The Next Stage of the Credit Cycle with Oaktree’s Poli

In short

Odd Lots Podcast Episode Notes

Episode Title

The Next Stage of the Credit Cycle with Oaktree’s Poli Hosts: Joe Weisenthal and Tracy Alloway Guest: Danielle Poli, Co-Portfolio Manager at Oaktree Capital Management

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Episode Summary In this episode of Odd Lots, the hosts discuss the recent Federal Reserve rate cut and its implications for corporate credit markets with Danielle Poli from Oaktree Capital. They explore how corporate credit has defied expectations during a period of high rates and inflation. The conversation highlights the growth of credit options available to companies and the potential effects of lower rates on future defaults and credit cycles.

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Key Points Discussed

Fed Rate Cuts and Corporate Credit
The Fed recently cut benchmark rates by 50 basis points.
Rate cuts could ease financing challenges for companies, especially those with floating-rate debt.
Despite previous high rates and inflation, corporate defaults have increased slightly but not drastically, indicating resilience in the credit market.

The Landscape of Credit Options
Companies now have diverse financing options, including syndicated loans and private credit, allowing them to avoid major financial distress.
The growth of the private credit market has increased competition and provided alternative avenues for borrowers seeking capital.

Current Credit Cycle Dynamics
The episode raises the question of whether we are at the beginning of a new credit cycle or merely a new phase.
Danielle Poli suggests that while defaults may rise in certain sectors, the overall credit market appears stable, with a high percentage of high-quality issuers in the high yield market.

Investment Strategies and Decision-Making
Oaktree's investment committee focuses on avoiding losses rather than solely picking winners, prioritizing relative value in investment decisions.
Danielle highlights Oaktree’s strategy of maintaining liquidity in order to capitalize on market volatility and opportunities.

Growth of Private Credit
The private credit industry has expanded significantly, with Oaktree being active in this area since the early 2000s.
The conversation touches on the competitive landscape in private credit, where demand often leads to a dilution of protective covenants in loan agreements.

Sector-Specific Insights
Real estate is identified as a sector facing challenges due to higher rates, but the outlook may improve with lower interest rates.
Danielle discusses how trends in technology and infrastructure investment are influencing borrowing patterns and credit quality.

Errors of Predictions and Market Sentiment
There were widespread fears regarding a recession following aggressive rate hikes, but many companies managed to strengthen their positions in the market.
The episode questions whether the perception of recessions will change moving forward, given the Fed's ability to intervene effectively.

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Key Concepts and Terminology

Credit Cycle: The fluctuating period of expansion and contraction in credit availability and borrower risk.
Default Rates: The percentage of borrowers who fail to meet their debt obligations.
Private Credit: Non-bank lending, often characterized by higher yields but also higher risks.
Covenants: Conditions that borrowers agree to in order to secure loans, designed to protect lenders.
Liquidity: The availability of cash or easily convertible assets to take advantage of investment opportunities.

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Conclusion This episode delves into the evolving landscape of corporate credit, emphasizing the resilience of the market amid changing economic conditions. Danielle Poli's insights into Oaktree's investment strategies and the dynamics of the credit cycle offer valuable perspectives for investors navigating today's financial environment.

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Transcript

Automatic transcript. May contain errors.

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1:53Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, it struck me that we might be at the beginning of a new cycle, a new credit cycle. Are you making a call? Are you making a market timing call? I would never, never. No, I'm trying to frame this episode. But we have recently, by the time this episode comes out, had a very momentous, presumably, decision from the Federal Reserve where they've been cutting rates or they will have cut rates for the first time since I think the summer of last year. Oh, sorry. Summer of 2022? I can't remember now.

2:32Yeah, it's wild. And whenever there is a turning point in the rate cycle, people are often, you know, we've had this regime, equity markets have done really well, credit spreads generally have been pretty tight. And so when you're in this sort of new phase of a cycle, then it's a natural time to sort of revisit where things stand, what kind of assumptions have been baked into markets, and of course, like what the risks and opportunities are. Yeah, and I think the previous couple of years have certainly surprised a lot of people who are in credit. You know, people thought when rates went up, there was going to be a spike in defaults.

3:11And we haven't really seen that. We've seen an increase, but it hasn't been disastrous. We've seen spreads, as you mentioned, still at kind of multi-year lows, which is very surprising. And so it kind of begs the question of whether or not this dynamic can continue where pockets of stress might emerge. That's right. And just to note for listeners, we are recording this Monday, September 16th. We are out in Huntington Beach, California. We are at the Future Proof Festival, I think it's called, which is probably one of the coolest, most distinct financial market conferences that I can fathom. It's literally out on the beach.

3:51It's entirely outdoors. Yeah, that's a nice way of saying we're at a beach for three days. It's very nice. It's pretty sweet. I love it around here. But, you know, the other thing I was thinking about recently is just the other thing that's happened over the past couple of years has just been the explosion in different types of credit available to companies, right? Like, if you're a company seeking some sort of funding, you basically have an option of everything from a syndicated bond or loan to maybe doing a private deal. There are just all these different types of credit that you could choose now.

