make sense from an inflation hedge perspective.

Jenna Dagenhart: Inflation came up at the beginning of the program, and I want to spend a little bit of time there because inflation certainly seems to be alive and well. Scott, if inflation persists, what asset classes in your universe tend to perform well?

Scott Mensi: Sure. So I think when we think about inflation persisting and it really depends on what type of environment are we in. What's causing the inflation. And I think normally what we see is inflation is the result of economic growth. And in that type of scenario, things that are sensitive to the underlying economy tend to do well. So what does that mean in fixed income? That means things like floating rate bond, or floating rate loans, high yield bonds and corporate credit, generally speaking, since as I mentioned before, these companies are sensitive than the underline economy have leveraged.

Scott Mensi: If the economy is improving and inflation is rising steadily versus it's spiking, this can be really good environments for those two asset classes. In fact, when I look at things like high yield bonds, the kind of optimal environment is a slightly rising inflationary period where costs go up slowly, companies can adjust their business models and they can still pay down debt. So, it really depends on what is driving inflation and what's going on. I think when we really looked at the numbers and you think about what asset classes historically have done well in rising rate environments, not surprisingly floating rate loans show up there, one, because you've got the strength in the economy if people get past periods of when inflation is going up until you have that floating rate component.

Scott Mensi: So that gives you very limited duration exposure. So as rates rise, your income will rise with that as the base rate, whether it's LIBOR or SOFR going up or SOFR moving forward goes up. I think high yield bonds historically have done fairly well in inflationary periods, but I think today, when you look at where some of the valuations are on certain segments of the market, particularly the higher quality segment, where average dollar prices are approaching 108, 109, that's a situation where maybe you don't have as much red cushion as you might've had historically.

Scott Mensi: I think you still do better than traditional investment grade bonds. But I think if inflation persists in a market like we're seeing today, with the economy continuing doing pretty well, I would think this is a time where loans probably are going to do pretty well just given the fact that you're basically taking a straight credit risk position in that asset class since there's no duration. And you're just betting on the fact that you think the economy will improve and these companies will continue to improve and can pay down their debt, or at least service their debt over the medium to long-term.

Chet Paipanandiker: Yeah. I would definitely echo what Scott said. Certainly, from an asset class perspective, leveraged loans and anecdotally as we, and then actually CLO tranches as well too. And then after that, if high yield bonds, we talked about some of the concentrations in double B and what that could mean from a fixed rate perspective, if rates were to rise. But just anecdotally, thinking about some of the names that have reported to you recently as we look at 2021, coming off of COVID, it has been interesting.

Chet Paipanandiker: You have seen prices rise for raw materials. You're already seeing it flow through, of course, for freight. That's a big one across a lot of these companies that are selling particularly goods. And what we're seeing is, is price increases are going through, to Scott's point, companies are experiencing pricing power. And so we're seeing that flow through to EBITDA margins as well.

Jenna Dagenhart: And Scott, okay, what if inflation does wind up being transitory, how do investors prepare for uncertainty?

Scott Mensi: Well, I think today when you look at the asset classes we're talking about, loans, CLOs, and high yield bonds, if inflation does in fact wind up being transitory and we don't see rates going up, ultimately what will happen there is I think you continue to see the economy, it probably means the economy is, I don't want to say slowing down, but maybe not accelerating as fast as we'd thought. As long as we don't see the economy decelerating, that's where things start to get risky and a little bit more uncertainty starts to come into play when it comes to loans and high yield bonds.

Scott Mensi: If we can have a benign inflationary period with the economy continue to doing okay, maybe not expanding as fast as we've seen over the last year, year and a half, but still in positive territory, that shouldn't be okay for the underlying companies that we're investing in. I think, so when we think about inflation, and if it doesn't happen, I think the companies today are pretty well set up. Chet has mentioned a number of statistics about margins, short-term debt.

Scott Mensi: I think another one is when we think about the high yield market and what rates have done over the last decade or so, the cost of debt services at all-time lows. So, we are set up for a good run here for the fundamental trajectory of these companies over that medium term period, whether or not inflation increases, or we stay flat. I think the big risk when we talk about these asset classes, anything that's non-investment grade is always going to be default risk. As long as we're not seeing a material slowdown in the underlying economy, that's a positive environment for these asset classes.

