The Insight: Conversations – Credit Picker’s Market with Wayne Dahl, Robert O’Leary, and Mark Jacobs

0:04Hello, and welcome to The Insight by Oaktree Capital. Today, I'll be having a conversation with three Oak Tree thought leaders about topics from our recent insights piece, The Roundup, the September edition. We'll be discussing the volatile interest rate environment, the opportunistic credit landscape, and a major bright spot in commercial real estate. First up is Wayne Dahl, Assistant Portfolio Manager of Oak Tree's Global Credit Strategy. Wayne, thanks for coming on. Thank you for having me, Anna. In the global credit piece that appears in the roundup, you and your co-authors discuss some of the recent shifts in the yield curve.

0:45Can you explain how the shape of the curve has changed in recent months and what this says about investor expectations? When you think about the yield curve, you first have to really think about expectations for short interest rates. And these have been on a wild ride this year, which I think speaks to the difficulty that our chairman, Howard Marks, always talks about when he mentions how difficult it is to forecast things like interest rates and inflation. If we go back to the beginning of the year, the market expected interest rates to end 2023 at about 4.5%. By the end of March, after the Silicon Valley Bank challenges in the market, that had dropped to below 4%.

1:26And now we're at a level of about 5.5%. So you can see why we refer to it as a wild ride, that markets have been on with respect to interest rates and trying to really understand the path of the Fed. I think today the market has come around to the idea that the base case is the interest rates will be higher for longer. And that's why we've seen that slow shift higher throughout the whole year. Let's turn to high yield bonds. In this environment that you're describing, this volatile interest rate environment, how have high yield bonds performed? High-yield bonds have actually done okay this year.

2:00They're positive on the year. They're outperforming their coupon. And I think high-yield bonds are a perfect example of why investors have been wise to not only benefit from the higher yields that we have been given by this rise in interest rates, but also the ability to outperform just purely investing in, say, a long-dated treasury security. Most treasury securities actually have negative performance on the year, but when you're willing to take a little bit of credit risk, you can actually offset some of that move higher in interest rates. And high yield bonds are a perfect example where credit spreads have compressed about 90 basis points, where five-year interest rates are up roughly 60 basis points.

2:42So that's what's really given it that extra performance this year above just earning the coupon. And why do you think we haven't seen some of the spread widening that maybe people had anticipated either at the end of last year or earlier this year? Well, I think, number one, the economy has just done better than people anticipated for a number of reasons. And number two, I think some investors really got focused on yield as opposed to focusing too much on spreads. And this is new. I mean, spreads have been the focus for credit investors really since the post-global financial crisis. Whereas today, once yields got into that range of between 8.5 % and 9%, investors were comfortable to say, well, if interest rates go higher, spreads should compress a little bit.

3:29If interest rates fall, spreads should go a little bit wider. And they've really settled into that locked-in range in the case of high-yield bonds. So I think that focus on yield has altered the spread landscape a little bit this year. So given the complex background that you're describing, how do you think credit investors have been best positioned thus far in 2023? Some of the best investments in credit have certainly been those with very low duration or really floating rate coupons. And part of the reason for that is it's abnormal to have interest rates at the short end of the curve so much higher than the longer end, which is the inverted yield curve we have today.

4:10And when buying those floating rate securities, your coupon is based on those short rates. And so getting maximum current income without the duration exposure to those rates moving higher has seen those assets really outperform this year. We've been saying in a number of insights pieces for a while now that higher for longer interest rates seem to be more likely than short-term cuts. As we now look forward through the end of the year, early 2024, what do you think it might mean for credit markets if this higher for longer interest rate environment persists? Yeah, I think one of the challenges is really what does that cost of higher rates do to companies' balance sheets?

4:56I mentioned those floating rate borrowers who, as investors, we've certainly benefited from their higher coupons, but that has taken away from more of their earnings in the form of higher interest payments. And for certain balance sheets and companies that maybe have too much leverage or have seen some of their earnings decline in this environment, that can be more and more challenging. So there are definitely pockets of the credit markets that could see increased stress if interest rates do stay higher for longer. I think that really speaks to the importance of focusing on good credit selection.

