Talk Your Book: Investing in Public and Private Credit

0:00Today's Animal Spirits Talk Your Book is brought to you by PIMCO. Go to PIMCO.com to learn more about their whole suite of funds and strategies that invest in fixed income from public to private public to private. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:37Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:45Welcome to Animal Spirits with Michael and Ben. Michael, I feel like investing in bonds used to be relatively easy. It was kind of like there was treasuries and there was the ag. And you kind of picked one of those or maybe you put them together. And that was kind of it. And now it just seems like there's so many other opportunities to find yield in asset-backed securities and CLOs and private credit and all these different areas that investors really didn't have to think about before. I feel like the debt people have been just in their lab for the last 30 years. Venture debt. Concocting stuff.

1:19And it's an interesting thing to think about that. It's just way more complicated. And I think you have to be way more thoughtful about fixing. Because we've got a lot of questions from people in the last few years just about these different spaces. And like, does it make sense for me to invest in this stuff? And it's floating rate or it's tied to this asset or whatever it is. So anyway, on today's show, we brought on Jason Duco, who is an executive vice president and portfolio manager at PIMCO to kind of walk us through this whole thing. And I thought he did a really good job of walking through the difference between public and private credit and how PIMCO thinks about that and how an asset manager of their size that manages tons and tons of money.

1:56What does PIMCO manage these days? I don't know. Trillions? Trillion dollars or something? You know, this was one of the first talks that we've done. And I don't know if this is more a reflection of him or us, maybe a little bit of both. pretty buttoned up. I'm going to say that's him, not us. This felt like a real professional interview, not to brag. Well, here's the thing. It started out very professional and by the end he said, you know what? That was very conversational. Thank you guys. He thought it was going to be a CNBC-like thing and then you were sitting back in your chair, leaning back.

2:29I think we got him to loosen his tie a little bit. Yeah, it was good. Fun conversation. As fun as it can be about things. income, right? So here's our talk with Jason Duco from PIMCO.

2:43Jason, welcome to the show. Thank you guys for having me. So PIMCO is, I guess, are you guys the largest active bond shop in the world? About$2 trillion in assets, and we focus only on active management. $2 trillion in assets, not bad. All right. So you guys are well known for your house view. You have opinions. You are doing something different than the indexes. Where is the house view today? It's been a really bizarre market, been an interesting year. Where do you guys think we are today? Yeah. I mean, obviously, there's been a lot of iterations in where things are to your point. Including today, we saw an upward revision in second quarter GDP to 3.8.

3:27And where it leaves us today is we think we'll see a little bit of a deceleration in the back half of the year. We're coming in on the end of the third quarter right now. I think our expectation for GDP there is around 2%. And then a little bit of a further deceleration going into the fourth quarter, probably closer to 1%. But nothing too alarming there because we think that's just a little bit of effects of some of the policies that we've seen coming in place. The tariff policies in particular kind of slowing some growth. But we're looking ahead to 2026, and we think some of the monetary and fiscal policy that's out there should be stimulative and offset some of the tariff impact.

4:02And so we're looking for a return to decently positive growth in 2026, somewhere in that plus 2 % area. Are you guys surprised that we have not really seen a significant impact that tariffs have had on consumer spending? We saw, to your point, we got higher revisions today for GDP. I just saw a chart from Tarzan Slock. We're pulling in$350 billion annualized in money from tariffs, which has not seemingly slowed down the economy dramatically. You guys surprised by what's happened there? Yeah, I think everyone was caught a little off guard by the resilience of the consumer. And I think also by the reaction function of the corporates themselves.

4:48you know they have passed through some of the costs you know so there's a little bit of upward pressure on inflation which you can't have a conversation to talk about GDP without talking about inflation but what we're really starting to see and what's concerning us a little bit is the corporates are offsetting some of the tariff pressure with a little bit of labor weakening which I think you know puts the Fed in play one thing we didn't talk about is we recently you know obviously we had our first Fed cut earlier this month and we're anticipating two more cuts by the end of the year. But I think that's the balance that everyone's looking at is, you know, how did this policy end up playing out?