Chet Paipanandiker: Yeah. I think Scott's exactly right. I mean, you go into the back half of this year, I suppose you might have some growth concerns, but we'll see coming off the first half of this year. But yeah, I mean, when you look at what happened with COVID and you think about the industries that got hurt, you effectively went through a mini credit cycle. We saw energy effectively fall apart when demand of course fell almost completely off. You saw the same thing pretty much happened with retail as well with bricks and mortar.

Chet Paipanandiker: And so what you effectively had happened is you wiped clean some of those names that were some of the weakest. And this is a theme that is true across loans and high yield bonds as you go back in time, called over the past 20 years. While it's true that you have macro events and you have things like the financial crisis, or you have the Asian bond crisis in the late '90s, and it's true that generally affects everything in the market, you also have many cycles. You might have telecom, you might have the airlines, you might have autos that are basically experiencing stress and distress away from a larger macro cycle.

Chet Paipanandiker: And so we effectively experienced that here recently, the same way that energy did back in 2014, 2015. And so post that mini cycle, post the ability of the fed to step in and largely help invest with great companies, but effectively everyone, you've got balance sheets, as Scott was talking about, that looked quite good. And so you've got runway, great interest coverage. So this could be the start of basically that new cycle.

Jenna Dagenhart: A mini and accelerated cycle there now. Chet, what are the supply demand and technical dynamics of the leveraged loan market and the follow on effects with CLOs?

Chet Paipanandiker: And I'd like to address this more so than anything from a standpoint of technicals, especially as it relates to the CLOs and the loan market. If you think back to what I said before about the retail investor, I'd mentioned there's probably about 135 billion in prime funds, maybe not 13 or so in ETFs. In terms of representation of the overall $1.3 trillion loan market, it's still relatively small compared to the past. So that's experiencing inflows as we talked about because of inflation. If you look at the CLO market, it's been just an amazing year for new issue perspective. You've probably seen so far year to date about, I think last numbers might've been in the 120 to 130 billion range of total issuance.

Chet Paipanandiker: And so from a demand perspective, things are looking quite healthy. From a supply perspective, you're actually seeing some of that supply starts to tail off here as you enter into the end of the year. Probably have a robust month here. And as you tail off into the fourth quarter, you're going to see things start to slow down just a tad. And as a result, you might end up with a little bit of an imbalance. And from a technical perspective, that could end up being very strong for leveraged loans. So if you imagine that you could have any type of a pullback here, again, from a technical perspective, for an instrument that is quite well hedged from a floating rate perspective, you could see a sustainable bid for the asset class.

Scott Mensi: Yeah. I would agree with Chet there, the demand function on the CLO side seems to be really strong. We've seen a number of institutions that invest with us on a CLO side really ramp up their investments within structured credit, particularly CLO. So, whether that's at the triple A level, at the top or down, in the mezzanine tranches all the way through the equity, there are more and more investors coming to that market, which to me brings obviously demand for CLOs, which then turns into demand for the underlying loan.

Scott Mensi: So, now I would agree 100% the technical aspect or the setup for leveraged loans here in the short and even medium term seems pretty good just given the fact that there is a need for yield as we've discussed, there is also a desire to limit duration exposure and CLO liabilities allow investors to really pick their spot in terms of how much credit risk they really want to take on and still have that floating rate exposure.

Jenna Dagenhart: Chet, we know that the CLO market itself is driven by the cost of funding versus the yield that can be earned on the loan CLOs buy. And we also know that the loan market is largely driven by the CLO market health. What are your thoughts on the CLO triple A market and dynamics around supply and demand for that instrument?

Chet Paipanandiker: Yeah. And it's an important topic. I mean, the CLO triple A part of the market is really the lifeblood for CLOs given that it's currently about 63% of the capital structure of CLOs. And of course, as we talked about before, it's a large part of the leverage loan market as well. So, where CLO triple A goes, goes everything else it's just a chain basically. And so, when you think about some of the idiosyncratic issues surrounding CLO triple A, you can start to see how it's in a special class all of its own, even within structured product.

