Strategist's Corner Episode 3 - Exploiting Long-Term Inefficiencies in Today’s Credit Markets

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  • 19 mins 46 secs
MFS Global Investment Strategist Rob Almeida and Fixed Income Portfolio Manager Henry Peabody explore what's driving today's credit market and how long-term active managers can try to exploit the market's short-term focus to add alpha.
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Rob Almeida:

Hello, this is Rob Almeida. Welcome to another edition of the Strategist's Corner Podcast.

Announcer:

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only, and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the advisor. No forecast can be guaranteed. Past performance is no guarantee of future results.

Rob Almeida:

Today's discussion is with US Credit Portfolio Manager, Henry Peabody. We get into his background, his learnings, what formulated his views in the US credit markets, the tools he uses to exploit those long-term inefficiencies and how he thinks about current risks and opportunities in the credit markets, today.

Rob Almeida:

Henry Peabody, welcome.

Henry Peabody:

Thank you very much for having me.

Rob Almeida:

Thank you for coming.

Rob Almeida:

Tell us about your background, how you got started in this industry.

Henry Peabody:

I was an Econ major in college.

Rob Almeida:

Okay.

Henry Peabody:

Loved the idea of central banking and interest rates. Outside of college, I did some rate strategy, so very much on the macro side of things.

Rob Almeida:

Okay.

Henry Peabody:

Spent some time trading, doing research, all within credit. And now as a PM, I feel like that's the three legs of the stool. And I'm biased, but I think that research analysts would benefit from spending a day in a trader's shoes. And traders would benefit from spending a day in a research analyst's shoes. Not everything is so cut and dry. Liquidity matters. Fundamentals matter. They all matter at different times in the cycle. And I think it's good to have that perspective from both looking at the inner workings of the marketplace, as well as the bowels of a credit, and the interplay between the two. So I like to bring that to bear in the PMC.

Rob Almeida:

Well, it's funny you say that. A little unrelated. I have a 17 year old who wants to be Henry Peabody when he comes out of college, so to speak.

Henry Peabody:

Oh, boy.

Rob Almeida:

And I'm trying to un-focus him from studying finance in school. And just thinking about Charlie Munger's lattice work and when you think about the importance of liberal arts, philosophy, physiology, biology, all these things.

Henry Peabody:

Put history on that list.

Rob Almeida:

Well, all of it. Right. A hundred percent. So what you just said there in trying to triangulate other, I guess, aspects?

Henry Peabody:

Perspectives.

Rob Almeida:

Perspectives.

Henry Peabody:

Sure.

Rob Almeida:

Right. It all triangulates back to what matters. And it's getting the asset right. So-

Henry Peabody:

Well, let me build on that for a second.

Rob Almeida:

Mm-hmm (affirmative).

Henry Peabody:

I think it's really easy to look at your CFA textbook, and look at a DCF, and arrive at a terminal value. Did you get the rate right? Did you get the macro environment right? Did you get the industry competitive positions? There are all these things. I think we're brought into this industry thinking that there is a simple answer to valuation. And it's never that easy.

Rob Almeida:

Right. You're right. Investing is simple, because it's about cash flows and profits and margins. But it is absolutely hard. And it's the things that maybe you can't put into a spreadsheet, you can't put into a DCF that make the investment go awry. So, just having all those perspectives matter. So, with that, maybe this is a good segue, when you think about your strategy, I know what you're trying to do, but for the folks listening, what are you trying to do? What are you offering? What's your value proposition?

Henry Peabody:

I think the best way to phrase it is that we're trying to generate above-average risk adjusted returns through a cycle.

Rob Almeida:

Okay.

Henry Peabody:

And one could argue that cycles in the era of central bank activism have gotten very short.

Rob Almeida:

Mm-hmm (affirmative).

Henry Peabody:

From some angles, the market cycles have. But I believe the economic cycle and the full credit cycle, assuming defaults eventually happen again, is much longer. And I think that, in order to generate these returns, you have to be cognizant, very cognizant, of underlying fundamentals of the economy, underlying fundamentals of companies, and who you want to own through cycle. But also, acutely aware of some fairly unique characteristics of fixed income. There's a tendency in fixed income to shoot first and ask questions later.

Rob Almeida:

Mm-hmm (affirmative).

Henry Peabody:

And that makes perfect sense. Your upside is your coupon and your downside is-

Rob Almeida:

Everything.

Henry Peabody:

... 70 points to default. So, that makes perfect sense.

Henry Peabody:

But if you can think about that behavioral inefficiency and be, for example, a liquidity provider when the market is stressed, either a sector, or security, or a segment of the market, or duration bucket, whatever it is, you can amplify those returns through time.

Rob Almeida:

Mm-hmm (affirmative).

