Greg Peters: Why Sovereign Bonds Now Beat Corporate Credit

20:33Wilfred Frost:If you kind of snapshot closer to home in Europe, a lot of people talk about France and UK having similar, though not as pronounced, kind of challenges as Japan has. You know, obviously debt to GDP is not up in the 200%. Are there nations here, big developed nations, that you look at with similar dynamics where you think there's only one way to go on the yield curve dynamics? Yeah.

20:57Greg Peters:So if you go back to where we started, just some of the preconditions, you know, France decidedly jumps off the page. Full disclosure, I've been saying this for the past decade or so. So these things take time to play out. But the critical piece there is, once again, around the political piece and the ability to govern, right? And so what happened over the summer with France was the markets woke up and the inability to form parliament and these sorts of items really spooked the bond market. So when you're operating with a high debt to GDP with fragile finances, that stability matters a lot, right?

21:42Greg Peters:We saw it here in the UK with the Lids Trust moment. So we're getting these signs and bouts. So I still think it's there. The most important piece of it, well, is that the preconditions exist. And what should scare you is that with those preconditions, you know it's lurking. Something's going to happen sometime, somewhere. You're just not sure when. And I think as a bond investor, not knowing when piece means that risk premium, term premium should be higher, all else equal. And that's what we're starting to see.

22:24Wilfred Frost:This episode is sponsored by BNY Investments. BNY Investments is part of BNY, a global financial services company supporting investors and institutions around the world. This sponsorship does not constitute investment advice.

22:46Hi, guys.

22:48Wilfred Frost:It's Wilf. I hope you're enjoying this episode. Just a quick reminder to please hit follow or subscribe on your podcast or video app so that you never miss an episode. And if you've got time, please do give us a five star rating and leave us a comment. It really helps other people find the podcast too. Now, back to the episode. I want to move on now to credit and to corporate trends. And I guess as a snapshot, maybe we've just sort of moved out of this period in time. But I think I'm right in saying for a large part of the last few years, big mega cap tech companies have been able to issue debt at yields lower than the sovereign market at times, almost negative spreads.

23:31Wilfred Frost:I mean, has that ever occurred before in history? How striking has it been those low rates that Apple and other companies have been able to issue debt at in the last five years or so?

23:43Greg Peters:Well, so go back in time. They had no debt at the time, right, on a net debt basis. They were sitting on a tremendous amount of cash. They used the debt markets really quite sparingly. And so the thought was these types of institutions are, quote, unquote, safer than the sovereign. I personally don't bite down on that argument. I think there should be a spread, a corporate spread positive to the sovereign, and that's what you mostly see. So I think that was highly anomalous. And I think as you kind of fast forward to today, the reason why it should be anomalous is because, you know, look what happened to those debt profiles, right?

24:29Greg Peters:So these companies have moved from using debt in a sparingly way to issue a tremendous amount of debt, eye-popping amount of debt to finance this AI boom, this data center bill.

24:42Wilfred Frost:And when you look at that, I mean, it's funny you mentioned free cash flows as a metric earlier in your 101. Some pointing now for some of those mega cap tech companies, it's either turning negative for the free cash flow or at least falling dramatically. Are you very worried about what's happened in terms of that debt student? Slightly worried? Do you own any of it? All of the above.

25:07Greg Peters:So I – here, let me start with I think the unsecured investment-grade corporate unsecured bond market financing this is not a good relative value. Like I worry about the market happily lending money to these hyperscalers. To me, that doesn't make a lot of sense as they'll continue to drain their free cash flow, lever up. And so what you own today is going to look very different down the road. And then you overlay the high level of uncertainty. We're just not sure how it's going to play out. I think that's a bad risk. But that gets to your free cash flow, right? So you look at Meta, it's running free cash flow negative this year.

