Legend claims that a frog will boil alive if the water is heated gradually – its nervous system will not produce the requisite reflex movements to inspire a leap to safety. It is tempting to believe that individually we would avoid the same fate but here we are: rates are low, credit spreads are modest, underwriting standards are loose, economic growth is meagre and corporate profits are sputtering.
As the Bank of International Settlements stated in its 86th Annual Report published in June, “a shift to more robust, balanced and sustainable expansion is threatened by a ‘risky trinity’: debt levels that are too high, productivity growth that is too low, and room for policy manoeuvre that is too narrow”.
Despite these challenges, investors are shouting in unison for “more yield!” By continuing to demand more from our credit investments, are we dooming ourselves to the same fate as that poor docile frog?
Institutional investors must weigh the risks of staying invested and the risks of not staying invested. A ‘risk-on’ portfolio will lose money when the cycle turns, and may not recover for a long time if central banks fail to engineer another V-shaped recovery. A low-risk portfolio should be able to invest in distressed assets when times get tough, but will not be able to deliver on important promises (eg, paying pensioners or funding charitable budgets) if distress is slow to materialise.
To complicate matters, central banks have artificially extended the corporate default cycle while reducing the ability to predict when the cycle will turn. The US is already 85 months into an economic expansion – the fourth-longest on record, but also among the weakest ever as measured by annual GDP growth. It’s expansion that could end in a few months but could just as easily carry on for years. As we wait for economic clarity and for government policy to unfold, investors must balance the risk of remaining invested too long with the risk of not being invested at all.
The combination of low rates and moderate spreads have conspired to limit the return potential on high-yield bonds and levered loans. Assuming moderate levels of defaults and current interest rates, “liquid” credit will be hard pressed to produce much better than a 5 percent unlevered return over the coming years.
To wit, the option-adjusted spread on BB-rated bonds was 400bps as of June 2016 and has traded +/- 10 percent of the current level 40 times since 1997. During the three-year period following these 40 occurrences, the BB index produced a median return of 4.5 percent per annum after stripping out the historical benefit of duration (using the performance of five-year Treasuries as a proxy). This is ok, but won’t meet the targets of most institutional investors.
Tough choices need to be made. But when making tough choices it is important to avoid stretching on risk without being compensated. Distressed investing is great if somebody else takes the loss – much less so if you owned the debt at par. Fortunately, there are ways of using this environment to your advantage. For investors that can flex on liquidity, we offer a few suggestions:
1 SPREAD OUT
Risks abound, especially in the current environment, and not always in the places investors most expect them. To shield against unknown-unknowns, increase diversification. Mid-market lending and distressed debt in the US and Europe are fine building blocks for a private credit portfolio, but they are correlated to developed market corporate profitability. Other strategies such as specialty lending, trade finance, transitional commercial real estate lending, insurance runoff, royalties, emerging markets distressed, and NPLs may add risk individually, but can work together to create a more resilient portfolio overall.
2 FOLLOW THE LEADER
Global regulators and central bankers wield considerable power and also tend to telegraph their intentions to the market. Investors should tread lightly when investing contrary to stated policy intentions. These monetary programmes will eventually stop (and perhaps start again and stop again) and there will be plenty of time to take advantage of mispricings created in their wake. But while they are in place, look to take advantage of their momentum or at least don’t invest against the tide that they create.
Similarly, don’t compete head-on with the banks in businesses that they like, since they have access to cheaper financing than you. Instead, look for gaps that are created as a result of financial regulation. Look to enhance yield by focusing on less liquid, complex investments. Be it mid-market lending, asset-based lending, corporate debt or structured credit – start your search by looking at assets which the banks (or other natural buyers) are disincentivised to hold.
Then (if you must, and instead of stretching on credit quality) consider enhancing returns on safe assets through the use of structural leverage or term, non-mark-to-market external financing. After all, from your perspective it is leverage, but from the perspective of your lenders (and their regulators) it’s a low loan that may receive favourable capital treatment. Executed thoughtfully, leverage can be used as an asset, allowing borrowers to take advantage of debt that is artificially cheap as a by-product of regulation and/or monetary policy.
3 EMBRACE VOLATILITY
“Liquid” credit is not particularly liquid. The increase of daily liquidity mutual funds and exchange-traded funds over the past 10 years is at odds with the reduction in liquidity created when banks were chased out of the inventory business. Liquidity still abounds during good times, but can disappear at the whiff of a problem. Without bank trading desks as a buffer, good quality bonds can freefall until they reach levels that make sense for hedge funds or other buyers with spare cash. We caught a glimpse of this in Q4 2015-Q1 2016, as credit markets collapsed before recovering just as violently over the following months. We expect this cycle to repeat itself over the coming years. Investors that are prepared to act quickly should be able to profit from these kneejerk reactions.
We live in an unprecedented world. Central bankers are experimenting, but their hypotheses cannot be tested in a lab; we need to wait and see what effect they ultimately have on the real world. Like a frog without a thermometer, we don’t have all the tools that would allow us to optimise our own fates. But with a bit of prudence and creativity, this complex environment can be fertile ground for great new ideas.
After all, this whole frog thing might be wrong anyway, according to Harvard University professor of biology, Douglas Melton: “[The frog] will jump before it gets hot – they just don’t sit still for you.”
But I’d be willing to wager he hasn’t tested that in a lab.
Patrick Adelsbach is head of credit strategies at Aksia, the research and portfolio advisory services firm.