Oaktree's Wayne Dahl on Credit Markets Right Now

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1:15Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. Tracy, we just got back from California. We were at the Future Proof Conference. I love going to Southern California. I mean, you can't beat Huntington Beach. It was pretty sweet. It was so beautiful. It was really cool. We were out on the beach. We walked up to the pier, watched the surfers. Perfect weather, watched the surfers, ate some really good food, and had some pretty good conversations about the state of financial markets. Yep. And we finally got to record an episode that we've been meaning to do for a while.

1:51We dived into, not the ocean, but the credit market. I guess the credit market comes up here or there in various aspects of our conversations. I guess typically when we talk about real estate, maybe a little bit about the Fed. But the credit market is obviously so diverse and it's such its own world that it had been too long since we talked about, OK, what is happening in credit? Well, also, I think there was this expectation that as interest rates went up, you were going to see lots of drama in the credit market. And even though we've seen bankruptcies rise a little bit, we haven't really seen the big fallout that a lot of people had been expecting.

2:31Right. And, you know, look, the way people think about the Fed is that it works by tightening credit conditions. Right. Like in theory, like that's what like how it's all supposed to work, as you said, when interest rates go up. And yet we have got this rise in interest rates for sure. We definitely see it on the mortgage side, like less housing activity. But the sort of like broader tightening of like business credit, we certainly haven't seen much of a widening in spreads at all. So it's a confusing time. Absolutely. So we really do have the perfect guest to talk about this. That's right. Our guest, we spoke with Wayne Dahl.

3:03He's a managing director, portfolio manager, and investment risk officer at Oaktree. We talk about all things credit. What do you see? Why did rates move so hard? Why are they still like pressed up against the ceiling? We went through a period so long where interest rates were very low and money was very easy. And unfortunately, during the period of COVID with some of the supply chain issues, with a lot of the stimulus that was put into the economy, both through the monetary channel and the fiscal channel, that really set up kind of the perfect storm for demand to go through the roof and supply to be diminished.

3:40And ultimately, we ended up with this big inflation push, which if you go back to the formula from the 70s and 80s, how do you cure inflation? You raise interest rates quickly. And I think that's the playbook that the central banks, not only in the US, but really globally, had no choice but to follow. What does risk actually mean to you, an oak tree? And does it differ from maybe other financial firms' definition of risk? Yeah, that is a great question. And anyone who's read our chairman, Howard Marks' memos, knows that he's very clear that risk is more than just a measure of volatility. I mean, typically at Oaktree, when we talk about risk, it is our number one investment philosophy and investment tenant to keep risk under control.

4:26Really, it's to avoid loss. And the tagline there for Oaktree is, if you avoid the losers, the winners take care of themselves. So as credit investors, especially in a market like this where yields are high, you want to earn that yield and keep that yield and not give it back in the form of default. So to us, minimizing risk is largely related to kind of minimizing loss for investors. All right, let's dive deeper into credit. I mean, let's start like spreads are still pretty narrow. Yeah. And a credit is such a huge world. So I know we have to like go from like slice to slice to slice, but like big picture, people don't seem particularly concerned about like defaults.

5:05Yeah, I mean, look, I think one of the things with credit that has changed is largely related to the backdrop of interest rates. And to quote Howard again, our chairman, he wrote a memo in December called a sea change. And in that memo, he talked about this change in what was a low return world to a high return world. And that has really, I think, shifted the dynamic and the expectations around credit. And you're right. Have credit spreads moved maybe as wide as people thought? No, but the yields have become very attractive. And ultimately, I think if you look at credit, this is something we did a lot last year.

5:45There's kind of three ways I would look at value in fixed income. Number one is, what is the yield? Well, that was very attractive. Number two, what is the price? If I can buy fixed income at a discount, then I can earn more than just the coupon. And number three, what is the spread? The first two were at very attractive levels and spreads, maybe kind of at median levels. But two out of three makes a pretty good investment. Well, how are you thinking about default risk now? Because certainly there were a lot of people, I mean, just last year in 2022, who were warning about we're going to get this big recession.

