Invest Like the Best with Patrick O'Shaughnessy - Bryan Krug – An Update on Corporate Credit - [Invest Like the Best, EP.161]

Episode Date: March 13, 2020

My guest in this flash podcast is Bryan Krug of Artisan partners. We discuss what has happened so far in the corporate high yield and investment-grade credit markets, and the loan market. We compare today’s environment to the financial crisis and other past crises with lots of nuances that I hope will be helpful to bond and equity investors. Please enjoy. For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag Show Notes 1:08 – (First question) – An overview of what he covers in the corporate credit markets 1:52 – How things have changed in the last couple of weeks 3:56 – Composition of the high yield market 7:07 – Major sectors of the high yield market outside of energy 8:39 – How do they price the risk in securities right now 11:21 – How do they handicap a great unknown 13:00 – Risk for broader contagion in the overall credit markets 14:49 – What’s the downside potential here 16:31 – Potential for upside 18:33 – How does he view companies that are drawing down on their entire line of credit 19:44 – An overview of the loan market 20:42 – What warning signs equity investors should be watching for in the bond markets 21:57 – What do credit spreads look like today compared to before this crisis Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on Twitter at @patrick_oshag

Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfield guide.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunacy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy asset management may maintain positions and the securities discussed in this podcast. My guest in this flash podcast is Brian Krug of Artisan Partners. We discussed what has happened so far in the corporate high yield and investment grade credit markets and the loan market. We compare today's environment to the financial crisis and other past crises with lots of nuance that I hope will be helpful to bond and equity investors. Please enjoy.

So Brian, I really appreciate you taking the time. I know we both have insanely busy schedules today, but giving people information on key parts of the market, I think, is really important in these times. And you're operating in the corporate credit sphere. I'd love for you to begin by describing sort of the universe of companies and securities more specifically that you cover so that we can dive into what has happened so far and what you're watching most closely in the corporate credit market. Well, we look at in my strategies, we invest across the debt spectrum. predominantly in the leverage credit market. So the leverage finance market incorporates high-yield bonds, leverage loans, and then selectively will look at some investment grade credit as well. All the

credit that we're looking at is syndicated. It trades through broker dealers. You opened our conversation before we hit record by saying that the world has changed a lot very quickly for you and your team. Maybe highlight the most interesting or important ways in which it has changed in the last couple of weeks. When you look at the corporate credit market, we're looking to invest in companies where we believe that there's not an impairment, and then we tend to look at relative value base on the risk that we're taking of the industry in a company that we're concerned making investments in. And if you look in the last couple of weeks, there's been a couple massive shocks. The first big shock is obviously with the coronavirus and the implications

there are obviously extremely broad base from not only a consumer perspective, but if you go into individual sectors such as cruise lines or airlines, which have been traditionally investment-grade credits, are now starting to trade more like high-yield credits because of correct concerns on the duration of this potential of the coronavirus and the severity of it. And then combining that, you get a massive shock with a fight between the Saudis and the Russians. And essentially, it's a nuclear war in the oil space. And as a result of that nuclear war, the price of the commodity is dropped. And as you think of more incremental players, such as shale, shale doesn't work at these levels on a sustained basis.

And then you kind of take the second derivative from that and you kind of go to MLPs in other areas. If the shale market has bankruptcies, there are also implications regarding the MLP space of the market as well. And then on top of that, from a market perspective, you've had just a massive repricing of risk across all asset classes. And that massive repricing of risk has resulted in cred spreads blowing out meaningfully and in a little bit of a panic environment. And quite frankly, this environment, the nearest comp is quite frankly, we're not quite the same severity, but of an 08-type level where you've got some panic selling, very quick repricing on debt instruments.

And so that's kind of where we are today. Can you talk about the composition of the high-yield market specifically? you mentioned energy, some of the cruise liners and others that normally have been investment grade now trading like high yield. Ratings have been static thus far. I'm sure we'll get ratings changes. I'd like to talk about that too. But talk about the composition of that high yield group. How much of it is energy? How sensitive is the composition of that group to the major things that have happened thus far? As you look at the high yield market, and let's look at the high yield and loan market separately because they do have some different characteristics. So if you look at the high

yield market, the high yield market is around 6, 7 percent energy in terms of E&P upstream exposure. As you look at MLP, the exposures similar, maybe slightly higher. And then if you've got oilfield service, it's a percent or so. So it's low double digits percent in aggregate as you look at the whole supply chain. And it's down from where it was before. If we go back five years ago, the E&P sector was probably 9, 10%, and in that time period, what you saw was a significant amount of restructuring. And we saw a lot of the second and third tier operators essentially liquidated or were bankrupted and just fell out of the universe because of that.