26:01Greg Peters:Google Alphabet's basically 90 % lower, likely free cash flow negative the following year. So yeah, so these are fundamentally much more risky companies. And so that concerns me for sure. So I think there's better ways to play it, which is what we're doing. But the unsecured market, I think, is something that worries me. So how are you playing it? We're playing through the structured product market. So what we're doing is we're effectively providing construction loans to these data center builds with collateral, with guarantees, with guaranteed power hookups, with guaranteed leases. And so you're in a much more senior position than the unsecureds, yet they're trading because they're through SPV vehicles.

26:54Greg Peters:So these specially kind of finance vehicles, they're trading anywhere from 100 to 200 basis points, cheaper than the unsecureds. And so to me, that's where the value is in the food chain.

27:06Wilfred Frost:If you kind of put yourself in the room for a Meta or Alphabet or an Apple or whoever it might be, can you blame them for funding things via this debt when they've got it away at relatively nominal yields? Or, I mean, you shrug suggest it's okay. I mean, will they regret it because they still at least have to pay the cash flows going forward? Could they not have issued a huge amount of equity? It's not like they're doing it at a cheap valuation.

27:33Greg Peters:Well, so that's the head-scratching part. So there's$5.3 trillion that has to be financed over the next five years. About$1.5 trillion comes from free cash flow. That's why it's being drained, of course. And then only like a small bit is slated through equity, right? It's all happening on the debt side. And I think that's because they want the gearing aspect of it, Right. You know, why why was this, you know, SBV concept so popular? Because it was off balance sheet and equity investors didn't really have to know about it. Right. And you think about there was a particular deal in the marketplace that they did off balance sheet meta that is.

28:20Greg Peters:and they did that because they didn't want another metaverse on their hand and have$100 billion right down that equity investors would see. So I think there's some of it kind of hiding some of the leverage and some of the financing to the equity side, but it's so public now that it's almost like a backfiring strategy. But I agree with you. I would have anticipated a little more equity. And that doesn't make me feel good from a debt perspective.

28:50Wilfred Frost:Yeah, it's really interesting. I think people do talk about it a lot, yet it hasn't pressured the equity prices much yet. One area that has seen equity prices pressured is software. This is something you kind of saw coming middle of last year.

29:07Greg Peters:Yeah, I mean, so did everybody else. I mean, I mean, this has been a well-forecasted story, but everyone thought they had a little more time. And this is one of these events where a trigger just all of a sudden became relevant, right? And so the latest Claude release just kind of opened up people's eyes to, wow, you can actually vibe code any software that you want. So, yeah, I mean, I think that is the story in the credit markets right now and equity market. I think it's an incredibly challenging one. I'm sure lots of companies are getting, you know, beaten up too much that don't deserve it. However, just think about it, right?

29:55Greg Peters:You have a situation. This is the classic, like, melting ice cube, and you're not sure at what rate and pace that ice cube is going to melt. But you're looking at the fundamentals of these companies oftentimes that are really quite good with a terminal value that's potentially zero. So how do you like invest in that complex? It's really challenging. And then the debt markets really was a large provider of financing over the past five years. And you're really seeing that show its weakness over the past couple weeks.

30:31Wilfred Frost:What's your take on the scale of nerves we see out there in private credit at the moment? I mean, the last couple of days has been super relevant once again. Overdone or legitimate?

30:44Greg Peters:Some aspects are likely overdone, as it always is. But I think most of it is quite legitimate. If you look at the growth in the credit system over the past 10 years, particularly over the past five years, has been in private credit. And use the high yield bond market, the junk bond market as a proxy. The high yield bond market is the best shape we've seen it in ever, probably. And it hasn't grown at all in the past 10 years. So that risk had to be transferred somewhere, and it was transferred there. So it's just kind of simple math, right? That's where the leverage in the system is. What makes it more concerning, of course, is the opacity.

31:34Greg Peters:And investors aren't really sure what's in there, which brings me to the BDCs, where that is a gateway into the fundamentals of private credit. And what you're seeing through the headlines here is a lot of weakness. You're seeing a lot of software exposure, up to 20 % or more. And that's tip of the spear. And I think a lot of those concerns are quite legitimate.