5:31As we've heard people in the market say before, this is a credit picker's market. What that means is just buying a generic index of all kinds of different securities may not be the best path because you want to make sure you're avoiding those companies that have those challenges as it relates to the cost of financing their balance sheets. So even if a company may not have a very significant maturity in the next six to nine months, they could still potentially run into liquidity issues. Yeah, that's right. For some borrowers, if they just simply can't afford to make the payments anymore, you could see some defaults pick up due to these rates being higher for longer.

6:10While up until now, taking credit risk has definitely benefited investors, it's taking that smart credit risk. Yeah, I think that's the right way to put it. One of the things that you and your co-authors note in the roundup piece is the importance of dynamic asset allocation, which can always be beneficial in a multi-strategy approach, but particularly in a volatile environment like the one we're in now. I was hoping you could speak a little bit more about this, and especially in the context of below investment grade credit. Yeah, I mean, there's always going to be some form of relative value analysis done in a multi-strategy portfolio, and even in one that primarily focuses on sub-investment-grade credit.

6:52If you go back a year ago, there were definitely some asset classes that were more disrupted than others. They saw spreads move relatively wider, prices move lower. I think one of the examples of that is some parts of the structured credit market, particularly CLOs. CLOs looked very, very cheap at the end of last year. And as we fast forward to today, we've seen returns for some of these rating classes of CLOs that are in line with what we've seen in equity markets. So being dynamic and being able to really move to where the best opportunities are has really paid off for investors who have that flexibility this year.

7:29Now, what would you say are some of the misconceptions about today's credit market? I think maybe the credit markets at times get lumped in with, say, an investment just in a plain fixed income security like a treasury bond. And we know with interest rates rising, prices decline for treasury bonds. And for many of those securities, other than the shortest dated, they have negative performance this year. Whereas when you invest in credit and you get that extra yield, that can really buffer you to some degree from some of the movements in just interest rates alone. When I think about investing in investment grade, that is largely a bet on interest rates.

8:07The majority of your yield comes from the interest rate component. Whereas when you invest in sub-investment grade credit, like high-yield bonds, the majority of your return comes from that credit spread. So you have that extra buffer to offset you from some of just the volatility around interest rates themselves. And I think this is a perfect year to show that where whether you're in high yield bonds or you're in broadly syndicated loans or you're in CLOs, there's a lot of places for the credit markets to give you very strong performance in what's been a challenging year otherwise for fixed income investments in the form of treasury securities.

8:42So do you have any final thoughts? Yeah, I think one thing that's important to consider today is there is a lot of talk about recession. Is a recession coming? When is a recession coming? And the one thing we, I think, have learned this year is that understanding that timing is very difficult. You just don't know when these negative events are going to come, so you have to prepare. And I think today the credit markets still offer a very good opportunity for investors to earn an attractive yield, which again, is guaranteed to the investor if you avoid default. As Howard, again, has mentioned in his C-Change memo and other writings this year, I think that's still the play that people potentially need to make.

9:26My next conversation is going to be about the opportunistic credit landscape, which has changed significantly in recent years. For this discussion, I'm thrilled to be joined by Bob O 'Leary, portfolio manager of Oaktree's Global Opportunity Strategy. Bob, thanks so much for joining me. Thank you. To begin with, I was hoping that you could explain a little bit about what we mean by opportunistic credit and then also how that market has changed over the last year, year and a half. Opportunistic credit is what arises when a company is generally unable to access syndicated financing. They're often limited by some aspect of their business model or what they're experiencing in their financials.

10:09They need to pursue alternative financing, and it often ends up with someone like ourselves. So it is opportunistic because it only comes up episodically, and it's not the regular channels that most companies pursue financing through. As to how it's changed, pretty big changes, actually. Greater sense of urgency on the part of borrowers. I think there are two reasons for that. Number one, what we sort of think of as two catalysts. First catalyst is really liquidity, which I think people have seen deteriorate in most private equity-backed companies, but just more generally in companies that have floating rate debt and maturities.