4:24Everyone, if you're a company, people will find ways to give you money. There's all kinds of different opportunities. So we need to talk about the credit cycle. We need to talk about the big growth in the options available to investors and also corporates. And we need to talk about what happens now, whether this is a new leg in the cycle or the beginning of a new cycle in itself. Let's do it. I can't wait. All right. We have the perfect guest to discuss all of this. We are speaking with the co-portfolio manager of Oak Trees, a diversified income fund, better known as ODIDX. Bit of a mouthful, actually.

5:00Danielle Pauly. Danielle, thank you so much for coming on All Thoughts. Thank you so much for having me, Tracy and Joe. Are you enjoying the beach as well? Oh, I'm having a great time. I don't think I've ever been to a conference quite like this on the beach. So many people. It's something. I've said this before, but all conferences should be like this. On the beach. But you're based around here. This isn't even special for you. Like for us coming from New York where the weather is starting to turn and everything is like, oh, a few more days of amazing weather. This is just your life, huh? That's true.

5:30As a commute down the 405, anyone that's watched Saturday Night Live and the Californians knows, though, how perilous it can be driving on L.A. freeways. So I mentioned you're co-PM of the Diversified Income Fund, but you're also a founding member of the investment committee. Talk to us a little bit about what you do at Oak Tree. I serve as a portfolio manager for global credit at Oak Tree, and that's our multi-asset credit business. So back in 2017, we tried to think about a way to bring all of our different credit areas into an easily accessible way for our clients. And I get to serve as a portfolio manager, a member of our investment committee, thinking about relative value and helping with asset allocation in the portfolio.

6:16Because as you know, these different strategies can be more attractive or not based on what's happening with interest rates or dislocation in the market. So it's an interesting role to be in. In my mind, I think I have some understanding of what a portfolio manager does. What does an investment committee do at an entity like Oak Oak Tree? Well, different firms will have committees doing different things. And our committee is less of a voting committee and more of a thought leadership committee. So we convene all of the different portfolio managers at Oak Tree that cover different asset classes, like high yield bonds and leveraged loans, structured credit, emerging market debt, even convertibles.

6:58And we meet every other week as a group to talk about what's happening in credit. So we'll talk about the fundamentals of the companies that we're lending to. Are we seeing any cracks? Is it likely that defaults may pick up? And we talk about technical trends, what's happening with issuance. Are there reasons why there may be more attractive opportunities in one strategy versus the other? So at one of your weekly meetings, what would be the big talking point during, well, presumably during FOMC meeting, it would be the Fed. But what have you been talking about lately? Well, we're bottom-up investors.

7:35We're not macro investors, but it's hard to ignore the macro outlook when we're at such a pivotal point with perhaps a change in Fed policy that may signal this new expansionary period in credit. We've had interest rates so high for so long. And really where we're focused on is what has that impact been on borrowers' credit worthiness. So we really are trying to avoid risk when we're investing in fixed income. We like to say at Oak Tree, if you avoid the losers, the winners will take care of themselves. A lot of our conversation is avoiding bad outcomes and focusing on that lower cohort of borrowers that may be in trouble given these higher rates.

8:18I love the idea. This is sort of in my mind when I think of stock investing, it's like you want to pick winners. And when I think of credit investing, you want to avoid losers. I always sort of think of it like cooking a steak, which is just like you want to just nail it every time. And the perfect steak is just like just avoid the bad ones. Just stay consistent. I don't know. Maybe that's a terrible analogy. I always think of stocks as pizza. Credit is like steak. Stocks as pizza is like you have the most extraordinary pizza in the world. Credit is steak. You just want to not miss. Not mess it up.

8:51Not mess it up. Exactly right. That's how I think of these things in my head. So one of the things that's really surprised me, or I think surprised a lot of people, we had this really aggressive rate hiking cycle and credit spreads have been really narrow. Now, the obvious answer there, although it's a little question begging, I suppose, is like, yeah, well, because we didn't get a recession. A lot of people expected a recession or some sort of major downturn from the rate hikes. We didn't get that. So that's maybe why asset valuations have held up. But how would you, is there anything more to it when you look at just how tight spreads generally have remained over this cycle?

9:26What's your story that you tell for that? It's a great question. I mean, spreads have been tight. I mean, typically in high yield, we see an average spread range of 300 to 500 basis points. Anything's higher than 500. No borrower really wants to issue debt anything lower than 300, no investor wants to buy it. And what I think we've had to have conversations with our investors about is that with yields so high, it's a different environment. You don't need spreads to blow out and then compress to get your total return when you can get a yield of 7 % or so. And so I think you're starting to see a shift from being more tactical buyer to a strategic buyer.

