The discussion on credit has been extended by the Bengua team since 2016 to the latest one. Of course, there have been many changes in various types of assets in the middle. The team suggests the following reading method:
Firstly, understand the background of the fund managers involved in the discussion and the investment areas they cover
Secondly, based on the changes in various assets from 2016 to 2017, we can see the consistency or changes in the statements of fund managers under asset changes. It may be more informative to understand the current cycle and configuration.
Discussion topic: The State of Credit Markets and Current Major Investment Strategy Risks
Key description of participants in the discussion:
Sheldon Stone: Principal and PortfolioManager, U.S. and Global High Yield Bonds
Edgar Lee: Portfolio Manager, StrategicCredit
Keith Gollenberg: Managing Director,Real Estate
James Turner: Portfolio Manager,European High Yield Bond and Co-Portfolio Manager, Global High Yield Bonds andEuropean Senior Loans
Jordon Kruse: Co-Portfolio Manager,Global Principal
Rajath Shourie: Co-Portfolio Manager,Distressed Opportunities
Max Wong: Managing Director, Marketing& Client Relations
July 2016
Oak Capital discusses the issue of credit cycle for the first time:
Here is a brief overview:
Firstly, no one questions the current viewpoint of CREDITCYCLE DOWN-LEG. And they all agree that we are currently in the early stages of Down League.
The current DOWN-LEG is more like the early 2000s, when more and more capital entered the “popular” star industry, the telecommunications industry. In the early 2000s, these communication companies defaulted one after another, and unless oil prices returned to a significant level, mining and production enterprises may also experience the same problem.
Jordon Kruse, Co Portfolio Manager, Global Principal, stated that compared to 2008 and 2009, the current DOWN LEG has undergone significant credit injections in both cycles. The difference is that there is currently no systemic problem. The problem in 2008 was the subprime mortgage issue, which was also the role played by large banks in subprime loans.
Afterwards, we discussed where the main defaults in 2016 would come from. The energy related industries will be the biggest problem.
Oak Tree will currently be more diversified in the field of senior loans, but will strictly limit its exposure to energy.
Next, questions were raised regarding the role played by China in this cycle:
What impact will China have on this cycle
Rajah from Oaktree Capital stated that China’s demand role in this cycle will certainly continue to be monitored, but the current situation is very unclear.
It is crucial for everyone to understand and comprehend the composition of the exposure of China’s overall economic sources at present.
Besides China, what other risks should we be aware of?
The distressed bond department stated that there will be opportunities to buy in the next two years, and there is still a large amount of funds left at present. And targeting companies with high quality but excessive leverage in the next two years, this is the opportunity to buy at a low level.
March 2017
Following the first discussion on the credit cycle in July 2016, further extended discussions were held in March 2017, during which the returns on various assets were as follows. By comparing and extending the basic story background of the discussions in July and March, we can better understand the significance behind the discussions and stimulate thinking
The entire discussion will be conducted in the form of a dialogue:
Max Wong:
In the previous OaktreeInsight Plublication, “Navigating Cycles,” we discussed the impact of cycles on different asset classes. So, where are we currently in the credit cycle in your investment strategy?
Edgar Lee （Portfolio Manager, Strategic Credit）:
In early 2016, we saw a downturn in new issuances in the capital market. But in the first few months of this year, there was an incredible surge in new releases and demand for such new releases. Let me give you the most intuitive example of high-yield bonds: a bond issuance of 500 million yuan can see 5-6 times the demand.
Sheldon Stone, Principal and PortfolioManager, U.S. And Global High Yield Bonds:
As Edgar pointed out, we see that the pursuit of income is almost greedy, mainly because of the very low risk-free interest rate and treasury bond bond interest rate. Investors have a strong desire for 5-6% returns. The essence behind this dynamic is radicalism – also a characteristic of the late credit cycle.
James Turner, Portfolio Manager, EuropeanHigh Yield Bonds and Co-Portfolio Manager, Global High Yield Bond and EuropeanSenior Loans:
Europe continues to experience slower economic growth than the United States, with a growth rate of 1.8% in the third quarter of 2016 and a GDP growth rate of 3.5% in the United States. In addition, the uncertainty of Brexit for the overall European economy has always existed, making it more difficult to judge the realization of the UK and the overall European economy. That is to say, I believe that the European credit market, including high-yield bonds and CLOs, is basically following the credit cycle of the United States, so even if we see a lack of bright spots in the European economy, I think we will also see the same demand for credit as the United States.
Max Wong:
Have you seen any key trends in your respective investment fields?