Chet Paipanandiker: So with CLO triple A, what's particularly unique about it is, is the bond indentures actually are pretty non-standard in nature. They're issued 144A, they're not typically indices. And something that's unique within even structured product is, is they're effectively actively managed, which of course we've talked about as an important part of the leveraged finance market is to actually be in an actively managed product. But as a result of those things, it doesn't necessarily attract the buyer base that one would expect as a result of those oddities of the market.

Chet Paipanandiker: And so talking a little bit about where the market is at today, and then relating that back to some of the differences or the uniqueness of the CLO triple A market, if you look at who takes part in that for buyer-based perspective, you've got the trust outside of the treasury functions of bulge bracket banks as being probably a number one buyer. You've also got insurance companies. And as you go to the COVID times, you think about going through the second quarter into the third quarter, a lot of those treasury functions effectively stepped away from the market and in came actually a larger proportion of insurance companies.

Chet Paipanandiker: So right there, starting in the third quarter of 2020 heading into the fourth quarter, you actually saw a nice bit of diversification into the buyer base. And we want that. We want to see more breadth and depth to that market. And that continued heading into the first quarter of 2021, but something silent was going on in the background that's equally interesting. And I'll tie that back into the oddities of the CLO triple A market. And that is that you actually saw a number of asset managers step in and buy these tranches as well.

Chet Paipanandiker: And the reason I say it's important is because for all those reasons that the CLO triple A market is so unique, these are managers that are going to take the time to understand the customized documents that differ from manager to manager, from deal to deal, and better be able to price that debt. And of course, every additional buyer that you can bring to the market helps that spread fall, which is obviously positive to the arbitrage for CLO, basically the difference between what you earn on the assets in the CLO and your cost of liabilities in the structure. And so we think that that is going to enhance the stability in the CLO pool.

Scott Mensi: Yeah. I would totally agree with that. And we've seen it firsthand at Fidelity and talking even with some of the investors that invest with us within our CLOs, that expansion of asset managers into the triple A rated space. And even we're seeing a little bit more well called non U.S. investors coming back in, whether that's from Japan, other parts of Asia and even Europe now. So, the investor base is really expanding on the triple A side. And as Chet said, that's only a good thing for the underlying loan market because the lower those triple A spreads are, the easier it is to make the arbitrage work on the structures. And that will continue the printing of CLOs. And obviously as CLOs print, they buy loans and that's obviously positive for the loan market.

Chet Paipanandiker: And I think actually, interestingly, there is now a retail product on this CLO triple A side. So retail investors have the ability to partake as well. And it's worth noting. I mean, I don't think I mentioned this before, but from a spread perspective, CLO triple A relative to other structured product triple A, as a result of some of the reasons that I talked about trades wider. And so it's definitely attractive for this buyer base.

Jenna Dagenhart: So Scott, if you were to compare loans versus high yield bonds right now, which seems to be the better option?

Scott Mensi: Well, I'm think most of the viewers probably know where I'm going to land here just based on the way this discussion is going. But I think, not only because of the floating rate aspect of loans, just given where we are from a rate perspective and the valuations, as Chet said, almost 60% of the high yield market being double-B rated, which are trading pretty tight right now. When we look at the loan market and the high yield market from a yield perspective, very similar.

Scott Mensi: And that's obviously, one is no duration, one is four years. I think too, when you take into consideration where loans are in a corporate capital structure, senior secured high yield bonds are usually subordinated underneath there. What that means is likely, less price volatility if we do see some sort of a hiccup in the economy, it also means historically lower default rates. So those things all mean, I think going forward here, we think at very similar yields, very similar fundamental outlooks, no real duration risk in the loan market.

Scott Mensi: As we mentioned earlier, the big driver in the loan market CLOs, they seem to be going really well. You're getting these a lot of positive signals, whether it's fundamental or technical in the loan market, which could mean, I think if we do see things move higher from a rate perspective or the fed does start to taper a little bit, loans are probably set up a little bit better than high yield bonds right now. Not that high yield bonds, as I said before, will necessarily be negative or adversely hurt. I just feel like that valuation, you can't ignore that right now, even though the long-term the numbers tell you, there's no correlation to 10-year treasuries.

