Fixed Income: What the Curve Is Saying

Stephen Dover: Walter, let's start with you. Talking about the current market where we are right now, one way if interest rates are going to rise, to look at a strategy is to shorten duration. Another way is to look at spread. So maybe just update us on how you're thinking about the high yield market right now and the opportunities in the market in general.

Walter Kilcullen: Yeah, today, certainly Stephen, much different prices. Valuations look a lot different in the high yield market. So, you're looking at a yield today of roughly 5.5% spreads over Treasuries about 3.45% [As of 2/15/21, measured by Bloomberg US Corporate High Yield Bond Index]. And I think with those types of valuations, you really have to look at two things: the fundamentals that we're seeing in the marketplace, what leverage metrics look like interest coverage, free cash flow generation, and then marry that with the technical. What is the market doing? What do retail investors want to be invested in?

I think, when you look back historically speaking, heading into a hiking cycle by the Fed [US Federal Reserve], when you couple that with an extremely low default rate right now of about 1% [As of 12/31/21, measured by Moody’s Investor Service ] typically that's a good environment to be in high yield, certainly a good environment for bank loans, the floating rate nature of that asset class. But I think as long as GDP [gross domestic product] is positive, we don't need 4%-5% GDP. I think if we're in that 2%-3% GDP range and the Fed, in terms of messaging, signaling, and ultimately timing of rate hikes does their job. I do think, given the fundamentals, given the strength in the consumer, ultimately the economic backdrop we're seeing here in the US, I do think the allocation to high yield makes sense. I think you have to be careful around some of the longer-duration credits in the marketplace, some of the eight and 10-year maturities that have been borrowing in the market that carry seven-, eight-year durations. But if the yield curve is going to go gradually higher from here for the right reasons, better growth, better growth prospects, we think the high yield market can handle that, can absorb some of that and spreads at 3.45% here could tighten.

In our opinion, at Western, credit fundamentals don't turn over in a handful of weeks. We don't think that's the case. I think if anything, we think this reopening trade from here has legs. Um, and with that, we should see a continued strong earnings forward guidance. I think what it comes down to is here is really active management issue, issuer selection, avoiding some of the tougher stories in the marketplace. And here at these new levels, spreads about 60 wider from year end, we do think there, there are good opportunities in the high yield market.

Stephen Dover: Let's turn to you, Reema, could you talk a little bit about what is floating rate mean and how does that market work?

Reema Agarwal: We invest in broadly syndicated bank loans. They're also known as floating rate loans. So, while we are part of the fixed income universe, bank loans have a floating rate income profile. They're picked to a benchmark rate. That's either LIBOR [London Interbank Offered Rate] or SOFR [Secured Overnight Financing Rate] that resets very frequently. Most often it resets every month or maybe three months, but while the loan itself may mature many years out, the income on it floats with short-term interest rates. That's the key feature of floating rate bank loans. So that's the market we are in. Right now, we are seeing very constructive conditions.

With bank loans, we sit at the top of the capital structure. We are senior secured in nature, especially the first liens. We are senior-secured and we are the first claimants in case of a restructuring. So, even if we have a moderation of growth going forward, what matters to us most is default risk.

So, as we have seen in corporates over the last couple of years, a lot of fundamental improvement has happened. A lot of liquidity buffers have been built up, and interest coverage ratios are still quite manageable. And there are risks obviously around inflation around raw material availability and costs, around interest coverage that we are all watching out for the longer term, but I think the fundamentals are quite constructive.

In addition to that, the whole rising-rate environment is a tailwind for bank loans. Since they are pegged to short-term rates, in a rate lift-off that we are expected to see, that creates really constructive technical conditions in our market. And we have seen that all of last year. If you go back to 2019 and 2020, loans were seeing significant outflows because nobody expected rates to go up in the near term; that flipped last year. And we've seen the market pivot away from outflows into inflows. And so, loans are seeing that technical tailwind quite strong at this time.

Stephen Dover: You talked about outflows and inflows, but I'm wondering about issuance and what the market is looking like in terms of availability.

Reema Agarwal: Yes. Issuance has been very strong. And as we have seen in years past, demand pulls supply. And so, we saw that last year, given the strong demand for loans last year and the continued strength that we expect to see this year, issuance has followed. We have seen a lot of companies come to the loan market. We saw record issuance last year, and this year has started off strong. In fact, a lot of issuers are rejiggering their transactions to move from the high yield into the loan market, just because they see that strength in the demand. So, we continue to see strong issuance. What is important to consider is the nature of this issuance. So, this is where I think active management comes in. It's critical because we've seen this in, let's say 2016 to 2018, and in a few years before that, as well, when you have strong demand, some issuers that have a higher potential of falling into stress in a downturn, or just based on idiosyncratic issues, those have the ability to come to market when they otherwise could not. So, I think the issuance is really strong. The volumes are really high. It requires really active management to sift through all of them, to identify the long-term attractive investment opportunities because all of that will get born out the next time, there is a correction.