5:21I think most broad economists got it wrong initially. You know, post-liberation day, we obviously saw the big sell-off. There was a lot of, you know, backing away from some of those initial plans that Trump had put in place. I think where it leaves us from now is the Fed is in this, you know, precarious spot of trying to find that balance of the labor weakening that the corporates are, you know, utilizing to offset the tariffs. And how do we find that balance going into 2026? So I'm just I'm curious from an overall perspective, how you think PIMCO has handled this decade, because I looked at the numbers.

5:52And if you look just at treasuries, so like the five year, the 10 year, the long term, I plotted out by decades, because I think Deutsche Bank did this thing where they said, this is about one of the worst five or 10 year stretches ever for treasuries. And if you add inflation on the end of it, it's even worse. So I think you could make an argument that the 2020s to this point has been one of the worst decades ever for just high quality government bonds because rates rose from such a low level in such a hurry. And, you know, we went 0 % to 5 % effectively in a couple of years. I'm just curious how that's been managing money through that type of period where you had such in what is kind of been maybe one of the worst bond markets we've ever seen.

6:31Yeah, fair question. And, you know, I think a lot of people were starting to questioning, you know, the 60-40 model in general because it's been such a challenging backdrop for a number of years. But I feel like that's behind us. Obviously, that move we saw in 2021 was quite painful. In 2022, sorry, it was quite painful. But where it leaves us now is, and we've been saying this pretty vocally, that bonds are back. I mean, we have real yields now, unlike we had for a decade plus coming out of the GFC. And this isn't just PIMCO speaking. You can see it in the returns. you look year to date, most core fixed income type products are returning, you know, high single digits.

7:09Some of our, you know, the Barclays Ag itself is up, you know, six and a quarter percent with a quarter to go. So I think the numbers kind of reflect where we are. And then the question becomes, you know, where do we go from here? I think you have a little bit of a tailwind with, you know, the Fed in cutting mode and your starting yield is still quite attractive. You know, you're going to get the benefit of that duration. I think for a number of years, the duration wasn't acting as that diversifier that we thought it typically would be in that 60-40 model. But I think that's clearly not the case today.

7:39And we're still pretty optimistic that bonds have a nice place in most investors' portfolios at this point in time, just given these starting yields and the diversification it provides in most models. It's pretty remarkable that there is a lot of headline volatility, at least in the news. The Fed, the economy slowing, cooling a little bit. People are watching the labor market. I mean, there's a lot going on. But bonds are not moving. I saw the bond volatility index. I think that's what it is. Is it the move index? It's at a four-year low. It's really interesting, right? Yeah, yeah, it definitely is.

8:17And we've been paying attention to it. But we've also been pretty vocal. If you look at some of the PIMCO literature that comes out, you're right. You look at the 10-year. It's been plus or minus four and a quarter, four to four and a quarter percent. It's stuck in a very tight range for a number of years. There's been obviously some volatility in those periods of time, some shocks along the way in both directions. But kind of the baseline going back, it's been stuck in a pretty stable range. I think the curve, though, has not been as stable. So like on the surface, to your point, there's been a little bit of range bound.

8:48But we were inverted a couple of years ago. The curve got pretty steep. It's been flattening most recently. So there's been some nuance to that view that rates aren't moving. I think the curve has definitely been moving. We're generally favoring the front end of the curve. Today, we're favoring the five to 10-year part of the curve. But I think that's where, when you take an active duration approach, which, again, we do in most of our portfolios, you can find value even if it looks like the 10-year has sort of been range-bound. There's been a lot of movement around that 10-year point. So to your point from earlier, obviously, there's a lot more yield today.