Scott Mensi: As I said before, 108 ish on double-B rated bonds. There's not much room for bond prices to go higher. And that's really, I think the issue that high yield bond investors are facing right now, because we think it's some of the more flexible mandates that we've seen we manage at Fidelity. We're looking at loans a little bit closer now, adding a little bit there where we can get very similar yields to a double-B rated high yield bond, or even from a single-B to a single-B, increased yields in the loan market versus the high yield bond market. So, if I had to put new money to work today in a broader portfolio, I'd probably be looking at the loan market a little bit more than I would be the high yield bond market.

Chet Paipanandiker: Yeah. I mean, I would echo that basically. One thing I would add to that is to consider the fact that when you look at the two markets, there are some differences in terms of composition by industry. So as an example, in the loan market, you have less of energy, I think is about 3% of total exposure versus the high yield market where it's closer to about 12% of total exposure. Vice versa if you take a look at say the tech side in technology, for example, the loan universe I believe you're somewhere around 13, 14%. So, you definitely can take views also on the overall index based upon how or what you want to express. If you think energy is going to be particularly high beta, particularly the downside because of course bonds can't trade materially above par, then you would, of course avoid high yield.

Jenna Dagenhart: Of course structurally, CLOs have changed from pretty great financial crisis. Chet, what are your thoughts on what makes them more resilient now, if at all? I mean, what does that mean for the loan market?

Chet Paipanandiker: Well, I mean, right off the bat, just in terms of some of the major differences, CLOs post the great financial crisis or less leverage. So they're basically about 10 times levered versus quite a few structures pre-GFC that we're probably closing in on 14 times, but there's a number of other major differences. One of those is ability to hold bonds. We've had as recently reversed here. You are seeing some smaller bond buckets creep into CLOs. It can be additive based upon some of the call ability features of loans and based upon where high yield bonds could be in the future, particularly senior secured.

Chet Paipanandiker: The other thing is, is for CLOs, pre-GFC, they had the ability to hold other structured paper and today they can't hold structured products at all. The other thing is from a structural perspective on CLOs, if you take a look at subordination and the capital structure, there's actually, if you compare a double-B tranche in today's capital structure compared to say a triple B tranche pre-GFC, they effectively have the same subordination. So that puts double-B investors in probably a happier state of mind in the sense they have better value effectively below them acting as a cushion.

Chet Paipanandiker: And the last and final point that's actually pretty material has to do also with the capital structure. If you take a look at the triple A and these structures, it's about 63% of the capital structure today versus pre-GFC deals that are probably closer to about 73%. And so if you think about the possibility of a CLO in its natural state potentially tripping a test and right-sizing itself and paying down some of the liabilities and the top of the capital structure, think about how on average CLOs are paying out a 4% coupon on a quarterly basis. If you redirect that towards paying down debt, it actually does a lot more to delever today's CLO than it does a previous pre-GFC, GFC, CLO.

Chet Paipanandiker: And why is that good? Because if you basically shut off cash flows to the equity of a CLO, you can turn them on a lot quicker with a post-crisis deal. And so, to some all of this up, you also have to talk about the state of the environment and how that's also different. So, if you go back to the pre-GFC times and if you take a look at how much of the market was in, call it TRSs or market value structures, estimates place at a property at about 300 to 330 billion back then, which is a very large swath of the market. And of course, as loan prices fell and back in the GFC, loan prices actually touched into the high '60s, a lot of it was due to this technical unwind for these market value structures.

Chet Paipanandiker: And if you look today, you just don't have that dynamic anymore. In the overall loan market, you might have about 100 billion or so of total TRSs in market value structures, effectively warehouses operating to launch CLOs themselves. But I think one important distinction to make, even with that exposure in the market, is if you take a look at how much equity is backing warehouses today versus pre-crisis, it's truly night and day. Today you've got material equity, pre-GFC, you may have had no equity, or the banks may have actually come with that.