And so what's more interesting today is that the quality of the assets and the acreage are actually far greater than they were five years ago. in the valuations of those same companies are material. The survivor's valuation today are materially lower than they were five years ago. So it sounds like from your summary of energy there, it's a smaller percentage of the high-yield market than it was five years ago and of higher quality, but that doesn't necessarily mean that this isn't still a severe crisis facing that low double-digit percent of the high-yield market. Correct.

As you think about energy in a $30 oil, it doesn't work for Saudi. it doesn't work for Russians and it doesn't work for shale. And so the level of the commodity is not sustainable. And part of the reason why it is where it is today is because coronavirus has affected demand. And then you've had the supply increase and it's resulted in a supply balance that depend on the length of Saudi policy as well as a coronavirus will be here for at least the next two to three quarters. And as we think through the high yield market, it is true that the lower quality companies have essentially been liquidated in what's left is more higher quality per year and acreage.

And the other point that I think is important is that the valuation of the debt currently of the remaining companies is immaterally lower. As you look at a lot of the E&P names, you have companies, I would say the market's anywhere from 10 cents on the dollar to 70 cents on the dollar for the highest quality, lowest cost acreage positions in the high yield market. I can't think of one bond over 75 cents on the dollar in the E&P space today. The numbers I gave you before are par value. If you actually were to use an estimate, I don't know if it's 40 or 50 cents on the dollar, the actual dollars at risk are materially less because of the discount. Let's talk about the rest of the high yield market

as it stands today. What are the major sectors that represent the whole pie? And what, in your are the spots kind of most at risk of a default-like event? If you look at the high-yield market, the high-yld market is fairly diverse. And if you look at the high-yield market, areas where there's large areas of issuance would be TMT would be one area that's telecom, media, and tech. Energy is another fairly meaningful area. And then healthcare is decent-sized as well. Those are probably the three bigger major categories.

And then after that, there's the smaller categories, but that's the high-year. high-level overview. In terms of my view, in terms of risk, I think what you're also seen in the market is you're seeing potential Fallen Angels, which are companies that are IG-rated, that will likely be downgraded or are trading-like potentially be downgraded. And that's an area of opportunity that we're seeing today. Because of the virus, you're seeing sectors such as cruise ships, airlines, hotels, lodging, where you've seen high-yield companies or investment credit credits that are technically investment grade that are trained more like high-yield and high-yield valuations today. In terms of areas that we'd stay away from, I mean, we're really bottoms up based,

and I think it's more company-specific as opposed to broad-based. I mean, wireline telecommunications is an area that, quite frankly, we're not too excited about. We think there's just secular challenges there. So, you know, thinking about, for example, some of those potential fallen angels, how do you and the team even begin to digest how to price the risk in securities like this that, you know, I'm sure in hindsight, some of them will have been enormous opportunities here and in the weeks to come. But sorting through the winners and losers, I'm sure, is a great challenge. How do you and the team approach that problem in a market like this? The way we look at fallen angels, we actually think fallen angels are a potentially very good opportunity because we think there's a void of capital there. And the reason why we think there's a void of capital is because you've got investment grade accounts that are concerned about potential downgrade. And if they have a downgrade, then they're a naturally for-seller.

And then you have a situation where high-yield investors are reluctant to buy the credit because the high-yield investor says, well, when they get downgraded, it'll probably come cheaper. And the interesting thing about investment grade credits in general is they tend to have more levers to pull. And when they have more levers to pull, downgrades may or may not happen. And so that's where it really, it's really incumbent for you to do your own work and get comfortable with the credit. So what we'll do is we'll run screens. And we look at valuations of companies. They're triple B.