10:46You're finally starting to see the beginnings of a significant maturity wall out in 2025 and 2026, and people are trying to get ahead of that. Most CFOs try to refinance any maturities before they get inside 12 months of that maturity because they don't want those liabilities to become current. I think the market, their vendors, their customers generally look askance upon any company having current liabilities. So most well-functioning companies try to address that ahead of time. Those two catalysts are coming into view, and I think companies are nervous, as I think they should be. Liquidity has obviously been an issue because of the move in rates.

11:26And as has been well noted, most of these companies did not hedge. The ones that did hedge have burned through most of those hedges. So now you're starting to see real cash flow impact, which is focusing people on how they get themselves financed. When you're saying hedging, you mean interest rate hedging? Correct. Yes. And you just mentioned maturities. So again, what are you seeing in terms of maturities in the next few years? And 25 and 26, by our estimates, we have about a trillion dollars of maturities coming due in both the high yield and leverage loan market. And that's a material number when you consider the size of that market.

12:00That's coming into view, and I think that's got people, especially CFOs, really focused. Are there any asset classes in particular that you think are most vulnerable in this environment? Any company with any material amount of floating rate debt is starting to see the gears grind a little bit on their financing model. And I think the ones that are most in focus are companies that have had a secular issue or an industry which has experienced secular issues on top of that rate pressure, not to mention some sort of emerging signs of recession. When you get a combination of those factors working, you can get some fairly dire situations.

12:41To the point about secular issues, you look at healthcare, no secret that there's been tremendous wage inflation in that sector. You've got a lot of very skilled, talented people that can take their services almost anywhere and get a better wage. And so companies have to compete for those people. And that's usually through their compensation. That would be fine if their reimbursement model allocated enough for that compensation increase. But by and large, reimbursement rates are lagging, not leading. And so there is a mismatch. And that's creating stress on income statements and balance sheets.

13:18And those companies are in some tough states right now. Telecom, another industry, you're seeing the same thing. Telecom, you've got companies that had very levered balance sheets coming in to this period of time. A lot of them have embarked on very ambitious projects to build out their networks to be more competitive. And you've got some disruptive threats in the form of fixed wireless that are further muddying the waters. So you've got levered balance sheets and an increasingly intense capital and competitive space. And that's a combination for defaults, especially, again, a lot of these companies use floating rate debt to finance themselves, and they're getting hit with that.

13:58What are some of the other trends that you're seeing in terms of fundamentals, maybe things like interest coverage ratios? Yeah, they're deteriorating. There's no question. I mean, the starkest measure of that is Moody's did a study where they showed B3-rated issuers with debt service coverage ratios of below one, which is the line of demarcation of about 30 % at the end of last year, at the end of 22. They show that going to above 60 % by the end of this year. And that's, again, just gets back to liquidity. These companies are burning cash. Even if they don't have a maturity, that's going to cause issues because they were thinly capitalized, a lot of them to start with.

14:38That doesn't really even account for EBITDA adjustments that a lot of these companies have made. And so that just adds to it. You put it together and there are going to be companies that are very focused on shoring up their liquidity in the next 15 months. And I know one of the things that you and your co-authors in the roundup noted was that even if there isn't a significant recession in the U.S., you still expect your opportunity set to expand meaningfully. So I wanted you to speak a little bit more about that. Sure. If you look at what is the addressable market for opportunistic credit, it's really four different categories of debt, BBB debt, leveraged loan debt, high yield debt, and private credit.

15:19If you look at how much debt comprises those four segments today, it's about$13 trillion. If you look at the same number back before the financial crisis, it was a little over$3 trillion. So you've seen a four times increase in the amount of debt outstanding that we consider the raw material for opportunistic credit. In the context of that increase, it doesn't take a very big pickup in defaults to see a very material amount of debt that you can pick through as a opportunistic creditor and credit investor. Historically, you go back over the last 10 years or so, default rates have been below their historical average.