9:22and there's a much bigger margin of safety. Are there any areas of the market where you don't see much of a margin of safety? Because it seemed like high-quality corporates, the credit spread is pretty tight these days. Are there any areas like that where you're just saying, like, we're not being paid to take risk right now, that we're being paid to take it elsewhere? Yeah, the most obvious one would be in the corporate direct lending space. We've seen record fundraising there. It's been a great run for them. There hasn't been a recession. the elevated base rate has been helpful for their all-in yields.

9:56But I think our concern there is what we're seeing is very healthy competition coming from the public markets. There's been pressure on spreads in general. You've also had the Fed in a cutting cycle, so there's going to be pressure on the yields from that standpoint as well. And then the lack of deal flow in general. I mean, we're optimistic that maybe, and we're starting to see a little bit of it here in the back half of the year, but M &A and LBO activity just really hasn't picked up in a meaningful way. So you're competing in this ferocious manner with the public markets that's leading to more leverage on these structures.

10:30You see elevated PIC, paid-in-kind interest on a lot of those direct lending corporates. You don't have great transparency. You don't have great liquidity, and you're all in compensation for that. Historically, the rule of thumb has been at least 200 basis points. We're seeing regular way direct lending deals get priced right on top or just outside of where a public broadly syndicated bank loan might get priced today. So I personally don't think it's going to be systemic in any way. I think it's mostly a real value trade that just feels very, you know, kind of tired at this point. So that's one area of the market, you know, that you could argue is, you know, not offering great relative value.

11:07So we generally have been shying away from that area of the market and many of our multi-sector products. Away from that, you know, think about high yield, you know, spreads are definitely tight there as well. But there's a lot of dispersion happening. Everything on the surface looks OK. It's been a decent year and high yield returns are approaching 8%. But beneath the surface, triple C's remain wide. If you're missing on your earnings, it's been quite painful in the secondary market where things are trading off. And then the other point to mention on high yield is the composition of the high yield market has changed pretty dramatically in the last 10 years, where it's a much higher quality index than it had been historically, somewhat justifying these lower spreads.

11:44So when you kind of quality adjust the high yield index, and JP Morgan actually just put out some good data on this, we are not back to the all-time tights on spreads on high yield on a quality adjusted basis. What is the higher quality coming from? Is that a private credit story or why is that? Yeah, it's interesting you're asking that. That's coming more from the bank loan market, actually. If you kind of step back in the last five or so years, the bank loan market has actually taken significant share from the high yield market. the CLO market in particular, which represents about 70 % of the market, started doing unitronic deals.

12:18Wait, Jason, I'm sorry to cut you off. What's the difference between bank loans and high yield? Yeah, good question. Thank you, Michael. High yield is unsecured fixed rate coupon debt. Typically, you can have secured debt. And then bank loans are floating rate secured debt. So typically senior in nature. But it would be the same type of borrower, right? Same type of borrower, below investment grade, large corporate borrowers. The market has generally been migrating up in tranche size. So these are larger borrowers, typically a billion-dollar tranche of debt or more in these markets. Because the private credit market is taking a lot of smaller issuers out of the market.

12:57Again, private credit, just to clarify there as well, that is also corporate borrowers. It's just typically smaller corporate borrowers. EBITDA, 50 to 200 million versus in the large corporate high yield and bank loan markets. The typical differentiation, and again, these lines are getting blurred as the markets evolve, is EBITDA greater than 200 million. But again, these are all below investment grade corporate borrowers across a wide range of sectors, 30 plus sectors in these indexes. Is it unusual for these companies to opt to finance their debt in multiple ways? Can they do some of the bank loan and some of the high yield stuff?

13:32Or is it either or? Yeah. I mean, that's one of the clear trends right now that's taking place in the market is the convergence of these three markets. And just coincidentally, all three markets are about$1.5 trillion, give or take in size. So you have a pretty big pool of capital looking to buy these respective deals that come to the market. And so you'll see the sponsor really take advantage of that demand that's coming from high yield bank loans and direct lending. And so less often you'll see an issuer issue high yield bonds and a corporate direct lending deal. But more often than not, you might see an issuer issue a first lien public bank loan and a second lien private direct lending as a solution to the capital structure because the public bank loan market is not set up or is equipped to kind of offer that second lien risk, which is often rated CCC.