10:08And I think there's reasons why that spread is lower in light of what you shared, Joe. In the high yield bond market, it's over 50 % double B today. It's the highest quality it's been in 10 years. Now, you have to contrast that with the leveraged loan market, where we have seen some degradation in quality. And that is a market where we're focused on the lower 10 % to 15 % of borrowers and looking at the upcoming maturity schedule and wondering how some of those are going to get financed. But generally, the market's okay, and so that lower spread feels more justified to us. So you mentioned the rate cuts earlier and described them as potentially an expansionary period in credit.

10:50I guess I'm wondering how much pent-up demand is there in terms of new issuance? Because overall, it feels like people have termed a lot of stuff out. But I guess there is that segment of struggling borrowers who perhaps for them, rate cuts will be really important and make all the difference. It's a really good question. I think when rates come down, there is just more availability of credit. And as you point out, there are those borrowers that have been struggling with higher rates, this will provide some relief to them, especially those that have taken out floating rate debt. And if we look at the maturity wall, I alluded to this a little bit earlier, for loans.

11:33Over the next year, there's something like$40 billion of maturities coming due. It's all in the lowest rated credits. So it's split B, triple C. And even for 2026, 2027, it's almost 70%. So it's this cohort of companies that haven't been able to get refinancing. And maybe, you know, lower rates will provide them some relief. There'll be a little bit more availability of capital. Some of them may not be able to be refinanced in traditional ways. They may need more rescue financing or capital solutions. But I do think it'll be positive for credit borrowers. When you look at the types of entities that are struggling, fallen out or actually impacted by this rate hike cycle, are we talking, is it heavily in real estate?

12:20Is that the area that would be most exposed or most feeling the pain of higher rates? Or like, where do you see these pockets that actually are facing some challenges in the financing environment? No, it's a great point because we do a lot more than just corporate high yield bonds, leveraged loans. Real estate, I think, has been ground zero for some of these challenges. And a lower interest rate environment should create, I think, a little more optimism about what's ahead for real estate valuations and force, I think, some sales and some liquidity in that market. And so we are starting to see some positive outcomes in real estate as people get more comfortable with the right environment.

12:58So I'm always curious about tactical decisions when someone is controlling a very big fund that has a lot of optionality embedded in it in terms of investments. There are tons of different things you could invest in as co-PM of the Diversified Income Fund. I mean, I know it's all relative value, but say in a month like August, when there was a lot of volatility, but despite that credit spreads were kind of stable, they weren't really blowing out during the big turmoil, how do you judge the opportunities presented to you at a time of uncertainty like then? We get so excited when there's volatility in the market.

13:39It usually means there's some bargains. But as you point out, I mean, credit spreads really didn't widen much. And I think by the end of that volatile week, it even tightened or at least made back that movement. So there wasn't much for us to do on the corporate credit side. We were starting to get excited about convertible bonds. So it's an area that we invest in. And for those that maybe are less familiar with convertible bonds, I think the easiest way to explain them is it's a way to get the safety of a bond with some form of income, but you also get to participate in some equity upside. We're not converting into equity.

14:15We'll sell before that event happens. But it is nice to have some correlation to equity markets at certain times. I don't think we've ever done an episode on convertible bonds. So we could just talk about this. But can you talk a little bit more about how big is that market and who are the types of issuers typically, or what is the typical situation in which an issuer would go into the convert market? Yeah, well, if you're going to do a session on that, you'll have to speak with our portfolio managers that only focus on convertibles. We'd love to set that up. So the convertible market is small, and it tends to be focused more in technology, health care, certain sectors.

14:57And it has more of a correlation, I'd say, to small cap stocks as compared to the S &P, even though the S &P does have a lot of tech exposure. And so it tends to follow that more. I mean, for us, our approach there is really to find good credit that we can underwrite and then participate in the equity, as I said. So just to clarify, from the issuer perspective, if it's small or if it's tech, and so that implies that they're probably fast growing, the appeal for them is what exactly? There's this pool of capital that they want to borrow, but this sort of sweetener is that the end investor can participate potentially in some of the actual growth of the company.

15:43Yeah, that's right. You don't have to give up outright equity. Yeah. And then also you can issue at a much lower rate than prevailing rates in the market. So that can be helpful for a company depending on where you are in a cycle. But it just ends up being a much smaller, more nichey market. And you can't avoid the correlation to equities. And we're credit investors. So we don't want equities to influence too much the performance of our funds. Today, we're very under allocated to converts. It's probably the lowest allocation that we've had since 2019 heading into COVID just because of the valuations and equities and not finding as many bargains.

16:27Oh, wait. So you said you were getting interested in convertibles going into the August sell-off, but I guess you changed your mind. Well, because of the volatility, we felt that maybe we could go in at a better entry point. Oh, I see. Because the valuations haven't made a lot of sense for us and we can get better potential returns from credit than equities, it's been low. But when you get some of these consecutive days in the market and there's a sell-off, you get excited thinking converts are going to be the first asset class to move. And so we started looking, though, at which converts moved.