Edgar Lee:
The most significant impact on the bond capital market recently is the introduction of new regulations, including those related to leveraged loans. The chain reaction of these regulatory policies is that capital quickly rushes into private loan funds, which are willing to provide leverage and drive the overall leverage ratio of the financial system to increase. Behind this significance is the transfer of risks from banks and public investors to private loan lenders.
Sheldon Stone:
We see Edgar’s mention of the moderate regulatory impact on the overall credit market leverage and the increased demand for leveraged buyouts.
Keith, Gollenberg, Managing Director, RealEstate:
Another thing we are currently seeing is the demand for a ‘preferred stock scheme’. Preferred equity occurs outside of the new regulatory scope, and as companies simultaneously issue traditional bonds and preferred equity, it will effectively increase the overall leverage level. This solution alleviates the impact of new regulations on companies, especially for buyers of private equity, which increases potential returns (and of course risks), thanks to these additional leverage.
Max Wong: Which specific top risk do you think currently has the most impact on the market or your strategy?
Keith Gollenber:
We live in a global environment of quantitative easing, where interest rates are very low in various countries, and investors continue to search for value in the real estate market. Our main concern is the impact of foreign capital on the value of real estate. We see the increasing demand from foreign investors and the continuous influx of foreign capital into the United States, causing upward pressure on asset prices.
Sheldon Stone:
I have fewer concerns about economic growth, geopolitics, and Washington’s internal affairs. Furthermore, I believe that the market has already fully priced in the significant impact of the commodity market on the overall market. For me, the biggest risk is whether a company has the ability to generate enough cash flow to repay its debts. At present, I do not believe that many companies have a risk of default.
James Turner:
I agree with Sheldon’s view, but I believe that geopolitical crises are the biggest potential impact, and this part is very difficult to pin down. Terrorist attacks will continue to have an impact on the market, and there will always be a moment when the market will panic. But recently, there have been no catalysts that have caused such shocks, and I feel that the market is getting used to this situation.
Max Wong:
How do these types of risks affect your investment decisions?
Sheldon Stone:
Oak Capital focuses on fundamental credit research and cautious execution of diversified investments. In credit, you never get strong conditions from concentrated investment or huge risks. As a result, we will maintain a large sample of bonds with strong fundamentals. We use our own specific independent credit research system to measure these configurations, and this research system already includes very detailed downward sensitivity model testing.
Keith Gollenberg:
Sheldon’s evaluation also applies to the assessment of private lending and public securities in the real estate category. Furthermore, in the real estate category, it is clear that there is no actual ability to transfer this asset from one jurisdiction to another, so understanding all your rights and remedies correctly becomes crucial. We attach great importance to the terms of the debt instruments involved.
Max Wong:
Where do you see opportunities based on current trends and risks?
Sheldon Stone:
In the field of high-yield bonds, we focus on two areas: the secondary market and the new issuance market. We usually find valuable bonds in the secondary market – because there are usually forced sales. In other words, when these asset classes are in the capital car. These situations have not happened recently, so we are still searching for value in the new release.
James Turner:
I agree with Sheldon. However, we have found attractive bonds in the secondary market in the European market, especially IG’s bonds that were previously downgraded. Furthermore, what is even more unique is that we see bonds issued by American companies with a face value in euros. Usually, American issuers are not recognized in Europe, so these types of bonds have a wider spread in the same capital structure compared to bonds denominated in US dollars issued in the United States. So, we can get better returns under the same credit risk.
Edgar Lee:
Beyond the risks of certain industries and companies, we have been searching for advanced loans that currently offer discounts or transactions at face value. Advanced loans are more advanced in the capital structure and typically provide exposure to floating interest rates. If the bond market continues to perform strongly and economic growth improves, convenience can bring some benefits with discounts. In addition, if interest rates rise, floating rate tools can provide upward protection. CLO bonds, especially 3B bonds, are another focus of our attention, although they are not as attractive as they were in early 2016. (Note: The performance of interest rates for senior loans and bonds is opposite.)
Keith Gollenberg:
We are seeing more and more opportunities under private lending structures. About half of the 1.3T US commercial real estate loans will mature in the next four years. Many loans cannot be renewed at face value in cooperation with banks and insurance companies, and as a result, obtaining loans from private lenders like oak trees will become increasingly popular.
Summary:
During these two discussions on credit strategies, Oak Capital extensively mentioned bond maturity and debt extension. During bond maturity, with a particular focus on energy, the mining industry is at the forefront. At present, enterprises need to pay attention to the performance of these types of enterprises in repayment. And it is also mentioned that most of this demand comes from China, so the percentage of China in the independent variable is very important. Additionally, commercial real estate loans in the United States will mature over the next four years. The continuation and cost of the loan will be key.