The Dividend Cafe - Some Extra Credit

Episode Date: August 4, 2023

Today's Post - https://bahnsen.co/3rVTWPV I hope that you found last week’s Dividend Cafe on Credit to be informative and interesting. It’s summertime, and some people are more focused on the beach and the sun than syndicated loans, but not me. The cool factor has never quite been something people associated with me, and if I have to enter the month of August with a double issue of Dividend Cafe on Credit markets, I am going to do it. But it isn’t just for the least cool of us like me – as I mentioned last week, Credit is a sine qua non in our economy. It is not an end for economic activity, but it is a vital part of the means. Oil and gasoline are not the points of driving, but good luck driving without them (okay, fine, or without electricity – the point is the same). The point of last week’s Dividend Cafe was that Credit is both a signifier or messenger about economic reality and, at the same time, a catalyst or influencer on economic activity. I wrote last week’s Dividend Cafe in sub-optimal conditions (I will leave it there) and knew as I was wrapping it up that there was more to say, so I committed to a second part. So consider today some “extra credit” (see what I did there) – and jump on into the Dividend Cafe! Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to this week's Dividend Cafe. I'm filming out in the library at my desert house. I ended up coming out here. I actually wrote the Dividend Cafe from Newport this morning, and now I'm recording from the desert. And I like the fact that there's been a couple hours in between because there's stuff that I wrote very early this morning that is kind of marinated over the last couple hours. And I'm hopeful that you listening to the podcast or watching the video will get some more of that information. This topic is so important to me, and I can't really explain why. I don't really particularly invest all that heavy in the credit asset class. We're definitely invested there, but it's by no means a core and foundational position around creating life

outcomes the way dividend growth equity would be. Nevertheless, I think that credit is so important in terms of its macroeconomic signifying effects. And of course, there really are tremendous investment opportunities. And particularly, by the way, on the alternative side, when you look at our Magnify platform of how we think about investing client capital, the alternatives asset class is much, much larger than what we have invested in straight long only credit. And in that alternatives bucket, there is a lot that would be considered credit oriented from direct lending to structured credit, to various elements of securitized lending to, of course, private market investing. And so there is plenty of investment allocation and

credit within the Bonson Group, but yet it isn't that that is driving this two-part series of Dividend Cafe. The reason why I'm doing an extra credit Dividend Cafe today is because I don't think that the current moment and the significance that credit has to the economic point of the cycle that we're in was fully captured last week. And so let me kind of pick up where we left off. The issue that I talked about last week, the defaults have been pretty low in the bond market, both investment grade and high yield. They're higher, but I mean much, much lower than recessionary levels. The spreads have been reasonably contained. They're higher, but much, much lower than recessionary levels.

Those things are good enough, but it was the issuance point I was making that you haven't seen a lot of new issuance in levered loans. You haven't seen a lot of new issuance in bonds for that matter. And that my point was very likely there were a lot of borrowers who weren't going to borrow at these new higher rate levels and didn't need to because they had extended their maturities. They had locked in better terms, lower borrowing costs at the zero rate environment in 2020, 2021. And I stand by that theory. And I think it makes a lot of sense. And I stand by the theory that the Fed is well aware of this and taking advantage of a free ride on this side of a maturity well to try to tighten credit. But I would like to add to that, and there are two charts in Dividend Cafe today that you

really ought to look at to make this point. It's not merely a bond market, a loan market that you see this drop in issuance, but in structured credit, by which I mean residential-backed mortgages, not Fannie Freddie, but what we would call non-agency RMBS, residential mortgage-backed securities, and the CMBS market, commercial mortgage-backed securities, you see a significant drop in new issuance. Not a big surprise. A lot less housing activity going on. A lot less credit instruments being packaged and sold off to investors because there's less volume activity. And then the asset-backed market, which is, again, securitized, pooled streams of borrowing, but it can be connected to credit card, auto loans, all sorts of different asset-backed instruments. And you see a really significant drop in all these different elements of loans, asset-backed, CMBS, RMBS. And yet the

second chart shows a really big pickup in T-bill issuance and the percentage of total credit, total debt instruments of our borrowing across the investment universe in treasuries. And there isn't a way to prove that this correlation is causation, but I think it is an incredibly likely byproduct of the credit environment that a lot of the borrowing has moved from the more productive private sector to the less productive governmental sector. And funding government deficits, because you're getting a higher yield to do so, is going to produce a different economic outcome than credit being invested towards some productive economic aim, something that is wealth creating. And therefore, it puts downward pressure on growth expectations in the economy. So if one believes that we just are dealing with a lower issuance of credit because we are right now focusing on higher quality, in theory, that could be a good thing. Like abundance of loan issuance and residential mortgages did not exactly prove to be a good thing in 2004, 2005, 2006.