Stephen Dover: Walter, let's turn to you now and discuss a little bit about default rates in the high yield market historically, and also what you see going forward.

Walter Kilcullen: So, the high yield market is roughly a 4.5% historical default rate. I think that does take into consideration some rather trying times, when you think about, long-term capital in the late 90s, into the telecom boom and bust early 2000s, obviously the financial crisis in 2008 into 2009, the commodity crisis in 2014 and 2015, and then obviously what transpired with COVID-19 and default rates got to about 8.5% for US high yield at the height there in 2020. They would quickly come down to about 1%. I think that's an important factor. When you think about spreads, as I mentioned, roughly 3.45% over Treasuries, that implies a default rate of roughly 5% in terms of defaults and that's using a $0.30 recovery in the event that you do have a default on average high yield, tends to recover somewhere between 30 and 40 cents on a dollar.

I think the difference today is we've seen so much secured issuance in the high yield market. It's been roughly 30% of issuance the last three years now has been more in the world of bank loan land. And I think those first lien, secured types of offerings historically have a $0.60 to $0.70 recovery on them. So, I think that is just another variable to factor in when you look at spreads and yes, spreads are through the historical average, albeit with a higher credit quality in the marketplace. The high yield markets, almost 55% double B at this point, and back in 2007 pre-crisis, you were looking at roughly a third of the market was double B rated.

So, in my opinion, this is the highest credit-quality junk bond market we’ve ever seen. Default rates here at 1%. We think it is actually they’re trending lower. It’s really hard to find a big distressed element in the asset class. So, I think that, again, it warrants attention. It warrants more focus on an asset class that historically is done well in a rising rate environment, provided those defaults stay low and growth is positive.

Stephen Dover: Reema, let's turn to you for a moment and just give us your view on the floating rate market, whether it's similar or not in terms of improving quality. And maybe also just talk to us a little bit about what sectors you see opportunities in and what sectors you might find some concern in.

Reema Agarwal: The loan market has seen trends that are a little different than what we have seen in the high yield market. In the loan market for several years now, we've seen much higher LBO [leveraged buyout] activity. There has been a lot of sponsors that have seen the high demand that loans have enjoyed over the last several years, excluding the 2019 to 2020 time period, but because of all of that demand, we've seen higher LBO activity—that causes the single B part of the market to grow in prominence. And single B issuers have taken share from double B issuers and triple C issuers in our market. So, it's becoming more centrally profiled. Last year, single B issuance was 80% of total. This year, already we are at 90%. So single Bs remain the place or the credit profile broadly that we are seeing in our market. That is something to watch out for as, as I've said, that there are issuers that will come to markets, the sub-investment-grade, fixed income markets that are able to tap investors for money when they should not be able to tap them. This is where I think active management comes in. So, we are very selective on what we want to look at, what is most attractive. And so, I think as active asset managers need to be very selective about what they invest in, in the current market, in the loan market.

Having said that there are a lot of opportunities that we find attractive. I think information technology is certainly a space that meets what I think, belongs in a good loan portfolio. It should have a long-term good record of defaults, loans are an asset class where the returns are asymmetric. And so, if you can avoid defaults, that's what generates returns in the loan market. And you want to generate your returns from income. So infotech is a sector that we quite like. We think that it has attractive income profile and it has a good default history. Certain pockets of health care we also like. On the other hand, I think undifferentiated retail is one that we are cautious on. We think that a lot of those businesses need to consolidate. They need to downsize. To the extent they have not built up their e-commerce businesses, they are in danger. So, we try and stay away from those. Having said that, there are parts of retail that are still attractive. Specialty retail, that has a higher staying power, that has a more loyal customer base, that is a lot stickier. Think about pet care, businesses like that, we still like.

Stephen Dover: As we look into the rest of this year and into next year and the possibility of a lot of rate hikes, how would you expect the floating rate market in general to perform under those conditions?