Chet Paipanandiker: So pre-GFC, it was possible a manager would walk away from the deal and just simply let it unwind. And of course, the banks didn't want to be holding those assets. So, they might've fire sold them. Today it's a different prospect. Use the COVID era as an example. There were a couple of warehouses that unwound, but it wasn't done because of the banks. It was done at the discretion of the manager, and it was to actually take the assets in-house. And so even during something as a global pandemic, you can see how that technical unwind did not impact the loan market in the same way it would have in the past.

Scott Mensi: I think maybe a couple points there to supplement, which Chet had to say about what we've seen from the structural changes is, even if you think about all the changes that we've made that have been positive I think for debt investors, you look back at GFC deals or pre-GFC deals and default rates on these liabilities are really, really low. You have to go deep into the mezzanine tranches to find default rates and impairments. So even with what I'll call more looser terms, pre-GFC than what we have now, the default rates on these types of liabilities was really low.

Scott Mensi: These documents are structured in a way to really protect the debt investors. So just think about the protection they have now versus what they had pre-financial crisis. And I think when you look at the equity tranches now, and I think Chet was alluding to this, managers are having a whole more of that. So the most risky part of these structures, it's not required necessarily in all CLOs, but generally speaking, if you're talking to a triple A CLO investor, they're going to want to see the underlying issuer has some skin in the game. That wasn't really required in the past.

Scott Mensi: And I think that aligns, I think interests a little bit more and ultimately, we think will result in probably better outcomes. Like we saw in 2020, it was really didn't affect the loan market or the CLO market at all, that unwind that we had. And I think that's a function of a lot of these changes that we've seen to the overall structure post financial crisis.

Chet Paipanandiker: Yeah. And we want those debt holders happy. I mean, ultimately the safer they feel, the better they feel about their capital at risk, the more likely it is that they're going to engage the market at spreads that are conducive to see this CLO market grow and thrive.

Jenna Dagenhart:  Certainly. And as we wrap up this panel discussion, Scott, any final thoughts on your end?

Scott Mensi:  So, I think when we look at the medium-to-medium term outlook for leverage credited, unless we get some [inaudible 00:55:21] shock like COVID or something like that, again, the companies are set up really well. I think too, when we think about how long really long-term in terms of the growth of these markets and what investors should expect, they think the CLO market and the way it's now expanded into the retail space, I think there's going to be more and more opportunities for investors of many different types to get exposure to these asset classes. We're just starting to see; I think some innovation take place in parts of the market that a lot of investors never have been able to invest in before.

Scott Mensi: And with that does come some risks. I think liquidity is one that folks really need to take under consideration, but I think ultimately, the demographics are there, the need for income is there. Those should all be good things for leveraged credit markets in the future. And for those who understand and willing to do the work in terms of understanding what drives CLOs, understanding what drives the loan market, there's a lot of really good opportunities for not just attractive income, attractive total return, and then also doing it in a way that diversifies a broader fixed income portfolio, or even and balanced or portfolio both stocks and on bonds.

Chet Paipanandiker: Yeah. I think that's right. I mean, if I hadn't said already, I do think that this is effectively like a gold page and credit. I mean, if you take a look at, I mean, all the comments that we've talked about today with regards to balance sheets and where we are in the cycle across all of leveraged finance, whether it's loans or high yield, it certainly feels like the asset class has the ability to whether what's going to come next. So definitely feel like this is a great trade from a carrier perspective, whether it's from the standpoint of loans or even bonds, definitely more of a preference towards loans and CLO tranches, but as a whole, we think the space could be pretty good from the standpoint of guarding against inflationary events.

Jenna Dagenhart: A lot for investors to consider right now. Well, Chet, Scott, thank you both for joining us.

Chet Paipanandiker: Thank you.

Scott Mensi: Thanks for having me.

Jenna Dagenhart: And thank you for watching this Asset TV Fixed Income Masterclass. I was joined by Scott Mensi, Institutional Portfolio Manager at Fidelity Investments and Chet Pai, Managing Director, Portfolio Manager, and Analyst at Barrow Hanley. I'm Jenna Dagenhart with Asset TV.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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