17:03And they didn't really meet our criteria for wanting to wander into equities, especially with this rate decision coming up, an election coming up, a lot of risk out there. But the idea would be in a volatility event as credit investors, if, I mean, that whole volatility event, it lasts about 15 minutes, really. Right. Like, it was so short. But theoretically, if it had lasted longer, the first opportunities likely would have shown up and converted. I think so, especially when spreads aren't moving. Totally. That makes sense.

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20:55Because I joked on the day of the big sell-off is like, oh, I should sell some stock so I can buy the dip here. Like I would have loved to take advantage of that, but I don't really keep a lot of extra cash around. How do you think about that from a portfolio standpoint, being invested, but also being in a position to take advantage of opportunities? It's more of an art than a science. I mean, today cash is an asset. It's not as dilutive as it used to be to hold, so you can at least get some decent yield. And we'll invest our cash in investment-grade, kind of short-duration-type paper. So we're getting an even better yield.

21:31And we do like to have some of that in the portfolio as a buffer to use for these periods of volatility. One thing that we did a year or so ago is we looked at the portfolio and which were our less liquid assets outside of private credit, because you really can't sell private credit in a sell-off. So we said leverage loans. While you can trade them quickly, they take a while to settle. And so we have other options. Maybe we should create some liquidity by taking some money out of leveraged loans. And what we did is we basically took every dollar we took out of leveraged loans. We put 50 cents into cash and 50 cents into CLOs.

22:10So it's a barbell strategy because CLOs are really levered instruments. You're getting a higher yield, but they don't take time to settle. And then the cash, you know, that's available to us. So we created liquidity and we didn't really change the overall yield profile of the fund. You mentioned private credit just then. What has the growth of the private credit market meant for the more syndicated stuff? So, you know, leveraged loans, publicly issued bonds, that sort of thing. I think, Tracy, you said it so eloquently earlier on. Borrowers have more options, right? They have different ways to get financing, whether it's through the syndicated market, working with a private lender.

22:50I think for us, it's provided really attractive opportunities to step in when markets have been frozen. So I look back maybe to the end of 2022 when banks were hung with, what,$40 billion on their balance sheets. And that was an opportunity to step in and dictate terms and say, we'll lend and in scale. But we want covenants. We want protections. Wait, sorry, explain that more. What were the assets that were frozen or weren't moving? What types of assets were those? and then what types of, what was this sort of, what was your package or what was your pitch to them? Yeah. So it was banks that had pre-agreed to syndicate loans.

23:35And because interest rates had moved so quickly, those banks were going to take significant losses taking those loans to market. And so those opportunities, you know, they needed private lenders to step in to speak for those deals. And so what we were able to do is we were able to command better terms in the form of pricing, so higher spreads. Got it. And then negotiate covenants that you wouldn't see in the public markets. That's been the big issue in loans. You've had no covenants or protections in the levered loan market. Whereas with private credit, when we're directly originating loans, especially on the non-sponsor side, we can actually protect ourselves in terms of structure and get covenants in there that are going to protect us.

24:17This is one thing I always wondered, but in the private market, when you're an entity like Oak Tree, who initiates the conversations? Is it the banks come to you and say, hey, we have a hung loan, we need to get rid of it? Is it the company looking for options? Do you approach potential borrowers? How does that work? It depends, but we do have a sourcing and origination team at Oak Tree that speaks for the entirety of our firm. I think it's a competitive advantage for us because they are facing off with companies, with sponsors, with banks. It's like having a sophisticated capital markets team within an alternative asset manager.

24:55And it allows us to have conversations more from the point of, what do you need? What's your problem? What type of financing? And then they will come back to us at Oak Tree and say, this is what we need to do. Where does this fit across the firm? Let's create something that really is tailored to that entity. And so that's kind of how we see a lot of different things. We're also a first call in terms of these types of opportunities, given our roots in distressed debt investing, special situations, and rescue finance. I mean, we've talked a lot on the show now about the growth of private credit.

25:30How much has private credit grown within Oak Tree? It's grown a lot. When I joined the firm back in 2014, I want to say at that time just the private credit industry was maybe$500 billion. It's grown to$1.7 trillion, I think, today. The unique thing about Oak Tree is we've been doing private credit for a long time. Back in 2000, the firm launched a mezzanine kind of middle market fund. And that's grown into direct lending. It's really taken on all sorts of forms. But I think we're still doing the same type of lending that we were historically. It's just now become much more popular and mainstream.

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26:17So on that note, how competitive is that market at the moment? Because I think back to you were talking about covenants earlier. One of the driving forces behind the rise of CovLite sort of post-2008 was, well, there was so much money chasing yield that it was a race to the bottom. And if one investor wanted protections built into their investment or their loan that the company didn't want, then someone else would step in and basically offer to do it on better terms in the company's perspective. Do you feel that kind of competitive pressure now in the private market? I think we still have some of that today.