Reema Agarwal: Sure. I think from a technical standpoint, that only creates tailwinds for our asset class. A rising rate environment has always been positive for the loan asset class. Investors see a way to hedge their fixed income exposures against rising rates by making allocations to loans. So certainly, I think the technical conditions remain very positive, and they are expected to continue through this year. So, we have that view on the technical side. On the fundamental side, as I said, this is a time where you're seeing a lot of demand. The default outlook is low. So, everybody feels like we are going to have a constructive time period for several years, but in my mind, the time to exercise caution is now. So, what we always advise people is to put on their security selection hat a lot more in this environment. So, I think the opportunities abound. The issuance is high. The technical conditions are positive. Fundamentals are constructive for the near to medium term. And we want to be careful about what we invest in for the long term.

Stephen Dover: Reema, how do you look at inflation, and what if the reserve banks are kind of over reactive or for whatever reason we're actually going to be in a recession and the economy is actually going to slow down. How might you perform in those types of situations?

Reema Agarwal: So let me address the inflation part of it. Certainly that's a headwind across all corporates, I think we are watching for that quite closely. There are issuers that are getting more impacted than others. Not every issuer, not every sector is being impacted the same way. I think there are certain profiles that are able to handle these inflationary pressures a lot better. Companies are responding to all of these pressures that they have been seeing on the supply chain side, on the raw material availability side, in general inflationary pressures. You talk about productivity improvements. You talk about bringing more technology into production processes. You talk about passing through price increases. You talk about cost reduction. So, companies are doing a lot. I do think that there will be sectors and issuers within those sectors that will do well in these pressures. And then there are issuers that will not be able to handle these inflationary pressures. And the key is to separate out those two.

On the central bank policy missteps, that's essentially the question that you're asking. Yes, that is again, a risk. I think the risk is that they are two aggressive that causes recessionary conditions. Certainly, loans would get hurt in that. And that, again, is going to cause the weakest issuers to fall into stress a lot sooner than some of the stronger players that come to our market. As I said, single B is the largest component of our market. Not all single Bs are the same. The idea is to find the ones that will be able to handle the potentially recessionary conditions that could develop because of policy missteps. So that is a risk. We don't see that as a huge risk in the near term or the near to medium term, but that is a risk that I think would percolate across credit markets if there are policy missteps, because that will impact fundamentals.

Stephen Dover: Walter, let's turn to you with the same questions. How do you look at inflation in making your analysis of companies and that market in general? And then on the other hand, to what do you see about the risk of, perhaps having a recession and how would that affect the market?

Walter Kilcullen: I think we've been really impressed with our management teams that we invest in and lend to, quarter two, quarter three, and now even reporting here in Q4 from 2021, clearly the headwinds from all things prices and inflationary pressures. For the most part, they've been able to pass those through to the end usage, to the consumer. And I think we've seen that in many different sub sectors, I think home builders is one that comes to mind where just given the demand we've seen. And that's probably most common response I get from our analysts when I say,” tell me about the quarter, what are they saying about guidance?” And everyone's talking about bottlenecks and input costs and all prices being higher like I said, but I think offsetting to that has been the demand that we have seen from the consumer. And I think if we were able to get that done in Q2 and Q3, Q4, obviously you have to factor in Omicron at the second variant that that really hit home. And that's going to be in the numbers. And I think if, if anything, if some of those delays are pushed into Q1 that could help on the fundamental side. I think that that demand that we've seen from the consumer, specifically here in the US, has more than outweighed the inflationary pressures that are taking place. You know, we tend to believe that in the next six or so months that some of these pricing pressures will alleviate and allow companies to operate as they once did pre-COVID. But really for credit markets and in high yield specifically, we don't need tremendous growth in earnings. We don't need big margin expansion. What we need is proper behavior by management teams, focusing on the balance sheet, de-leveraging the balance sheet, paying down debt with free cashflow, ultimately paying our coupons and our maturities in the end, hopefully getting these credit calls, right, getting some spread compression along the way. Look, the inflationary issue is front and center for the Fed. I think they look at jobs numbers, they look at wages and inflation has certainly become the topic on the front burner. We think that will work itself out this year and, so far, been really impressed and pleased with the way our management teams have navigated through that type of turbulence. So, certainly will have an impact on the yield curve, ultimately will drive growth and margins, but as credit investors, really just need sort of steady as she goes, good prudent balance sheet management and, and ultimately just paying down debt, keeping cash full and respecting what bond holders have done for a lot of these issuers.

Stephen Dover: Reema and Walter, we want to thank you for giving us some information on how to look at the shorter end of the yield curve and opportunities both in high yield and floating rate.

Host:  And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about anywhere else you get your podcasts. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.