32:07Wilfred Frost:I mean, one of the kind of big talking points at the moment is it's not contagious like in 2008, because the leverage, the risk is carried on private capital, not in banks. Do you buy that? and or either way, do you feel exposed as a credit investor?

32:26Greg Peters:Every contagion is different. Every crisis is different. I think investors take too much comfort and they use kind of simple analogies to the last crisis. And so if I heard it's not 2008 once I've heard it a hundred times, of course, it's not going to be like 2008. It's going to be different, right? But there's elements of contagion risk and elements of worry. There is leverage in the system. I talked about the BDCs. I talk about on CLOs, the lower parts of the CLO structures. So there is leverage. There's subscription line leverage and nav leverage on top of these funds. So there's leverage upon leverage that a lot of investors don't see.

33:10Greg Peters:Do I think it's cataclysmic? No. Do I think it's a healthy credit adjustment? Yes. but things never move in a swimmingly straight line. And so that's where the overreaction. But I just think we're in a very early stages of this as this creative destruction nature of AI. We were very focused on the creative piece and now we're focused on the destructive piece. And I think there's a lot more to happen there. And I think private credit is part and parcel to it.

33:50Wilfred Frost:This episode is sponsored by Interactive Brokers. Building wealth starts with the right broker. And Interactive Brokers helps you reach your goals with powerful tools, global market access, low costs, and unmatched financial strength. That's why the best informed investors choose IBKR. Learn more at ibkr.com forward slash master investor.

34:20Wilfred Frost:So are you now kind of coming back to something that we started on near the top? Are you more attracted to the sovereign debt than the corporate debt at the moment?

34:31Greg Peters:I am. I see a lot more value on the sovereign bond side than the corporate side. That being said, I love taking risk and shots in credit, but I don't think it's a beta play. Like I think too many investors have been thinking about credit as just like a beta overlay. And I don't think that's the right way to think about it, particularly as we're in a credit cycle here. And gosh, I've even heard investors talk about getting beta exposure to private credit, which is quintessentially like an alpha-driven investment, not a beta investment. So I think this whole beta idea around credit is what is no longer.

35:10Greg Peters:and I see a lot more value in sovereign. And you can see that in a couple of ways. You can see that in just the tightness of the credit spreads themselves, right? They're at the richest destiles that we've seen in history. So very, very tight. So how much tighter can they go? But in the second, you see it in swap spreads. So how does treasuries cash, let's say cash sovereign bonds trade relatives of swaps? kind of funded versus unfunded. And globally now, what you see is that sovereign bonds trade cheap to that. And so that says to me that that's kind of additional premium. So the cheapness in the market in my mind is on the sovereign side, less so on the credit side.

36:00Wilfred Frost:Obviously, on the sovereign side, at the short end, where central banks keep their rates is going to be heavily influenced by inflation outlook. It's kind of the crux of the outlook for the next decade. But do you think the AI will unleash a deflationary productivity force that means inflation will stay very low? Or is there a risk that it's sticky, the inflation we've had the last couple of years?

36:28Greg Peters:I think it's a two-step process. The first step, go back to just the unleashing of the spending. That is classic, putting pressure and inflationary pressure in the system. So I think if anything, this is inflationary over the near term. Over the long term, if you do get the productivity, which I do think you'll get productivity out of it, then it'll be disinflationary. But I think the first step in this process and the first step of the trade is inflationary, not disinflationary.

37:03Wilfred Frost:And that lasts for how many years?

37:05Greg Peters:Well, I don't know. I mean, the adoption rates are happening at record speed, but the investment is continuing en masse, right? And I think the investment piece is not fully understood either. So there's this massive spend on data centers. So you build a data center, it's up and running. the 70 % of that data center expense is chips and racks. So if you want to stay on the frontier, you have to reinvest. Just pick a number, anywhere from four to seven years, five years in new chip technology. So it's a constant spend. So this maintenance CapEx cycle is probably the largest I've ever seen. It's not like laying underground sea cables where you do it once and then you kind of get leverage, operating leverage off that investment.