26:57And we will going forward, just given how much demand there is for private credit. But I do segment the market. So I feel like that's most acute in the direct lending, LBO finance, sponsor-backed transactions, where we try and play, though it's a smaller opportunity set, it's more episodic, is directly originating debt, non-sponsor. And there you don't have the competition. And so you're able to set terms and you're the sole lender or maybe one of two lenders. And there's just a lot less competition because when you manage a very large private credit fund, you've got to put a lot of capital to work.

27:37And there are just more LBO sponsor-backed opportunities available. So if you are able to be nimble or manage private credit in a multi-asset portfolio like I do, where you don't have to constantly be deploying in private credit. You have other tools in your toolkit. We can be selective and try and overweight those non-sponsor opportunities. So you've been talking about the credit markets from the borrower perspective. You mentioned in the beginning that in the current rate environment, or at least the recent rate environment, credit has also had a really big yield component as part of the value proposition.

28:15And with rates as high as they are, credit spreads may be a little narrower, but all in, investors are getting a decent amount of income. How have you seen the demands of investors evolve? What are people looking for in terms of an income product or a credit product? And how has that changed over the last few years with the worst inflation in 40 years and the aggressive rate hikes and such? What have you seen on the investor end? I think investors have wanted more diversification, exposure to a mix of fixed and floating rate so that they aren't so susceptible to what's happening in the interest rate regime of the Fed.

28:57Like fixed rate, IG, and high yield only portfolios got pretty beaten up as rates were rising. And you saw a lot of interest in more floating rate, leveraged loan, private credit products that could continue to offer higher income. But now where we are, they want to toggle back, right? Because the fixed rate is really what's going to benefit the most from a rate cut. And so having portfolios set up that can tactically access both of those opportunity sets, I think that's really what we're hearing a lot of demand for. Wait, so talk to us a little bit more. You know, earlier we were discussing credit spreads and the fact that they've remained fairly low.

29:34But as you say, maybe because of yield, they look a little bit more attractive in the higher rate environment. But what does like a good entry point into credit actually look like right now? Like what should investors be looking for if they want to kind of flip the switch on higher exposure? Well, I think today in the high yield market, you can get good income from a high quality bond. You're looking probably around a 7 % yield. And that's attractive for some. I mean, I work with a lot of institutions as well, pension plans, endowments. Oftentimes, they're trying to solve for 7%. They no longer need to allocate to equities to get that type of return.

30:13Has the yield been higher? Sure. I mean, it was as high as 10%, you know, not so long ago, which is more of an equity-like return. If you think about the S &P the last 100 years, it's probably given you around 10%. I mean, if you're getting 10%, it feels somewhat like a free lunch to go into credit. And so I'd say, like, that's an entry point you don't want to miss. But today, you're still getting, you know, 7%. It's pretty good. That's that old joke, Joe, where like if you liked high yield at 7%, you should love it at 10%. You'll love it at 10%, except no one actually does. Yeah. Okay, so it was very logical.

30:47As rates were rising, suddenly interest in floating rate debt goes up, then the interest rates turn around and suddenly, oh, people want the fixed rate debt for obvious reasons. You know, one thing I wonder about, and it comes up in many interviews, does the memory, though, of 2022 persist? And do you see that over the next decade, the fact that you can have these very sudden sharp spikes in inflation and therefore rates, do you see that leaving a fingerprint on investor profiles or on investor risk management for years to come, even setting aside this cycle, that memory of that experience? Hmm.

31:27I'm a little skeptical. I think many just have this low rate, zero interest environment stuck in their heads. And they think that we're going back down there and we're staying there. And what you raise is a concern of mine. Like if inflation rears its ugly head again, and at the same time the economy is slowing, like stagflation, not something that many investors who are investing today have seen. Well, then that actually brings to mind another question, which is that one of the extraordinary aspects, I would say, you know, starting in March 2022 is through policy, through fiscal policy and aggressive Fed action.

32:06You know, we knocked out the recession in like three months. Those are the shortest recession ever. And we sort of proved through policy that we can always fight recessions, that they don't really have to happen, but we know they'll happen again. But it also makes me wonder. And then we didn't have a recession in 2022 or 2023 when everyone expected it. And so I'm curious from the other side, like, are people anxious about recession or is there a view that settled in that, like, we don't have to have recessions and they could be kind of a thing of the past? I mean, it feels like the latter in the market, right?

32:40The Fed just took this big bazooka and really kind of shot the economy and got things going. And they're also in a pretty good place right now with rates so high to be able to aggressively cut rates if something does happen. So I agree with you. I think a lot of people are thinking, will we ever have recessions again? Now, at Oak Tree, yes, we think we will. You know, we're very much a believer of cycles. So maybe one theory that we have is because the recession was so talked about, this upcoming recession, that CFOs got in front of it. And you did see that, right, with the wave of refinancings that occurred.