6:23There's going to be a big spike in defaults. We certainly haven't seen, you know, the bankruptcy rate has picked up a little bit, but we haven't seen this wave of failures that a lot of people were predicting. Yeah, that is definitely true. And I think for part of that, you have to think about what happened during COVID. And in a way, you could almost say COVID was maybe recession part one and we're on our way to recession part two. And the reason why I say that is because if you think back to the end of 2019, before COVID, the Fed had stopped hiking rates in December 2018. And at that time, actually had planned to continue to hike.

7:03Chairman Powell pivoted in early January 2019 and ultimately ended the year by cutting rates three times. There were a lot of the similar signs of slowdown in ISM data, in industrial production data. a lot of your typical signs of a recession. So in a way, COVID potentially just accelerated us into a recession that was maybe on its way already. But what it also did is brought forth a number of defaults. You had, you know, default rates in the high yield bond market, the broadly syndicated loan market, anywhere from kind of four to 6%. And in a way that was kind of a cleansing event that prepared us for this time here.

7:43In the high yield bond market, because of that default rate, you cleared out a lot of the lowest rated companies that were under the most stress. Simultaneously, you had a number of downgrades. So triple B rated securities into double B or single B rated into high yield. So you up the quality of the high yield bond market, maximum triple B's, minimum triple C's, and kind of created this environment where everybody just refinanced at the lowest rates in history, and they don't really have a cash flow problem or a maturity problem. So you anticipated my next question. And I appreciate that you brought the 2019 experience because we don't really talk about 2019, but it's that much anymore.

8:27But of course, that was an interesting year. And then so, okay, so we have these defaults, then the pool of credit gets better, and then the big terming out of debt. And so everyone refinances, fixed rate, ultra low. Talk to us about like today in September 2023, how that terming out is playing into things now. And like, you know, people talk about the maturity wall. No, Joe, you have to say looming maturity wall. That's the rule. The looming maturity wall. Talk to us about like the effects we're seeing today from that terming out. You're absolutely right. I mean, just to kind of put some numbers to that.

9:02in 2020 and 2021, the high yield bond market in the US had gross issuance of about$800 billion in a$1.3 trillion market. So you had two thirds of the market refinance. Now today, you're right. We've obviously the duration has shrunk in that market because refinancings have declined, but it does kind of become a 2026 maturity, you know, kind of problem. Companies don't wait for the last minute to refinance their debt. That wouldn't be wise because what if the capital markets freeze up? So you kind of bring that forward maybe one to one and a half years. So I think as we get into 2024, you will start to see a situation where companies are going to have to come to the capital markets.

9:49Well, it's not there yet. Well, I was about to ask, though, because this month we have seen a pickup in new issuance. So what's going on there? Like, why are companies deciding this is the moment to start selling new bonds? I mean, there are certainly companies. I mean, I can't remember the exact number, maybe less than 20 % of the market that comes due over the next 18 months. So there is some amount to refinancing. There is some capital activity going on. And some of it, I think, is moving exposure from one market to another market. If you look at the broadly syndicated loan market, that market is made up of floating rate debt.

10:27I mean, there is a market where people's interest cost has gone, well, it's more than doubled in the last 18 months. And the high yield market has seen some refinancing out of the loan market into secured bonds in the high yield market. So there has been some kind of new entrance in there as opposed to simply refinancing. Are there sectors or types of borrowers who, in your view, are going to have a trickier time over the next 18, 24 months as some of these refinancings pick up? Well, like I said, I mean, if you want to talk about the places in, I'll say that non-investment grade or speculative grade market that's going to have trouble, it will, I think, potentially be some of these issuers in the loan market.

11:11And again, the reason for that is they have seen their cost of financing really go up as their index to short rates, which are now 5.5%. What type of borrower is in the loan market? So you certainly get exposure to many industries, but the loan market today has really shifted into the financing source of leveraged buyouts. That is the majority of the issuance in that market. When you talk about a pickup and issuance in the loan market, you're typically expecting a pickup in M &A activity using loans to refinance. And one of the biggest areas that's seen a lot of M &A activity from private equity sponsors over the last few years is in some software and technology related business.

11:57So that is the largest single sector in the loan market today.

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13:36It's built to grow with your business, whether you are just starting out or already scaling up. Plus, it's easy to use, customizable, and designed to streamline every process. So you can focus on what really matters, running your business. Thousands of businesses have made the switch. So why not you? Try Odoo for free at odoo.com. That's O-D-O-O dot com. Do you see froth in the leveraged loan market? Because this was an area of concern for, I mean, years, even before COVID. You saw a lot of financial regulators start to crack down on, you know, capital requirements for leveraged loans. You saw, I should tell a story about, I was in a bank one time and I won't name the bank, but I was going to see their leveraged loan bankers.