And when there's rumors of potential downgrades, you see this, this widening of spreads. Because typically, in investment grade markets, over four times larger than the high yield market. So you have four to one sellers in that situation. And so some accounts will want to get in front of this potential downgrades and they sell. And valuations can push to between, depending on the credit risk, sometimes between single B and double B valuations. And just as an example, a very high profile example that happened about 18 months ago was General Electric. And so that was a name that there's fear of downgrade. The debt in the fall of 18 traded to valuations that were between single and

in double B valuations, and the company had plenty of levers to pull through asset divestitures. And in doing so, if you actually use that as an example, that was a potential big opportunity, those bonds returned on a price basis over, if you go further on the curve, 30%. And if you factor your interest is close to mid to high 30s total return, which is exceptionally high for a company with not huge credit risk. But that's an example of something where we can see some voids. In today's market, what we're seeing is airlines fit that bill, cruise lines fit that bill, MLPs are fitting that bill. Auto sector is starting to fit that bill right now. And that's something that we're spending a lot of time in individual credits in those sectors. For some of those examples, how do you handicap or begin to incorporate a great unknown, which is sort of like how long this crisis around the virus will last and what the policy responses,

will be, say, for a cruise line industry or maybe an airline industry, there's more visibility because of historical precedents, say, around 9-11. For the cruise line industry, I'm not saying you're looking at that, but I'm just curious how you begin to incorporate these sort of uncertainties when deciding whether or not to invest. When you look at any company, we tend to look. There's always uncertainties, and the uncertainty now is different than anything we face. We don't have anything we can point to. We think of this as a known, unknown. And this known unknown is something where we will use present examples and try to stress it. So we can use an example, like 9-11 as a demand shock, use that in our model for airlines as a proxy. Or for cruise ships

as an example, there's probably nothing that's significant. So we can try to, we can have some view as to what it can be. We try to be very conservative in our projections. And that's how we will do it from that perspective. We don't bank or make it investment thesis predicated on like a bailout or aid, I just think that's too risky and unpredictable. And so we will look at our analysis and say, okay, how much cash do they need? What's the value of these businesses? And then when spreads are wider, we tend to have a longer term horizon. We're willing to take more mark-to-market risk, knowing that we're not going to get the bottom. But if the upside is there where you can make equity like returns, we feel like that's risk we need to be taken.

Can you talk a bit more about sort of the participants in this market, specifically around this potential, I'll call it a supply cliff, where there are downgrades and because of requirements, holders of that investment grade paper have to sell into the high yield market. Who are the important players here? You know, that sounds maybe naively like something that would mostly affect the returns of the credit holders. But tell me a little bit about whether or not you think there are risks beyond that to like a broader contagion in the overall market system. In credit gets downgraded from high grade or investment grade to high yield, there are more constituencies than just the holders of the debt. You have to also think about from a company perspective and how does it affect their business. And if a company were to lose investment grade rating, how would that affect their competitiveness, how to affect their working capital. As a good example, if you were to get the financial crisis, any bank that got downgraded high yield, it just, their business just doesn't work because they rely on short-term financing at very low rate and they use liquidity as their life-flot. So that's a prime example of credit

that doesn't, companies that don't work beyond just the debt holders experiencing the losses. So we obviously think through the implications of the motivation to the company. In different companies, we'll have different motivations. Some companies are okay with the downgrade. And if you look as an example, Kraft was recently downgraded into the market. And the company had levers to pull. They could have reduced their dividend. And if they had reduced their dividend, they would have maintained an investment grade rating. But for them, that wasn't that important.

And for other companies, it's critically important. And you'll see them sell assets to de-lever. And when they do that, that's a way to maintain investment grade writing because they're worried about a short-term downgrade. And they may sacrifice the long-term profitability because of that. Can you talk about what you think sort of the ends of the spectrum here as you sort of handicap bigger picture what might happen from this point forward. Maybe we'll start with the bad news first. What is sort of a downside potential scenario in your mind, in your market specifically? Because of the action that we've had, I mean, the markets had circuit breakers coming up multiple times this week.