Henry Peabody:

So, you have to have a core positioning around good quality companies that are going to reward you through time, and you're going to feel comfortable owning through volatility, but also have the wherewithal to go really against the grain a little bit and layer on some of that, if you will, situational alpha, for lack of a better a phrase.

Rob Almeida:

Well, at a high level, the market, because of its increasing short-termism, you talked, there's a lot of mini cycles, but it was really one long economic cycle. I guess, two, if we count the post lockdown. Really, one long cycle with lots of mini cycles in there. But ultimately the short-termism market offers long-term investors a time horizon ARP. Is that where you're going?

Henry Peabody:

Yes. A hundred percent. I feel like time horizon is one of those very, very persistent sources of alpha.

Rob Almeida:

Right.

Henry Peabody:

And it matters when credit's inexpensive, but also matters when it's expensive.

Rob Almeida:

Right.

Henry Peabody:

The market tends to not be stable at extremes. And I would argue, up until the fourth quarter post-COVID, again, central bank activism, backstops for credit, has been a fairly extreme event on the up side. And we've been very much low risk that entire time, knowing that our clients and I agree on a philosophy of long-termism and I don't want us to be exposed. I don't want our clients to be exposed to late-cycle credit at rich valuations that we don't want to own when there's a bump in the road.

Rob Almeida:

Yeah.

Henry Peabody:

And so, it works in, really, both ways. I feel a little bit like managers who outperform in that scenario are taking risks that they're not well-compensated for, and that's never a really good long-term strategy.

Rob Almeida:

Right, right, right.

Rob Almeida:

Because, at the end of the day, you're lending money to companies. Or, if you're buying the equity, you're investing in the company. You're buying a stream of profits. In your case, you're lending money. So, you need to fundamentally understand their willingness and ability to pay you back. And that's really what you're talking about.

Henry Peabody:

Yeah. And let's think about where we are in a very, very long-term cycle.

Rob Almeida:

Yeah.

Rob Almeida:

Well, that's a good segue.

Henry Peabody:

We've had a generation of declining interest rates, a half a generation of central banks fighting deflation. And let's call a spade, a spade.

Rob Almeida:

Okay. Here we go.

Henry Peabody:

It's been relatively easy to outperform over the past 30, 40 years.

Rob Almeida:

Right. Right.

Henry Peabody:

You can own over-leveraged credit.

Rob Almeida:

Mm-hmm (affirmative).

Henry Peabody:

That's a big portion of the benchmark, because passive money's buying it, because it's cost of capital is getting lower and lower, over time-

Rob Almeida:

Well, let me interject.

Henry Peabody:

Yeah.

Rob Almeida:

Are you saying, Henry, there was a central bank put in credit?

Henry Peabody:

To an extent, to an extent. Inflation is declining, the cost of capital, both debt and equity, is declining. There were certainly cycles where defaults occurred and think of all the tech in 2000 and banks in '09. So, there's certainly cycles within there.

Rob Almeida:

Yeah.

Henry Peabody:

But the put's been both monetary and fiscal, right?

Rob Almeida:

Sure. Sure.

Henry Peabody:

You've had packages of bailouts, and you've had credit markets backstopped. So, there's been a push towards getting out of jail free.

Rob Almeida:

Loss prevention.

Henry Peabody:

Loss prevention. And I'm not entirely sure that's going to continue.

Rob Almeida:

Not with inflation at these levels.

Henry Peabody:

Exactly right.

Henry Peabody:

And you have capital being defended for years and years and years and years.

Rob Almeida:

Right.

Henry Peabody:

And I would argue the shift towards labor share, we're seeing it in wages, now, right?

Rob Almeida:

Yes.

Henry Peabody:

In the mid teens, you had minimum wages starting to go up, and you had big box retailers starting to pay more for labor.

Rob Almeida:

Yeah.

Henry Peabody:

And so, this is a longer term phenomenon than we think. And you don't want to lose the forest for the trees, but with the government, the fiscal authorities, providing handouts, and this is not a social statement or a political statement, but we had checks written, okay?

Rob Almeida:

Yeah.

Henry Peabody:

The onus of growth is less on central-bank-fueled liquidity and growth, and it's got move towards labor and organic growth and consumption. And if we don't need capital markets to fuel people's portfolios as much as we have in the past, then maybe the Fed steps away, and maybe the Fed's not going to backstop a 20% decline in stocks.

Rob Almeida:

Right.

Henry Peabody:

We've grown up with that put.

Rob Almeida:

Yeah.

Henry Peabody:

And if it's not there, we need to be cognizant of that downside risk.

Rob Almeida:

Yeah.

Henry Peabody:

And I would argue, the next handful of years are going to be as much, if not more, about what you don't own than what you do own. And I feel as though the risks in the market around overleverage balance sheets, margin declines, cost of labor, energy prices, take a pick, are going to be major headwinds for companies that are not prepared for that outcome.