14:23see. So yes, you will see the markets kind of play off of each other a little bit there. So back to the private credit thing. I'm curious if it's having any impact on the spreads in high yield or corporates or any other area. And is all the money that's flowing into private credit having an impact on the flows into fixed income at all? I'm just curious how that interaction between public and private is happening. Just because in the advisor space, we're seeing it, we get pitched private credit funds all the time. And there's a ton of money flowing into there. And it's got to be having some sort of ancillary impact on the fixed income markets as well.

14:56Absolutely. It is. First of all, the spread competition that you're pointing to is real and happening in real time. One of the unique things that the PIMCO platform is that we can dual track. We are agnostic. If the deal goes public or private, we have capital for both. So oftentimes we're talking to the sponsor about a solution that could be either or. And they're proposing spreads are a little bit more elevated in the direct lending market. So more often than not, when the competition is healthy, you'll see them kind of price in the public markets to take advantage of that lower spread. But yes, there is competition on spread.

15:27There's also competition on structure because you can maybe get a looser structure in the public markets. We've seen a little bit of a degradation in the structures for the private credit market as it's competing. And the last thing, one thing that is positive, you know, these are negatives I'm pointing out, but there is a positive element to this capital coming in. And if you think back historically, you didn't have this private capital out there looking to deploy. If you find yourself with a good company but a bad balance sheet, we've seen private capital come in and refinance some bank loans where they have a little bit more flexibility with, I mentioned earlier, picking or amending or maybe even putting an equity capital injection into the capital structure.

16:05And it could potentially mute defaults for certain borrowers that historically wouldn't. They run into a maturity. They run into a liquidity wall. Isn't that a good thing? Yeah, that's what I'm saying. That's a positive. I feel like the cynical person would be like, yeah, well, they're keeping these crappy companies alive. It's like, well, I guess, I mean, maybe in some cases, I'm sure there's a lot of nuance in there. But having the ability to get surgical and for this not to be syndicated and for these companies to make sure that they don't default and assuming that they're doing it in a responsible way and not just piling on debt and debt and debt, which, listen, they want to get their money back.

16:40I think on balance, it's probably not a bad thing. Yeah, that is definitely a positive. Having that capital out there, it's going to mute your default rate. And by the way, in high yield, we're seeing default rates for two years in a row now, less than 2%. Unbelievable. That is definitely having a positive impact from that standpoint. I think the negative, though, Michael, to your point, though, is that that amount of capital, think about the success of the direct lending product. And Ben, you're mentioning it. You're constantly getting pitched to these private lending funds. They've raised an incredible amount of capital the last number of years, and they have to deploy.

17:11So there's a little bit of this urgency or necessity to deploy. And then when you have that kind of timeframe with limited deal flow, you're going to compromise some things that maybe in the past you want to compromise, i.e. structure and spread. But so don't you think a reasonable and then onto this is not necessarily an implosion or systemic risk or people getting hysterical about too much money choosing too few deals? It's probably lower returns. Yeah, that's what we're seeing. But lower returns, but you're giving up transparency and liquidity, which I think is critical. Right. Because unlike the public markets, you know where things trade.

17:53There's an active market. So you're getting, you know, I would argue, you know, there will be periods like Liberation Day earlier this year, as an example, where that lack of liquidity can be really painful, where you can't, you know, go sell your private loans because there's not an active bid for them to rotate into an asset class that maybe gets oversold in those periods of dislocation. So that's the trade-off, and you should get compensated for that liquidity. Historically, I mentioned earlier, you should get at least 200 basis points. You're not seeing that today. How do you think those fund structures will handle that?