15:58It's almost inevitable that they start to creep up. They already have. And we think that only continues given some of the things I outlined earlier in this conversation. That's part of the picture. The other part of the picture is when there is a default, you've seen a real deterioration in recoveries. It used to be that a first lien loan would recover between 60 and 65 cents on the dollar. That's rough numbers, nothing scientific to that. You're seeing first lien loans recover in the single digit percentages. So real meaningful impairments. And some of that's as a result of prior liability management exercises that companies engaged in.

16:36Some of it's the product of really bad businesses that don't have assets that are nearly worth what they were appraised at when the original loan syndication was done. Some of that's predatory action on the part of other creditors or the sponsor. Whatever it is, this is not the same market it was several years ago. Capital destruction is a function of defaults and impairments. And I think you're going to see people surprised at the level of impairments that they take in some of these situations. And that ultimately will feed into higher spreads. So not only do you have a base rate move, you should have a spread move as well.

17:13We've obviously already been touching on this a little bit, but I was hoping that you could speak more about the opportunities in private credit. Yeah, you're seeing very large rescue financings get done right now. Most of those are privately negotiated. I think buying liquid credit, you have to be aware that you're dealing with documents, especially the loan market, but even the high yield market that are highly deficient. And you have to have a plan if you're going to do that to make sure you can defend yourself. Usually that means you have to be very large so you can't be avoided when the company or the sponsor or other creditors come with some kind of action.

17:51But there are other ways to do it. The other approach is to deal with the borrower directly and be the party that provides the private financing that, frankly, takes advantage of the bad documents. There are lots of things happening on the private side. The availability of private opportunities and opportunistic credit is as good as I've seen it in 10 years, if not longer. And so, Bob, what are some of the ideas that you'd like listeners to take away from this discussion? I think you're at the beginning. What we try to focus on is that spreads really haven't blown out. We've got high yield at 380 and you've got loans at 560, depending on which index you look at.

18:32Those would indicate very mild stress, but I think what's happened is that issuance has really fallen off. So those types of spreads, 385 or 380 on high yield, 560 on loans, are really only available for the best borrowers. As the markets pick through who they want to support, it's the higher quality credits and a lot of people are being left out in the cold. And that can only mean a pickup in alternative investing channels. I do think those spreads are going to have to move out. I think over time, you're going to see deterioration and spreads, if we are in for a normal cycle, should move out a couple hundred basis points from where they're at.

19:11Loans should be worse than high yield. I think the differential between those two is generally correct. that might have to go wider. But our view is you're only at the very beginning of spread expansion and most of the opportunity set still looks very strong. For my final conversation, we're going to be digging into some areas of opportunity in real estate. For this discussion, I'm excited to be joined by Mark Jacobs, co-portfolio manager of Oak Tree's Real Estate Income Strategy. Mark, thanks so much for joining me. Thanks for having me, Anna. Now, the macroeconomic backdrop over the last year or so has obviously been challenging for many parts of real estate, but there has also been considerable divergence by sector and geography.

19:59What are some of the areas where you've been finding opportunities? Well, clearly, if you've been reading the headlines, which seem to be every day in the paper, all real estate seems challenged today. But as you point out, there are large differences in terms of performance and liquidity across sectors and markets. Supply-demand fundamentals, for instance, in multifamily and industrial are still very healthy and above historical averages. However, even in multifamily, we are seeing a divergence start to appear across markets, which historically has been the case. Now, that's why it's important for us to really focus on risk control, which has always been one of Oak Tree's investment philosophies.

20:43In the piece that you and your co-authors included in the recent roundup, you focus on opportunities in the industrial sector. Why has this particular sector been outperforming? It's really pretty simple. It's all about supply-demand fundamentals. Coming out of the pandemic, we saw a huge increase in demand on the industrial side, really driven by e-commerce sales increasing dramatically, a complete retooling of the global supply chain, which is going to take years to really settle in, and just simply a growing economy creating more demand for industrial space. and why, yes, we have increased supply across the country, the demand has been somewhat overwhelming that we've seen historical rent growth across the industrial sector.