33:21And frankly, COVID, the reopening was pretty good for companies. Like higher inflation has hurt consumers, but it didn't hurt companies who saw their revenues increase. So they're in a better cash position kind of coming into this period, too. Wait, talk a little bit more about that. I find that interesting, the idea that because everyone was talking about potential recession, maybe a bunch of corporate treasurers decided to term out their maturities. And that's maybe why we didn't have the big maturity wall disaster that everyone thought we would. Yeah, maybe I'm giving them too much credit, right?

33:56Look, I think another thing that happened was COVID. And you could argue that that was a recession, a mini recession, or maybe it's just like the - It was something. It was something, right? I mean, we did see default spike. And what's happened there is some of the worst companies kind of fell out of the index. And that's where you get that better quality, right, that I was alluding to. And so maybe you just had this kind of cleaning event that happened. And because the market is of higher quality, market participants see that. And so they're not as concerned about having as big of an issue going forward.

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37:25Learn more at adobe.com slash do that with Acrobat. Can you talk about this? Whenever I hear my credit colleagues and Tracy talk about high yield, that environment just fundamentally doesn't look like the high yield environment of past. I hear people talk about like fallen angels or all these different things that are a little bit outside of like my own comfort zone. What is this sort of, I guess, the credit profile of the market look like? How has it changed over the last, I don't know, five years, 10 years, et cetera? So when we talk about high yield today versus high yield five years ago or high yield 15 years ago, like how have these markets changed?

38:04Well, credit rating agencies will issue their ratings. And, you know, if they were right all the time, we wouldn't have a job. We like to say that. But assume they are. And what you've seen is that these markets have tended to skew to lower ratings because they are sub-investment grade credits and there's inherently more risk than investment grade. But it's a higher quality market today because some of those companies prior to COVID were in the market. And then during COVID, they defaulted on their debt. And so it's more of a technical thing, right? The market looks better because you got rid of some of the worst companies from the indices at the same time than that some of the investment-grade rated companies fell into the index or the fallen angels that you mentioned.

38:51So it's changed the composition of what's available out there. And then in terms of just what kind of companies look like today versus the past, leverage has stayed pretty steady. It's actually come down a little bit in high yield, which is interesting. Even in private credit, you know, you're looking at maybe five turns of leverage. It's not excessive. And so the fundamentals are okay, I think, for credit. And then you kind of overlay that with an economy where you're not seeing cracks in the labor market in any significant way. Like, sure, there are things that we are focused on at Oak Tree, like student debt picking up, delinquencies in auto payments, other indicators that, you know, show some stress.

39:35But like generally things feel OK and the same for the borrowers. It is true, Joe. I don't know if you remember, but there was a moment pre-COVID and sort of post-COVID where everyone was worried about the Triple B bubble in bonds. Do you remember that? Yeah, kind of. So it was the idea that like, so Triple B is the lowest rung of investment grade. And it was like the fastest growing cohort of the IG market. And so everyone was like, oh, God, the quality of the overall corporate bond market is deteriorating. Everything's triple B now, blah, blah, blah, blah, blah. And it's going to burst one day.

40:09And instead, what we've seen over the past year or so is the triple B bubble kind of burst, but because everyone got upgraded. Yeah. So like no downgrades, no falling down into high yield status, but everything getting upgraded to speak to the quality point. Okay, since we have you, Danielle, one thing I've been wondering about, and I feel kind of bad because I've used this term in previous conversations, but we've never really fleshed out what it actually means. Creditor on creditor violence. It's a very popular talking point, but what do we - Sounds exciting. Yeah, it does, right? It sounds active, at least.

40:45What do we mean when we're talking about that? You know, it's funny. It's nothing new. It's happened for a long time. But I think the dollars at play are a lot bigger given the growth of these markets. And it's what we talked about earlier, that a lot of the deals that got done over the last few years have no covenants in the leveraged loan market. And so what that does is it just there's holes in these deals and it allows for sometimes nefarious activities. Explain that further, covenants and holes for someone like myself who is not, doesn't have a concrete idea of what this means. Like what is, talk to us a little bit about how that plays.

41:24Yeah, sure. So ideally when we're structuring a loan with a company, we want to find ways to protect ourselves. Especially if they are going to miss an interest payment or default on the entirety of their loan. We want to ensure things like we're first lien in the capital structure, meaning that we're going to get paid back first in bankruptcy. We may want to tie our loan to certain assets that the company has so that those assets can be used to pay the proceeds of the bankruptcy. And so you put these covenants or terms into the bond indenture, the loan document, so that you're protecting yourselves.