18:23Because the way that they've set these interval evergreen fund structures is you can take like 5 % out. It's a very small amount that you can take, so you can't have an investor rush for the exits. So does that actually help with the illiquid nature of these? Like you can't get this crazy event where like everyone rushes for the exits to sell because the investors themselves are kind of stuck right or wrong. No, no, that's right. But I wouldn't say that's a positive, right? Right. You want your money back at times of dislocation or times of fear and you can't get that. I won't mention by name, but we had a large competitor a number of years ago in the real estate space that did put up gates and limit flows back in a very large vehicle.

19:06And it was quite frustrating. Eventually, they found capital away from the traditional retail investor to kind of solve some of that problem. But I think that's a real problem. And also, you have the question, Ben, of, OK, in that time of the gates are going up and you're not really getting a daily mark to market, how much do you trust the marks as well? in that period of risk-off, dislocation, et cetera. So those are our fundamental concerns, is that not necessarily systemic, Michael, to your point, but that you should be getting compensated for the risk that you're taking. And it just doesn't seem that way.

19:39And with the Fed cutting and spreads competing with public markets, all of a sudden, this isn't a 9%, 10 % yield product. It's probably more like a 7 % plus percent yield product. All right. So you are one of the portfolio managers, along with the very famous Dan Iverson of the PIMCO Multisector Bond Active Exchange Traded Fund. The ticker is PYLD. When you say you guys are active, does that mean that you're making bets away from the benchmark? Or, and maybe, does it mean that you are actively turning over the portfolio based on relative value and things like that? Yeah, good question. And I'm glad we can clarify that.

20:23So first and foremost, PYLD is benchmark agnostic. So one of the differences, think about PYLD versus like a core product, it's not beholden to the Barclays Ag. So we can more actively manage duration and we can also access parts of the market that maybe the Barclays Ag can't offer you, such as Securitize or Agency MBS. So active management to us is a multifaceted approach. It's duration. And it's also going where we see the best relative value in these other asset classes outside of just corporates. I think that's very important. So it's a risk adjusted total return orientation and really utilizing the broad PIMCO platform.

21:04to, you know, we talked earlier in my kickoff comments about our top-down views, where we see value today. And then you combine that with some bottom-up, you know, views from the credit standpoint. And that's kind of how we, you know, think about portfolio construction at PIMCOs. Public or, you know, if the mandate allows for public or private, corporate or securitized, I mentioned earlier, we think, you know, corporate's a little bit tight right here. We find better value in funds like PYLD on the securitized side, on the agency mortgage side, where the technicals are very different there. I described overwhelmingly positive technicals on the corporate side.

21:39It's not the case on the securitized side. What does technicals mean? I'm sorry. What do you mean in that sense? Just demand for issuers, right? There's a lot of buyers. You were mentioning earlier the amount of people pitching direct lending funds to you guys or corporate funds to you guys. It's not the case on the securitized side. The banks have been in retreat for a number of years now. You had the regional bank crisis just two years ago. So they don't have the same kind of balance sheet or footprint in this securitized market. And that's where strategies like PYLD can come in and find some excess spread in those areas of the market.

22:14And being benchmark agnostic, it just gives it a bigger toolkit to kind of express our best relative value views. So I'm curious what you think about the mortgage-backed security market, because that's been an interesting one, too, that seems to be kind of messed up by this decade. You have higher-than-average spreads there, and I understand why they're there, because essentially the duration of these bonds got pushed out, right? Because people haven't been refinancing, right? They got stuck in their 3 % mortgage, then rates went to 7%. Why would you refinance or why would you sell your house and get a new mortgage?

22:47So I don't know what the numbers went to, but I think the usual mortgage duration is something like seven to eight years. It probably went to, you know, much higher than that on average. People want, seem to want mortgage rates to come down. They're falling a little bit, not as much as most people would like. So what do you think about that space? It's one of our favorite trades at PIMCO for a variety of reasons. You're right. It's been elevated for a while now since the Fed started raising rates. You know, the spread is still at historically wide levels. I mentioned the word technicals earlier.