2004, 2005, 2006. Sending out money to bad borrowers is not what I look at as a great indicator of economic health. But I do not believe that we see a contraction in productive credit issuance because we are rechanneling from bad borrowers to good borrowers. I believe money has largely been diverted out of the productive economy into the governmental sector. Now, when we look at the default rates, the yield spreads, all of these different components as to what is kind of happening in credit, it doesn't draw a picture of horrible things happening, but that default wall, the maturity wall that I think is a default reckoning, if credit was still this tight. With the amount of loans that will mature in a year and a half, definitely two years,

definitely three years. So you're kind of looking out into, let's call it 2025, 26. If credit was still this tight then, oh, it would be, I can't imagine someone reasonable drawing a different conclusion than it would be a bloodbath with rates this much higher, that much money, the pressure put on EBITDA. I think there'd be a lot of challenges. But of

course, there's another possible ending here, which is that credit isn't this tight in a couple years. And so you have to kind of look at this whole global picture, meaning the universal dynamics and determine where these things could go. One of the things I want to do with our time here today is parse out the categories. I'm doing a dividend cafe on credit. Last week, I largely talked about credit as the bond market. And within the bond market, you add high quality bonds, and then you add higher yield bonds that are lower quality credit, credit quality, and then the levered loan market bank loans. But, you know, there are different terms that get used that I think some dividend cafe listeners, viewers and readers may be interested in. So I'm going to do that very quickly. And then I want to just summarize the whole two weeks of credit talk

with a few quick takeaways that will either be useful or not, but I hope they will be for your sake. So bonds, loans, structured credit, direct lending, and private credit. These are five different terms. And I want to make sure we understand the distinction because they're all kind of in a similar vein. They're debt instruments. They're things that are lent out that have a maturity date and the profit is to come from a coupon that is being paid, an interest rate that's being paid on that loan. And yet there are different sort of definitions and particulars that would apply to each within the credit universe. So bonds are the easiest because I think most people understand that they are a security. They're regulated as a security. They generally trade in a marketplace. Investors can buy and

sell bonds from one another. Some bonds have more liquidity than others. Treasury bonds are the most liquid instrument on earth. A certain real high yield, unrated muni bond on an obscure bridge or private school in Montana might not be very liquid at all. But nevertheless, bonds are securitized. They have ability to create a secondary market. They have a coupon, a debt instrument. And then there's different credit ratings. There's different tax treatment, municipal versus taxable. And of course, there's different issuers.

So the bond market can have companies, it could have governments, it could have municipalities. And then there's good rated bonds that we call investment grade and low rated bonds we call high yield. It's a nutshell of the bond market. That's been around forever. Easy breezy. But then when you talk about the loan market, a bond is a loan, but it's a secure, it's a loan that is backed by the issuer. A loan may not have any asset backing it. It's just really based on the issuer's creditworthiness, but it's senior. It's issued by a bank. The banks these days often syndicate the loans together, securitize them, and sell them off to what's called a CLO, a package of the loans. And you're just drawing all these cash flows, and they generally are floating rate,

a bond is a fixed rate. And these loans have floating rates. That's a good thing for investors when rates go higher. It's a bad thing for borrowers. So there's, you know, kind of different depends on what hat you're wearing, how you feel about it. But you know, the loans to banks will have to get paid before even bonds and let alone different instruments down the capital structure. You you look at structured credit as different than the bank loans, because bank loans might be backed by a particular issuer, but not necessarily with an asset, they may not have a particular issuer, but not necessarily with an asset. They may not have a building, okay, where a structured credit is going to be backed by an asset like

residential mortgages is backed by the underlying houses, commercial mortgages backed by the office building or warehouse or self-st storage units or what have you involved in that commercial real estate asset. I mentioned earlier the asset backed where they've kind of securitized around a pool of things that might be backed by aviation, you know, actual aircraft or, or different pools of loans. That's what we call structured credit. And it's structured around different tranches of risk and reward. And I don't want to get overly complicated. That's different than

lending against cash flows. Now, direct lending is lending against cash flows, but it's a non-bank lender. And so why would someone go to a non-bank lender for direct lending versus the loan market generally they're both going to be floating rate but the direct the private lender might have less covenants might have less onerous conditions to underwrite might be able to go quicker and so forth and so on there's a number of different factors that could make sense within the direct lending space. But the point is generally there, they are lending against cash flows, not again, and they're usually senior secured, but they're not lending against necessarily an underlying asset. And then private credit is a kind of term that gets used a lot. And I would distinguish this between direct lending

and private credit is first of all, the size, usually when we talk about the non bank lenders and direct lending, they're much smaller cash flow, you know, they're lending against cash flows, private credit, they're also probably lending against cash flows, but it's usually larger. But also they're lending oftentimes on LBOs, leverage buyouts. They're providing the debt against which equity position is taken in the purchase of a company or a partial purchase of a company. And this is a very heavy part of economic activity. And private credit has grown exponentially as a mechanism by which a lot of MNA, uh, a lot of LBOs get funded. They've taken a lot of market share away from the bond market, high yield bonds.