Rob Almeida:

Every pressure point on the P&L is there, right? And it wasn't there before. So, you were in, don't mention the company name, I'm pretty sure you were in that consumer cyclicals meeting a couple weeks back. And I'll be careful not to mention the name, but there was a quick service restaurant who was talking about 15% of their boxes or their stores are closed because they can't find labor. And what stuck to me was, it didn't matter the level of wages that they offered. They can't find labor.

Rob Almeida:

Now, maybe some of that is transitory. Of course it is. Ultimately, supply will meet demand. But at what price?

Henry Peabody:

Mm-hmm (affirmative).

Rob Almeida:

So, when you describe those tailwinds, I would almost offer them now as headwinds. The cost of labor is going higher. The cost of capital is going higher. It's equity or debt. All these things are transitioning to a different P&L, a different margin structure, than I think what many investors have grown up with, like you said, generationally.

Henry Peabody:

And this is domestic, right? This is local. And I live on the north shore of Austin.

Rob Almeida:

Mm-hmm (affirmative).

Henry Peabody:

And there's a very famous and historic sailing bar. I happen to know the owner. And I asked her, if I held a gun to her head, could she fully staff up? And she said, not a chance.

Rob Almeida:

Right. Right.

Henry Peabody:

Workers who worked in the cash industry are retooling to go back to nursing school, or something like that.

Rob Almeida:

Yeah.

Henry Peabody:

Which, from a macro perspective, it's great. It's a more educated workforce. That's positive. But maybe we have to accept the fact that $10 hamburger is now 15, to bring people back in. We have to come to grips with that.

Rob Almeida:

Yeah.

Henry Peabody:

I'm very fortunate that I can weather that storm, but not everyone can.

Rob Almeida:

No. No, no.

Henry Peabody:

So, this is something we definitely need to be cognizant of. But, that was the local aspect of it. There there's a global aspect, too. And we've had Chinese labor hit the market, WTO, Eastern Europe. We've had an influx of labor for decades.

Rob Almeida:

Right.

Henry Peabody:

And that's over.

Rob Almeida:

Yeah.

Henry Peabody:

That's over. It's global. It's local. We're going to have to deal with retooling, reshoring. Does that tie up capital? Does that tie up working capital? Do we need a greater degree of capital to invest in actual productive capacity here?

Rob Almeida:

Yeah.

Henry Peabody:

I would argue, that's what we've been lacking for a long time.

Rob Almeida:

Right.

Henry Peabody:

All politics aside, we have not had productive capital put in the ground.

Rob Almeida:

Right.

Henry Peabody:

You've talked about this a lot. We've had financial engineering to generate returns.

Rob Almeida:

Yeah.

Henry Peabody:

Now, it's going to get lumpy, because we're going to have to figure out what the next leg of the cycle looks like. And it's going to be expensive. It's going to be capital consuming. And that says to me, yes, we've had a high savings rate that's kept the cost of capital down. Will that persist? I don't know.

Rob Almeida:

Yeah.

Henry Peabody:

But will the demand for capital exceed that? That's possible. And if that happens, that implies higher interest rates, higher cost of capital, potentially wider credit spreads.

Rob Almeida:

Right.

Henry Peabody:

All these things that contribute to a market that you're going to need a good partner to get through to avoid a lot of these landmines.

Rob Almeida:

Yeah.

Rob Almeida:

It's interesting. Disorder is just order misunderstood. And, to the extent that these things manifest, I think we think they will, into a disorder. Hopefully, folks will maybe come back and re-listen to the podcast. We just explained it all, right here.

Rob Almeida:

So, maybe with that, in our last few minutes, without mentioning names, as we don't want to run into compliance issues, talk a little bit about your portfolio, just at the aggregate level. Maybe, where are you, where have you been de-risking? Where are you increasing risk? Just based upon these factors that you highlighted today.

Henry Peabody:

Yeah.

Henry Peabody:

I'd say the portfolio is on the lower risk side of things. We certainly have room to flex, adding high-yield exposure, adding EM exposure, going down in credit, going long in duration. There's plenty of levers to pull. We've been trying to think about, where's there value? And there's value, right now, by virtue of the liquidity in the banking sector.

Rob Almeida:

Okay.

Henry Peabody:

It's been taken to the woodshed over the past handful of months.

Rob Almeida:

Yeah.

Henry Peabody:

That's-

Rob Almeida:

Because of the yield curve, or..?

Henry Peabody:

No. No. That space tends to just be more liquid. So, when there is a fade in the market, that's where investors command liquidity. And I'm a big fan of providing liquidity in sectors and names we like, when we're paid to do it. And I believe that this is potentially one of those times.

Rob Almeida:

Okay.