14:22and they had a framed T-shirt in their office that said, I stole this shirt off my client's back. So that kind of encapsulates - What year was this? What year was this? I think it would have been like maybe 2015, 2016. It was definitely the height of the leveraged loan boom. But is there froth? Look, I mean, there's definitely been froth in that market. And maybe to define that a little more clear, to say there are certainly borrowers that probably are at risk of having extended their balance sheet too much. And in the face of borrowing costs or interest rates going so high, they've kind of put themselves in a tough situation.

15:10I think one of the things to remember in the loan market that has maybe masked some of the potential volatility over the years is the majority of buyers in that market, almost 70%, are coming from the CLO market or collateralized loan obligations. And those buyers are not active traders. So you don't see loans traded like you do some of the other investment grade bonds, high yield bonds, and in a way that can kind of mask some of that building volatility. Again, one of the stories pre-pandemic was this idea that a lot of the power in the market had shifted from lenders to borrowers. So the companies who are issuing debt or taking out a loan could dictate the terms of that deal.

15:55And so we saw a lot of CovLite deals, maybe some sketchy leveraged loans. Is that still the case or does it feel like the pendulum has swung a little bit as interest rates have risen? I think in the broadly syndicated loan market, that's probably still largely the case. There is a lot of demand. And obviously, over the last, call it 18 months, supply has been diminished. So you have people who want to buy loans as institutions, you're competing against CLOs buying loans. So that demand has kept up. I think one of the places where maybe you have seen a little bit more of a shift there is in the private credit market that's issuing loans where you've seen kind of a pullback from some of the buyers that were very, very active in 2021.

16:38And either the new buyers or continuing buyers have been able to be a little bit more strict with their demands for terms, covenants, things like that, and those deals. When private credit comes up all the time, and we probably should even do more on this, but it always seems like for whatever reason, and I don't really understand it, I don't know much about the market, for whatever reason, it seems like it doesn't matter where the cycle is. It It just grows and grows and grows. Private credit. What's up with that? By BDCs. How does that happen? Well, I mean, who wouldn't want to put an asset in their portfolio that has no volatility and the price doesn't move?

17:15Is it really that simple? Is it like, because people say that and like, I can't really be like that. That can't really be the story. But is that the story? I mean, Joe, to date, I think that largely has been the story. I mean, you're right. There has been a story. Well, the time will come for the day of reckoning of all this borrowing and this private credit market, all these marks that are staying at par are going to come down. And perhaps we are getting closer to that date, but you're right. That really still has not been tested. Although I think people are preparing a little more for that day to come.

17:49Every time I hear about PE or VC or private credit and people are like, well, the big nice thing is it doesn't move. And so I'm like, that can't be it. It can't be that. And yet maybe that is a big thing. I mean, it has kind of been that easy to date. But like I said, I think people are getting a little more concerned where you see, you know, I think some private credit managers deciding, do I want to deploy this incremental capital that I can draw down? Or do I need to preserve this to potentially, you know, rescue some of the deals that are already in my portfolio? I think investors are getting a little more picky as well when looking at some of these legacy portfolios going, hey, I like private credit and I like where it's price today.

18:28But do I want to buy the portfolio that was built in 2021 when money was free? Does the rise of private credit affect Oatree at all? And what I mean by that is like, maybe there are certain opportunities that end up getting taken by private lenders versus publicly traded. You know, a company will decide I'm going to do a private deal. There's a lot of appetite, a lot of demand rather than go down the publicly traded route. Maybe the caveat is it depends which group you talk to. Yeah. But no, I think the growth in private credit, especially over the last few months, has been positive for Oak Tree and has potential to be positive for more areas.

19:09I mean, we are certainly active in these private credit markets seeking to find value and really fill a gap that I think has grown over the last 18 months where some of the larger players have maybe stepped back and including some of the banks. I think on the other hand, Oak Tree, obviously we're known for our distressed debt business, which now is our global opportunities business. Here's an opportunity for a group like that to maybe step in and support some of these deals if things go south. So I think there's multiple ways where we can see a benefit from this growth. So you mentioned, you know, maybe like some of these private credit managers and maybe they don't want to like deploy that additional marginal capital for that risk.

