March 6th, 2018 | By Casey Basil
The main forecast for the U.S. corporate credit market seems to be that we are generally in the “later innings” of the cycle with returns in high yield for 2018 expecting to be in the low/mid-single digit returns and other asset classes forecast to return below historical averages. We can be reasonably assured that we aren’t early in the credit cycle, but how do we know if we are late in the cycle? There is certainly a lot of evidence for it — the economic recovery is historically long in duration, the Fed is raising interest rates, the yield curve is flattening, risk tolerance is high, etc. But the forecast examples noted in my previous blog that went horribly wrong also all had convincing evidence as tailwinds (that’s what makes them so convincing). On the other hand, believing we are late in the cycle is not the same as saying it will end soon. We could still have many innings ahead of us in this upcycle as central banks delicately unwind their coordinated QE programs. Demand for corporate credit seems insatiable, high yield issuance is of reasonable quality, economic growth is moderate, and volatility is low. We could also go into extra innings for many years. European high yield corporate bonds yield close to 2.0%, inside the U.S. 10-year Treasury yield. U.S. high yield investors could have a few very nice years ahead of them should we trade to that level.
In short, we are hesitant to predict when the credit cycle will turn. Rather, we should acknowledge current valuations and relative value, assess probabilistic outcomes, and manage risk accordingly. Investors that attempted to predict higher oil prices or higher interest rates and then invested to those predictions have reaped the damaging effects. We should be wary of following other macro forecasts now, too. Investing in this manner is particularly troublesome because not only would you need to predict what is going to happen, you: 1) require markets and securities to behave as you think they should in that particular scenario (which is not always the case), and 2) need to keep predicting the unpredictable for this process to work over the longer term. That’s an unsustainable business model for any kind of investing. Considering point #1, nearly every economist acknowledges that the economic recovery since 2008 has been anemic. Annual corporate earnings per share have been routinely guided down from original forecasts. Knowing that ahead of time, most investors might be wary of the stock market. Yet, it has powered its way to incredible gains during that time, with the S&P 500 notching over 70 new all-time highs in 2017 alone. So even if you make the occasional correct macro prediction, the markets don’t always oblige.
So when investing in the capital markets, what should we be doing instead? As opposed to predicting, we should be:
For our multi-strategy portfolios: How much capital should we allocate to credit risk? Given where we are in the cycle, where does the best relative value for credit risk lie: Investment Grade, High Yield, Structured Products? What does the TIPS market say about inflation and how does that match up with our allocations and thesis across asset classes? If we are wrong; how big are our exposures? Does the scaling of our allocation match our conviction?
To use our High Yield portfolios as an example: How would our portfolios react if interest rates rose dramatically? What if rates continued lower or stagnated? What if we hit a recession? How might the Federal Reserve respond to various scenarios? What if the capital markets tighten access to corporate borrowing? What sectors represent the best/worst relative value right now?
For individual credits: How strong are the fundamentals of the business? What is liquidity and access to it? How might certain bonds react if particular commodity prices increase/decrease? What are the main drivers of our sectors, and what could upend that? And how are we positioned for those changes? What is the relative value within particular sectors?
Instead of getting married to an uncertain prediction and investing accordingly, we can instead have a continual assessment of possible future scenarios along with current relative value. This is a daily process of considering relative value and probabilistic reasoning.
Perhaps an example is warranted. Oil prices, as noted in my previous article, are notoriously volatile and challenging to predict. We should therefore not spend material amounts of time towards the endeavor of better predicting oil prices. Instead of spending a significant amount of time analyzing the fundamentals of the global oil market – OPEC production and guidance, inventory levels, geopolitical uncertainly, U.S. shale growth, issues with Venezuelan production, Iran sanctions, potential disruptions in Libyan or Iraqi production – an Energy credit analyst can spend productive time on relative value given potential scenarios. How would this bond react relative to others if oil got over $60/bbl? What if oil dropped to $45/bbl? For the E&P sector as a whole, will we lag if oil rallies significantly? Are there other bonds we can buy that have similar risk profiles but offer better return potential? We find very often that bonds of similar credit quality trade wide of each other. Or bonds of different credit quality trade right on top of each other from a spread standpoint. Companies that make money with oil at $40/bbl often have bonds that trade at similar levels to bonds of companies that can’t make money unless oil is over $50/bbl.
Regardless of where we are in the cycle, we should be relentlessly asking ourselves: Given current spreads and potential probabilistic range of what could happen, what securities represent solid relative value? Is the market extending itself a little too far (i.e. spreads too tight, equity valuations historically high, etc.) or are securities pricing in too much fear? The question we should be asking ourselves over and over is, “Are we getting paid for the risk we are taking in the asset class, in the portfolio, in the individual securities?”
All these questions are appropriate at every point in the credit cycle. Often at cycle tops, we do find investors taking on too much risk, requiring too little in terms of return, and leaving little margin for error, especially for lower quality securities. We should be moving the portfolio to a higher quality spectrum because of those factors, not a prediction about when the cycle will end. As valuations tighten, the relative value between assets change and we should change our investment stance accordingly. It goes the other way at the bottom of the cycle. Sure, there was an incredible amount of uncertainty when oil plunged to $30/bbl in early 2016. But many Energy bonds were pricing in a worst-case scenario at that time. Many E&P’s, like formerly investment grade rated Continental Resources, which has an oil price breakeven in the mid-$30’s per barrel, had bonds trade into the $50’s. While seemingly chaotic at the time, this actually gave investors a high margin of safety, much less downside risk, and enormous return potential. There was further downside potential, of course, but only under the direst of circumstances. Even a modest oil price bounce to $40/bbl would likely lead to huge investor returns (this ultimately came to pass). All this could have been missed by instead rushing headlong into the process of oil price forecasting (much of which at the time was calling for oil to go under $20/bbl, which did not happen).
There is a big difference between saying “Bond Y provides better (or worse) relative value vs. Bond Z at this time” and saying “I think the credit cycle turns next year”, “I think interest rates head much higher soon”, or “I think high yield returns 5% next year”. It should be this incessant analysis of relative value and thoughtful review of probabilistic outcomes that drives our allocation of capital, portfolio positioning, risk management, and ultimately security selection.
When it’s mid-week and we look ahead to the weekend weather, we don’t blindly get dressed Saturday morning for what the weather forecast said on Wednesday. We will continue to monitor our weather app throughout the week, we’ll click on The Weather Channel, we’ll glance out the window and look west, we’ll make sure we have a raincoat handy, if necessary. There are a range of scenarios for what the weather will ultimately be on Saturday, and we’ve naturally learned to make those adjustments to be properly “positioned” as we finally head out the door Saturday morning. We know from experience given changes in temperature, humidity, atmospheric pressure, etc. that weather forecasts, even a few days out, are highly susceptible to being wrong. We accept this, and we treat weather predictions with great skepticism. If we treated our weather forecasts the way so many in the investing world treat financial forecasts, we might find ourselves standing outside in a thunderstorm without an umbrella wondering what went wrong. We should know by now given the enormous number of variables involved in the economy that predicting particular market levels, recessions, interest rates, and even credit cycle turns is filled with just as much uncertainty, if not more. We should invest accordingly.
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