21:30So then as you're saying, even though the industrial supply has grown, it hasn't grown at the same rate that the demand has grown for industrial space. To date, yes. However, I think we're going to start to see that divergence that we talked about earlier start to appear even in the industrial sector. If you look across the United States, there's always been a little bit of a difference between the coastal markets and the non-coastal markets. We're starting to see demand start to moderate, which is what we would expect. It can't stay at historic highs forever. And I believe we're going to see that demand decelerate faster outside of the coast or in the middle part of the country.

22:11And that's also where we're seeing the highest level of supply. And as Howard mentions in his recent memo, for us at Oak Tree, it's all about avoiding the losers. I think over the next year or two, we're going to see elevated supply in the middle part of the country, coupled with this slowing demand, and we're unfortunately going to see more losers. As compared to the coastal markets, which I think are going to hold up much better in the environment that we're going to experience over the next couple of years, the coastal markets just have very little new supply. Why? It's really a combination of limited land availability and how difficult it is to get new developments entitled and approved today.

22:55As a result, even with moderating demand, I think we're going to see fewer losers in the coastal markets than we're going to see in the middle part of the country. Understood. Let's broaden out a little bit. As you said, the real estate market is obviously in the news quite a bit, has been over the last year. What would you say are some of the biggest misconceptions about the real estate market? I would say probably the biggest one is that all commercial real estate today is distressed and will continue to fall in value. While, yes, we will see a lot of distress and continued downward pressure for a good portion of the real estate sector, there are a lot of high-quality assets in strong markets with strong supply-demand fundamentals that are performing very well, even in today's marketplace.

23:47And I think valuations for these assets have adjusted, and they're settling in to where I think makes them a pretty compelling value proposition. As I know, Howard often talks about that idea of wanting to buy things when they're on sale, not when the price has been marked up. Yeah, and I think there's definitely some core assets and core markets that seem to be on the sale aisle today and I think are going to make very attractive buying opportunities. And what are some trends that you think aren't being widely discussed that you think should be? I wouldn't say this is necessarily a trend, but it's definitely not getting as much conversation as I think it should be.

24:26And that's the antiquated process of how we measure shelter costs that flow into the calculation of CPI. The current process has many flaws. We've been using the same process for a long, long time. And in my mind, just miscalculates what's happening with shelter costs today. Some research reports predict that they believe that the way we currently measure shelter costs can lag up to 12 months. I don't know why we're not using the tools that we have at our disposal to measure what's happening in real time in shelter costs or multifamily or the cost to own a home, if we use these tools available to us, CPI would be a lot lower today than it's being actually reported.

25:15I think that's such an important point because shelter costs make up something like 40 % of core CPI. It's huge. It is. And I don't think it's getting enough conversation. It really is an antiquated process. We know from owning many, many thousands and thousands of multifamily units across the country that rents have moderated, and we're just not picking up that moderation real time. It's a real lag effect, and I'm surprised more people aren't talking about it. Now, do you have any final thoughts or anything else you'd like to speak about before we end our conversation today? I think I'll leave it with this.

25:49Up until a year ago, we've been in a period of time where we've seen a lot of stability across the real estate sector. Obviously, we had low interest rates for a very long time. And this environment produced very few losers across real estate. Going forward, I expect much higher volatility and constant volatility, which will continue to lead to more divergence across product types and sectors, as we've talked about, which historically has been the case. Our goal has always been to avoid the losers. And there's going to be a lot more losers, I think, in the years ahead. We can take advantage of the limited liquidity that exists today and all the negative perception that you read about in the headlines every day to buy high quality assets at discounted prices.

26:40As I look out there at the opportunity set, anytime you can buy core assets and core markets at big discounts with, I may add, great downside protection, it feels like a great buying opportunity. And that's what we're seeing today, Anna. Well, I think that's a great point to end on. So thank you so much for joining me today. Thank you for having me.