19:57It made me wonder, just going back to sort of the beginning of the conversation, like you can get a real return risk free these days, which you haven't been able to get in a long time. And you don't even have to take any like duration risk. You can like the positive rates at the short end. Does that change risk appetite? Or you see people like, yeah, look, I can make money and I don't have to take any risk. Does that change how money gets deployed in your view? Yes, I definitely think it does. And really, from our standpoint, it kind of shifts even where we take risk on maybe the risk spectrum or the duration spectrum.

20:31I mean, it's rare that you have short rates being the highest part of the curve. So what's kind of resulted in that is securities that pay interest indexed to those short rates have become even more and more attractive. So just to, again, kind of put some numbers to that, if you look at the high yield market, a fixed rate market, sure, their yields have gone up, but their income they generate has stayed right around low sixes, despite the call at 9 % yields. Can you just explain that a little further? What I mean is the coupon on a high yield bond is under 6%. Their price is currently below par.

21:07So you take that coupon divided by the price. That's your current yield. That's going to be in the low sixes. Whereas if I can buy a high quality floating rate security, that might be a structured asset, that might be a broadly syndicated loan, I'm earning that near 5.5 % SOFR rate plus a spread of call it 400 basis points. Now I'm earning 9.5%. So yes, risk-free is certainly a viable investment, but so are a lot of other investments that are reasonably safe that have an appropriate kind of spread for their risk. So we're talking about yields sort of enticing buyers at this moment in time, but there's something else that has happened since the pandemic, which is the Federal Reserve announced this massive corporate bond buying program that in theory is now a permanent backstop for the market.

22:00Do you think that's affected investing behavior? There's no doubt that had a significant impact on investing behavior in 2020. just knowing that that backstop was there. I'm not sure how much today. I mean, I think in the case of, say, the high yield bond market, you have seen that market kind of shrink over the last 18 months, shrink because deals have come due that haven't been refinanced. You've had actually more upgrades than downgrades in that market, which may be surprising given the, you know, all the talk of recession and the need for spreads to be wider. So, you know, you do kind of have this almost supply demand mismatch on the side of, you know, maybe demand kind of pushing those those spreads tighter.

22:47But I think it's in it's in the back of people's minds somewhere. How do you think about the Fed here? Tracy mentioned the backstop. But in terms of like the sort of good old fashioned where they are on the rate rate side, obviously, there's hope that maybe they could cut rates even in the absence of a recession. But is the Fed like, are we clear? Is the Fed going to like we got the inflation thing licked? I think that's a mistake that the market has made for the last year, that inflation would come down regardless of what the economic backdrop is, regardless of what happens to asset prices. The Fed would turn around and cut rates.

23:24That was a big story in January of this year when you had kind of everything rallied, spreads compressed, rates rallied, high yield rallied, investment grade credit rallied, kind of everything rallied on this expectation that rates would come down before the end of the year, despite the fact that people called for a recession. And that, I think the market's kind of coming around to the fact that it's probably maybe a little bit too much wishful thinking. My memory is kind of hazy. At some point, people were thinking that they would already be cutting by this point. Yes. Oh, yeah. In January. Well, the other triggering event for the Fed was in March.

24:02Right. In March this year, when you had the Silicon Valley Bank, Signature Bank, kind of regional bank flare up, the market really pivoted to expecting rates to be cut by about 150 basis points by the end of this year. That's completely reversed. And everyone said, like, historically, the Fed hikes until something breaks. And then a few weeks later, it's still red hot. I think the Fed's kind of in an interesting spot right now. And obviously, you guys were at Jackson Hole and had a number of guests out at Jackson Hole. And I think looking at Chairman Powell's speech this year, maybe compared to the last two, I think he's got to be feeling pretty good about himself right now.

24:41Because clearly, last year, he kind of had to give the market a bit of a scolding and say, Hey, all you dreamers out there that think inflation is going to come down and we're going to immediately kind of ease financial conditions. You're wrong. We're in this for the long haul. And this year he was kind of able to stand up and say, thank you for listening to us. We're still in it for the long haul as long as the data dictates.

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