If you look at the downside that, I believe, high yields had the last 30 some years, three negative years have returned. And what we're experiencing so far in 2020 is the second most negative of return that the market's experienced yet. I mean, I would think that after today, and this is Thursday, that you have a 10% down in the market. So you are starting to get to the point where there is some more evaluation support in the market. And your pricing is starting to dictate, quite frankly, pricing is starting to dictate some

recessionary levels. And as you think through there, it's like, could the market go lower? Absolutely. But I do think that investors tend to be a little more comfortable going into credit if there's a little earlier cycle of asset class. Because growth, quite frankly, isn't important. And financing tends to come back a little faster than equity does. So it's hard to know exactly where we are in that point. But from evaluation perspective, things are attractive.

I think the big, the known, unknown is the duration of the coronavirus. Will this be a virus that goes on for another 45 days? Is this going to go on for another three months? six months. And you can look at other areas, other areas of the world as a proxy, but there's differences between everyone. And I think that's the thing that is really hard to handicap at this point. On the other side of the ledger, you're thinking kind of about opportunity. Say a little bit about how things are priced in terms of the return. They may potentially offer investors sort of in the absence of default. You made the comparison to 08. You know,

I think credit spreads have widened a lot. So talk a bit about sort of what the opportunity set you think looks like and the return profile, not exactly, but sort of a general sense of the available return profile should things surprise to the upside in terms of their stability. If you think about the return profile, it really depends where you're investing in the market. So if you're in the higher quality part of the market, there's been some benefit with treasuries and there's been some spread widening. But if you look at the math and if you get back to a more normalized spread level, mid to high single digit returns. If you were to have an example where energy were to go to $50, $55

oil in some debt instruments, you can make 500% of your money. And so that's like the bookends between, you know, a very high quality issuer and the example of the energy company that I gave with the bonds, you can make 500 plus percent returns. Those are companies that are issuing that have par paper six weeks ago, just to give you some context. So I'm not quoting something that a company that was, you know, par three years ago. This was literally six, six, nine weeks ago. So that's kind of an example of the bookends that you're seeing out there. As we're looking at the mark today, and we tend to underwrite our risk, our returns based on the risk.

And so we need a higher expected return for obviously more risk. And companies that we feel very comfortable with, we're underwriting between today. 8 to 20, 25% IRAs, depending on the risk we're taking. So the returns are opportunities that's much greater than it was three weeks ago. And we're in a situation of volatility. And we'll see how the world evolves over the next month or so. What do you make of companies like a Boeing or a Hilton that reportedly are drawing maybe their entire revolving lines of credit down on an effort to shore up their balance sheets? Does that factor into how you think about in this market at all?

When a Hilton or a Boeing is drawing down the revolver, they're likely doing it as an insurance policy, unsure if they'll be able to draw it down in the future. Or they're very concerned about their cash burn and they just want to draw it down today before they potentially test some maintenance covenants. I actually have never looked at Boeing, Boeing's in IG credit. But in the financial crisis, what we saw was there was more concern about the solvency of the banking system. instead of going to the banks and asking for money and not being there, they preemptively drew it down. And that's, it's a similar maneuver as to what they ran in the great financial crisis.

So I'm not as worried about the banking system. The bank system is actually very healthy. So that is, I think that's being cautious if you are concerned about the banking system. If it's a situation where you're concerned about your business, it's probably prudent because you could have a supply chain or working capital depending on the company. that's there. Could you also say a bit about the loan market and sort of what that looks like today and what you're seeing? Sure. The loan market has experienced some of the same trends. If you look at the composition of the loan market, it's less energy exposed. So more industrial exposed as opposed to energy exposed. It's a fraction of that. I believe it's two or three percent energy versus the 10 or 11

percent that we are talking about of the high yield market. The dynamic with the loan market is loans price off at LIBOR, and LIBOR has dropped as rates have dropped. And so generally, loans are senior to high-yield debt. But what's happened is that overall coupons have dropped with LIBOR, and as high-yield pricing has dropped as well, the relative value, quite frankly, has deteriorated from what it was six weeks ago. And so they're experiencing similar pressures to high-yield, but probably not quite to the same magnitude at this point. What would you encourage equity investors to be watching most carefully in bond issues through this period of time? Maybe thinking back to the financial crisis or other periods of hardship.