42:02But because there's been such competition to invest in these deals and there's been this low interest rate environment and just a lot of capital, it's been harder to get these types of protections into the documents. It sort of sounds like when everyone was buying homes a few years ago and no one did the inspection. They like people waived the inspections, right? You just buy it as is. And that was like one that's like, no, if you want an inspection, someone's going to buy it before you. It's like the same basic principle. Yeah. And so when it comes to lender-on-lender violence, and as you were saying, Tracy, these companies are struggling from higher rates, right?

42:37They may not be able to make their interest payments. And so what's happening is you have certain creditors and sponsors looking at, well, how are we going to remedy this situation? We need fresh capital for this company to kick the can down the road, if you will. And so what you're seeing is different techniques applied, taking advantage of there being no covenants. So a classic example of this is stripping assets from a collateral package, dropping them out. It's called a drop down. So you might see that they might go to a new entity, an unrestricted entity that can then take out debt. That will just lessen the amount of assets that investors can have to pay back their claims.

43:20You also have the ability to have new capital come in, so effectively priming first lien investors. You go to bed thinking you're first lien, and then you wake up the next day, you're second lien. Surprise. That's challenging. And oftentimes, really, the company can work with the majority of creditors to do this really quickly, and not all creditors may be involved. And it can be really violent, I guess, if you will, which is why the term is used. So one of the things I've been thinking about recently, we started this conversation talking about the credit cycle and the idea of, well, maybe we're at the start of a new credit cycle or a new stage of the current credit cycle.

44:02It does feel like the cycles have kind of become a little bit muddled, right? I guess, as we were discussing, there are all these new options for borrowers. So if they can't get a loan in the syndicated market, maybe they talk to someone in the private market. And so there's, I guess, additional pressure valves. Does it feel to you like maybe the credit cycle has changed in some either fundamental or permanent way here? You know, what you raised, I think, is important because in some ways it may have extended the credit cycle because there are different avenues for companies to access capital.

44:40You know, will I think it create, you know, a lasting impact? I think we'll have to wait and see. But probably the answer is yes, especially as private credit grows and morphs from more of an industry that was focused on sponsor-backed direct lending to areas like non-sponsor directly originated loans, which I had mentioned, and then other things like asset-backed finance. I think they'll just continue to be an evolution of the market over time. I'm curious about industry sectors, and we've talked about it a little bit. We talked about where companies issue preferreds. We talked a little bit about the sensitivity of real estate to the interest rate cycle.

45:19One of the other big macro themes that we talk a lot about on the show is like this incredible boom into certain types of CapEx. Things like data centers, things like infrastructure, things like new energy, all the different factories and plants that have come out thanks to the CHIPS Act and the Inflation Reduction Act. How do some of these big economy-wide trends play out in the credit space? And have there been new areas of borrowing that you see due to things like some of these secular trends in the nature of the economy? Yeah. You know, we have seen secular trends over time. And most of the activity that was in M &A and LBOs of the last however many years was in tech in particular.

46:02And now tech is such a large part of the leveraged loan market. Yeah. And now today, as you point out, new areas of investment, AI, chips, I think it's growing that area. But I mean, the market has a beautiful way of adjusting itself, right? Like we loved investing in data centers last year, but then everyone else did too. And so the yields have really compressed. So there is somewhat, I think, of a resetting of return expectations in some of those hot sectors. And then you really have to shift to say, wow, so much of this was issued. Are these really quality loans that were made? Is this going to be ground zero for defaults?

46:42And then it becomes more of a problem, right? Like what's hot then becomes the area of concern. So one thing I was wondering about at an event like this, future proof, it bills itself as a wealth festival. the predominant audience member seems to be RIAs. So I'm curious, when someone like you comes to an event like this, what are you talking about with all the people here? Are you like pitching the specific funds or like what are those client conversations or potential client conversations actually looking like? I mean, if you're an RIA, you have so much to consider in terms of asset allocation outside of alternatives.

47:22But even with alternatives, you've got VC, private equity, all these different areas to consider. So I think a lot of my conversations are around why credit is a compelling investment opportunity today. Getting those high yields and income, I do think credit could potentially outperform equities. And having them think about it as a steady allocation in their portfolios of their clients so that their clients can do other things. I mean, why not have fixed income credit be that steady core allocation that hopefully, you know, they can then use to fund other areas. So a lot of my conversations are educational.

48:04It's also about talking about the different types of private credit that's out there and the different types of vehicles that they can access to. So we've seen interval funds, BDCs, these types of funds become more mainstream. And we're really excited to just kind of have those conversations about how individuals can access what institutions have for so long. What type of questions do RIAs have about private debt? Like, I'm curious to hear their concerns and how much they overlap with the stuff you see in the headlines about, you know, private debt bubble or creditor-on-creditor violence, which we kind of already discussed.