They've taken a lot of market share away from banks and, and, and the syndicated loan market. And why would someone perhaps want to go into the private credit world? I think that it's because sometimes they're going to pay more in private credit, yet be able to execute quicker, execute with more privacy. The whole world doesn't necessarily have to see it the way in the bond market, you're going to have more transparency. And there's a greater assurance of execution. You know you're going to transact. And then also, very candidly, there's oftentimes more intangible things, just value added. There's intellectual capital from these private lenders, the private credit world, that could be strategically beneficial for the companies. for the companies. These private lenders are in the business of doing debt and equity across the landscape of global economic activity, whereas a bank is generally very bureaucratic

and much less capable of adding value to the enterprise. The other issue I would say is that when things go bad, generally the bond market just has trust documents and specific legal paperwork for how that's going to go. And the banks have very, very little flexibility, even from a regulatory standpoint, whereas private lenders have entrepreneurial freedom to kind of work with someone on a workout. And so there's just more creativity that could come into that process. So private credit is exploded, direct lending is exploded, structured credit is more asset backed, you have the bank loan market, and then you have the bond market. These are all different elements of credit, they have to do with how debt gets issued to fund some economic activity. Okay. So with that kind of overview,

my takeaways of these last two weeks, I'm going to do this kind of quickly and I got to make this a little larger for me to see it. They're all listed at dividendcafe.com, but there's eight takeaways. I know it seems like a lot, but I'm going to do them quickly. Just kind of summary statements. First and foremost, credit is tightening. Right now, credit is tightening, but just simply not at a point where we're seeing real high defaults or overly restrictive access or overly expensive cost of capital that could get to that point of real economic contraction. Not yet. Credit's tightening, but it has not become this shutdown of credit. But number two, there is a maturity wall in about two to three years where a lot more new credit will be needed from just different maturities

of current loans and bonds. And if credit remains as tight as it is now, you would have a significant avalanche of defaults and problems. Number three, those problems in number two would not merely be for the borrowers and for the lenders, because you'd have a ton of defaults, but also for the economy at large. If that were to happen, it would have a big impact on jobs, wages, profits, and overall, and counterparty activity. It would lead to an impact to those on the other side of different transactions, vendors, suppliers, things like that. Number four, I find it unlikely that credit will be allowed to stay tight through that election year of next year and through the

maturity wall that lives on the other side of the election year. That's not to say it can't or it won't. It's not even to say it shouldn't, although I do think it shouldn't, but I find it unlikely. Number five, demand for corporate loans, for bank loans, for other credit activity is dropping quickly. Right now, we see a significant drawdown in the level of issuance. So defaults and distress may be low, but new issuance is way down. Number six, private credit, that kind of last category, the five silos I went through, has been the big winner for some time. I believe it will continue to be from out of bank failures, out of just the avalanche of change post Dodd-Frank, post GFC, the capacity of some of

the large private equity sponsors to arm themselves on credit capabilities. I think we're living in a very different world in non-bank lending and private credit's been the big winner. We'll continue gaining market share from both the bond market and the loan market. Number seven, from an investment standpoint, what we do professionally and what those of you listening want to understand, not just for economic relevance, but for portfolio relevance. I really think an all of the above kind of approach is the best thing to think about in terms of the menu of what might go into one's portfolio. into one's portfolio, that there could be tactical opportunities and loans and you could have structured credit that becomes less attractive and vice versa at different points, the way yield spreads move, the way defaults move and so forth.

There is a really big benefit to us constantly vetting right managers in each of these asset classes because it is not a sort of pick one versus the other and stick there. You want to have all on your menu for a variety of reasons in terms of optimizing the portfolio risk and reward and capturing opportunities as they become available. And then finally, number eight, declining credit conditions are here. We already know that, but what is not known is how much they decline from here. A few notches lower into 2024 and a soft landing will not happen. If credit worsens much, you will end up getting a harder landing recession. And if credit has already sort of bottomed and there's a kind of pickup in credit conditions,

credit quality, a tightening of credit spreads, then that stabilization, recovery in credit almost certainly means you will not see a recession at all, let alone a soft landing from one. So I'm not here to make a prediction of what will happen to credit. I'm merely telling you that as credit goes, I think the economy will go. And that there is right now this sort of middle ground of weakening credit conditions that are not horrid, that can become horrid, or that can become stronger. And if you find that unhelpful, I don't blame you, but that is the lay of the land. And it's not really understood the way I think it ought to be by many who are talking about the recession, that can just continue to

obsess with the jobs number, when in reality, the jobs number is sort of a byproduct of the fact credit's hanging in there. And that if you have a wave of defaults, that job number is going to change very quickly. So if we're trying to get to cause and effect, chicken and egg, all these cliches, just trust me, credit is a really good place to start in the kind of domino of how things will go, as opposed to trying to pick it up in the middle of the chain and guess where things are, where things are going. So that's my take on the economy as seen through the lens of credit. I appreciate you bearing with me these two weeks. I hope it's been informative. I love your feedback on it. If there's still questions, if you found it to be totally boring and dry, then go ahead and just delete those emails. But if you did think there's something beneficial here and you want to unpack more, I'm very happy to answer questions. And with that said, I do hope you have a wonderful weekend.

I'll be back to New York City on Sunday. I'll be there all next week. And I will next week be doing a Dividend Cafe that is, let's just say, at the heart of what we do at the Bonson Group. Thanks for listening. Thanks for watching. And thanks for reading the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC.

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