38:04Greg Peters:You have to spend time and time and time again. And it's just really hard to get a return on that invested capital. So, it's an open question, I think.

38:17Wilfred Frost:In terms of the sort of short end, Do you think it's attractive then at the moment? Or do you think rate cuts are going to follow suit next year, this year and next year as they have in the last year?

38:29Greg Peters:Well, who knows, right? I mean, there's so many open questions. And it's not like central banks have much keener insight than I think the investment community writ large. But I think the bias is for rates to remain stickier, higher. I do think there's some scope to cut globally. A few cuts in the US, maybe three here in the UK, a couple in Europe. So I think there's some scope for that. But the reason why I like being closer to the front end is because that has more predictive power. So, the more you can understand or the closer you are to central bank policy, the more certainty around your performance is as you go out the curve.

39:17Greg Peters:So, once again, go out to those 30 years, you're tied to a lot more exogenous factors, a repricing of term premium at all, and it just makes it a more dangerous game.

39:29Wilfred Frost:And as we get towards the end, Greg, I'm interested on a sort of stepping back question, which is, you know, the pace, I guess we sort of all started thinking about this suddenly again with Blue Owl and with private credit the last couple of days, but how quickly things can turn when they do turn. And I mean, as we touched on earlier, maybe apart from what gold might be saying, all other parts of the markets do seem quite calm at the moment. Do you agree with that? Is it going to stick around?

39:59Greg Peters:Yeah, markets have been unbelievably calm. I said the same thing last year, right, with all the geopolitical and the tariffs at all. The market really took it in stride. It is a little surprising to me, so I'll be honest about that. But oftentimes what you see from a historical perspective, things are really quite common and they break, right? And so you're kind of short the tails always as an investor. And so there's a lot that can go on within that tails. As soon as you get outside that distribution, that's when things really start to roll. So we've been staying within that kind of distribution, the meat of the distribution.

40:51Greg Peters:If you get a move outside, then I think things really start to unwind. So I don't know. I'm coming across a little doom and gloom more than I want to be because I think fundamentally we're in a good place. There's lots of positive things going on. There are some excesses. There are some fragilities. But by and large, I think there's a lot of positives going on. I think maybe that undercurrent is keeping investors much more calm.

41:19Wilfred Frost:And then just finally, Greg, we ask everyone this, which is your overriding investment advice for our listeners. And you can make it broad. You can even make it career advice rather than investment or specific to your sector and to fixed income. But what is your advice?

41:34Greg Peters:Yeah. So I'm not going to give any specific advice. But I would say broadly, it's about being incredibly humble, particularly in this environment. God, there's so much we don't know. We talked about software a little. How do you model that? You have to really examine things in a multidimensional way. So my advice is to build a model of a scenario-based approach. Don't look at point estimates. I think point estimates are the things that get investors into trouble. I blame CNBC for that too. I can tell you the story later. but I think it's incumbent upon investors to look at the full possibility of what could happen instead of just narrowing in on what you think might happen.

42:31Wilfred Frost:I struggle to blame CNBC for anything because I had such a great time there but I totally accept your concluding remarks. Greg, it's been such a pleasure to have you on the Master Investor podcast. Thanks so much for joining us. Thank you. That was, of course, Greg Peters from PGM joining us here in London. Coming up next week on the Master Investor Podcast, we'll be joined by Rushia Sharma of Rockefeller Capital. Please do hit follow or subscribe if you haven't done already to tune in for that particular episode. But for now, our thanks again to Greg Peters. The Master Investor Podcast is sponsored by BNY Investments, LSEG and Interactive Brokers.

43:13Wilfred Frost:Please do remember the views expressed in this podcast are for general information purposes only. Nothing in the podcast constitutes a financial promotion, investment advice or a personal recommendation. More on that in the show notes. This podcast is produced by Paradine Productions and Master Investor Limited. in association with Birdline Media. If you've enjoyed the show, please do subscribe on YouTube or click follow on your podcast platform and you'll be automatically notified each time a new episode drops.