48:41So I think RIA is the questions that we get surprisingly relate more to the macro environment and less about the fundamentals of credit. I think they're really wanting to understand what rate cuts will do to private credit because it will lower the yield. And the yield is really important in private credit for them. And so we've had some conversations around that. I think less so the conversation has been focused on the quality of private credit and whether, you know, a type of bubble is brewing at this point, though maybe the focus should kind of turn there at some point soon. I do think that active management in the space is so important.

49:24And you are starting to see some products, you know, now being recently announced like ETFs that may be passive. And I think we have to figure out, like, what is that going to mean? What does that look like? Like, those are questions that our A's should be asking. All right, Daniel, Polly, thank you so much for joining us. That was really fun. That was fantastic. Thank you so much. Thank you so much.

49:56Joe, that was a good episode I felt to record after the conversation with Dan Iveson. Yeah, it was great. It kind of dovetailed. So one of the things that is standing out to me after all these discussions with bond market participants on the West Coast is the yield versus spread. Yes. So everyone's been complaining, not everyone, but a lot of people have been pointing out that spreads are still very, very low. And so it's difficult to find entry points into credit. But on the other hand, as Danielle pointed out, like at 7 % yield, that might be very attractive. I think a 7 % yield will double your portfolio in about 10 years.

50:34That's not bad. Like you just like, if you could just like lock in that 7 % yield. Just avoid messing up that credit stake. Yeah, just avoid overcooking the stake. Get all your money in a 7 % yield. And then 10 years from now, you've doubled your wealth. Like that's not bad. Yeah. The other thing that stood out to me was, you know, she was talking about, I guess, quality trends within the index itself. And I do think it's so funny how much hand wringing there was about the triple B bubble bursting eventually and like causing this big wave of like downgrades and defaults in the credit market. But instead of the downgrades, it basically has ended or started to reverse with upgrades.

51:12You know, I think one of the reasons my brain, like when I first got interested in markets, it was through stocks. And stocks are really nice because it's like there's one Microsoft, there's one Google, you know, and then when you look at credit and there's just like this like endless proliferation of new terms and like interval funds. I don't know what that is. What's it? Do you know what an interval fund is? I don't know. We got to learn what interval funds and business development core, just like all of these new things and preferreds and stuff. And so, you know, there's just this sort of endless, how do you mentioned in the beginning, just like this endless buffet of credit products.

51:47And it's sort of always interesting. And then the fact that like you talk about like investment grade, but that does not mean the same thing in 2022 as it means in 2021 or 2025 or 2019 or same with high yield, just this endless buffet. And then you understand why you sort of have these entities like ratings agencies that can sort of segment risk in a sort of useful way because it's just so sprawling. Yeah. This is why I always like asking the process questions of like, how do options actually get in front of someone like Danielle or Dan Iveson? And then how do you choose from like there must be dozens, if not hundreds.

52:26There's just endless permutations. Of different like investment categories within credit. Like not talking about single loans or investments or direct loans, that sort of thing. But just like the actual categories must be in the dozens. Let's do it. By the way, let's do a creditor on creditor violence episode. Like let's just find one, like maybe a specific incident and like dissect it. Because I just want to get that in a headline because I think people download it. But that also just sounds like it's very it's like the thought that like you could have like the first lien debt and then the next morning somehow you don't or that the idea that a company could move assets that are sort of like a collateral into some other vehicle and then the creditors can't get access to them to liquidate them or pay the debt.

53:08Like let's let's talk about that more. I always think an episode about creditor on creditor violence sounds almost like a PSA. Like have you been hurt by creditor on creditor violence? Well, let's do one. All right. Shall we leave it there? Let's leave it there. This has been another episode of the All Thoughts Podcast. I'm Tracy Allaway. You can follow me at Tracy Allaway. And I'm Jill Weisenthal. You can follow me at The Stalwart. Follow our producers, Carmen Rodriguez at Carmen Armin, Dash O 'Bennett at Dashbot, and Kale Brooks at Kale Brooks. Thank you to our producer, Moses Andam. For more OddLots content, go to bloomberg.com slash OddLots, where we have transcripts, a blog, and a newsletter.

53:44and you can chat about all of these topics with fellow listeners in our Discord, discord.gg slash oddlots. And if you enjoy Oddlots, if you want us to do that creditor on creditor violence episode, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening. Thank you.

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From the publisher

This week, the Fed cut benchmark rates by 50 basis points. Lower financing costs should be a relief for companies that need to borrow in the form of bonds or loans. But, the weird thing about the previous few years of high rates and high inflation is how much corporate credit has defied expectations. While defaults increased slightly, there wasn’t a huge wave of bankruptcies. And most companies haven’t really had trouble finding financing, with a smorgasbord of options available to them — including from the booming private credit market. So what happens now that the Fed is lowering rates? In this episode, we speak with Danielle Poli, co-portfolio manager of Oaktree’s Diversified Income Fund and a founding member of the firm’s investment committee, about how she sees the next leg of the credit cycle unfolding, and how she decides between a multitude of potential investments in the space.

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