What things tend to flash in the bond market before the equity market? If you look at the bond market, there's a lot you can look at. If you want to understand investors appetite on liquidity or risk, you should look at the treasury market. If you're looking on the corporate market, I would look at spreads between investment great credit to see how as well as high yield in terms of what that availability is. I think that's important metric to look at. And then on the loan side, I would tend to look at spreads as well as dollar price to get a sense as to the health of that market as well. I mean, obviously a strong credit market provides a lot of benefit to the equity market. It allows companies to

perform M&A. It allows companies to do CAPEX. It also allows the financing for leverage buyouts, which actually benefits equity investors without the credit markets and the leverage market. It wouldn't make sense to have a biot activity, which can obviously benefit equity investors. So those are the things that I would focus on if I was an equity investor. Just a couple other questions on the credit spread specifically, since I know obviously that's something you watch closely. Give us a sense for what those spreads look like today, where that stands relative to, say, two months ago and sort of what historical extremes have been in spreads? If you get high yield spreads over time, they vary dramatically over time. The wide end in the 2008

crisis, which was a little more, was definitely the most extreme that the market's ever seen, was just under 2000 basis points of spread. So 20% spread at that point. The prior downturns in 91, and then in 91 and then the late 90s spreads peaked out around 1,000 basis points. And then the tight end has been around low 300s in aggregate. As of this morning on Thursday, spreads were around a little over 660 basis points for the market. They were 365 about a month ago. and after the day they'll probably be close to $750,000, depending on how the market closes today.

So that's kind of the range as to what they have been and where they are today. And why do you think such, so let's say they're at the upper end of that range after today, market just closed, you know, down 9.9% the S&P 500, which is a historic down day for sure. Why do you think that those aren't closer, given this volatility, the VIX is at 73 right now? why is it not closer to the financial crisis or really even sounds like the early 90s or late 90s on the spreads? We'd ask ourselves, what are we being paid for on a spread basis? And so you need to also combine the outlook for defaults and the outlook and the severity of defaults in the market relative to what you're being compensated for. It's every cycle a little different.

So if we go back to the 2008 cycle, there's a boom of LBO activity. And if you remember back then, you had companies like TXU going private. You had Univision going private, Clear Channel, Harris Entertainment, etc. And the amount of default that you saw in the riskiness of the asset class was actually much greater at that point because leverage was much higher at that point in the market. If you go back to the late 90s, late 90s default cycle was predicated by telecom. So in the telecom business, you had a number of business plan financing, where companies were linked fiber. And the math just didn't work.

And that was about a quarter of the market. And that ended up defaulting at that point. The market composition is something that people probably don't appreciate enough. The other piece versus, if you compare it versus 08, which I thought that be the biggest extreme in my career. And I hope that remains the case. But you get a tremendous amount of financial leverage in the system. at that point, banks were giving credit and hedge funds specifically were allowed to lever their credit, investments, bonds, and specifically loans around eight times.

And when you had Lehman default, there was an unwind of the financial leverage in the system combined with the default cycle. and then you also had on top of it at the time around $250 billion of announced acquisitions of LBOs that weren't consummated. If you had $250 billion supply that was there, if you look at today's market, it's nowhere near that. I would be surprised if you have $10 billion of commitments to close transactions, the quality of the market is much higher than it was before. and then as you look at the outlook, it depends on your view, but I tend to view the coronavirus as more of a transitory event. I mean, you think through it if you're, you know, this could take a quarter or two.

It's highly likely within 12 months there's going to be a cure for this. So this will go on for the next quarter to. This isn't like, this is a financial crisis event to the same magnitude in my opinion. So that's how I'm thinking about it. And that's why I think the market's got that view as well. So it gets a very, very different setup. You really have to kind of look at the underlying drivers. And you can see that the market is different.

Well, Brian, this has been incredibly edifying for me. A market that I know is really important in the midst of this market panic. So I appreciate you taking the time to walk us through it all. A lot of nuance there. I knew there would be. Thank you so much for your time. Thanks, Patrick. Appreciate it.

Hey, everyone. Patrick here again. To find more episodes of Invest Like the Best, Go to investorfieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfieldguide. com forward slash book club. After you sign up, we'll receive a full investor curriculum right away and then three to four suggestions of new books every month.

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