Henry Peabody:

We also think about, let's think about long-term trends that we can invest in. And it might be EV against legacy OEMs. And that's not to say we're owning EV manufacturer converts, or anything like that. But let's have exposure to materials. Let's have exposure to-

Rob Almeida:

Yeah. Backdoor into that.

Henry Peabody:

Aluminum manufacturing.

Rob Almeida:

Right.

Henry Peabody:

Right?

Rob Almeida:

Right.

Henry Peabody:

And this is ESG from an environmental standpoint.

Rob Almeida:

Mm-hmm (affirmative).

Henry Peabody:

This is not necessarily owning the capital-intense industries that pull materials out of the ground, and are very tight spreads. And this is having exposure in that materials bucket with a very secular and relatively low capital-cost capital cost tailwind.

Rob Almeida:

Yeah.

Henry Peabody:

So, there are ways we can think about having long-term exposure to these trends, but also maintaining that exposure to, in this case, the materials index.

Rob Almeida:

Yeah.

Rob Almeida:

Well, it's interesting that say that you say that. A couple podcasts ago, I had Anne Glancy, Jake Stone and ...

Henry Peabody:

Bright folks.

Rob Almeida:

Yeah. Really smart.

Rob Almeida:

And Matt Doherty from the equity side. And we were talking about housing and, is it a bubble? Does it look like '07. And they walked through how it's different, and not at those levels. But, really, what I want the audience to walk away with was the ways to backdoor into those sectors that are maybe more commoditized, not dissimilar from auto OEMs, because the EBIT divided by the EBIT vol, your sharp ratio, right? For your margin, if you will. Do you think about credit through that lens, as well?

Henry Peabody:

Yeah, a little bit. I would say that a couple of experiences that shaped me were, certainly the credit crisis. I was I was trading and researching credit in '08. And you learned that things, aren't always what meets the eye.

Rob Almeida:

Mm-hmm (affirmative) mm-hmm (affirmative).

Henry Peabody:

And you learn that vol is real in credit. And liquidity is real. I would also say that 2015, '16, '17 energy materials crisis was another formative experience in that, the volatility of margins and the durability of margins matter. And so, I do think about that. And I think, touching on your housing example, is there a shortage of housing? Probably. Right? How can you approach that? And you can think about lumber suppliers. You can think about home builders, who have traded relatively rich for their credit ratings. You can also think about apartment REITs, right?

Rob Almeida:

Mm-hmm (affirmative). Mm-hmm (affirmative). Mm-hmm (affirmative).

Henry Peabody:

Rental home REITs.

Rob Almeida:

Yeah.

Henry Peabody:

And there are different ways of getting this exposure, and-

Rob Almeida:

If you need a place to live, you don't have to own a home.

Henry Peabody:

And, if you can do this in a relatively low-volatility manner, and get that exposure, and get that additional carry in the portfolio, you can find some attractive alternatives. You don't need to the volatile commodity, or the builder, which is facing labor shortages and is trying to push through cost to consumers. You can buy a portfolio of homes, for example, wrapped up in a REIT wrapper.

Rob Almeida:

Yeah.

Henry Peabody:

And that's certainly one area that we have an expertise in, here. And so, there are different ways of getting this exposure and having that flexibility to do so, I think, is pretty important.

Rob Almeida:

Yeah.

Rob Almeida:

Well, let me maybe summarize what I think I heard, today. There's long-term exploitable inefficiencies in the credit markets.

Henry Peabody:

Absolutely.

Rob Almeida:

Being a liquidity provider, as you described it, is one advantage or one lever-

Henry Peabody:

With that time horizon.

Rob Almeida:

With that time horizon. Right. You have to marry those two things together. And it comes back to, though, understanding the borrower, understanding the fundamentals, not dissimilar than how an equity investor would approach it.

Henry Peabody:

Absolutely. And think about it. If you're investing in credit, and you're provided an opportunity to buy something, sector, market, security, at relatively attractive levels, if you don't have a deep, deep understanding of those fundamentals, you're going to the casino.

Rob Almeida:

Yeah.

Henry Peabody:

And hope and prayer is not an investment strategy. So, we rely heavily on our research analysts.

Rob Almeida:

Yeah.

Henry Peabody:

And we rely heavily on them having fortitude and having a long-term view on fundamentals, on margins, on balance sheets. You need it. It's absolutely fundamental in outperforming the long term.

Rob Almeida:

Yeah. That makes sense.

Rob Almeida:

Well, Henry, thank you very much for your time today. And I've said this to you offline, but I'm really glad you're with us.

Henry Peabody:

Great to be here. It's fantastic.

Rob Almeida:

All right. Thank you.

Henry Peabody:

Thank you.

Rob Almeida:

Thank you very much, Henry, for the discussion today. Folks, look forward to our next edition with Mike Skatrud on the US high yield team. We'll get into the inner workings and the risk and opportunities presented in the US and global high-yield markets, today. Thanks for listening.

 

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