David Lebovitz:    Welcome to the Center for Investment Excellence.

Anurag Agarwal:    Thanks for having me.

David Lebovitz:    Today I want to spend a little bit of time talking about a sector in investment strategy that’s somewhat new for many of our clients, and that's the transportation sector. And I think the story here is becoming better and better known, and in the run up to the financial crisis you saw European banks playing a massive role in terms of lending for the purpose of shipping. And ship finance was kind of the hot ticket out there.

We got to the financial crisis, things inevitably rolled over. And coming out of the other end of that obviously you saw regulatory standards change, capital requirements changed. And these banks that had been huge players in the shipping finance space were forced to step back out of that market. Now in the couple of years immediately after that, it wasn't necessarily the end of the world. There had been pretty significant supply, which had accumulated in terms of ships over that prior period.

But as supply and demand come back into balance, and obviously as the need for shipping and transportation more broadly has continued over the course of the cycle, we're at a juncture where we see some opportunity in this space that we think investors can take part in.

So to start, can you talk a little bit about the growth in the sector in more detail, a little bit about how you see individual companies adapting to this dynamic? And then a little bit of how we approach the shipping sector and the transportation sector here at JP Morgan.

Anurag Agarwal:    Sure, thanks, David. I think as you rightly put it, this is not an asset class which is new in itself, but it certainly is an asset class that a lot of our investors and clients are now starting to hear about more. And I think it's important to put into context what and how an asset class that has actually bene around obviously for centuries is only now becoming available for investors to think about as a viable solution to add to their portfolios, specifically for those investors who are (unintelligible) income.

And more specifically for those investors that are looking for an uncorrelated source of income. And by uncorrelation, we oftentimes hear late cycle, are we in a cycle, what we do in a late cycle environment? And as you think about alternatives and (unintelligible) assets, people are very familiar with real estate and infrastructure. And what we've seen more recently is transportation get thought of as the third leg of the real asset stool.

Just to paint the picture of why the relevance of the asset class is (unintelligible) today, I do want to talk about where the opportunity really comes from. So for that -- you know, just to pick up on a few comments you made earlier -- you have to look back at what is the history of how these assets were getting financed? So traditionally -- this is no secret -- that the world has a lot of goods and cargos that move.

In fact, 90% of the world's consumed products and cargos travel on water at some point. So shipping in particular as one form of transportation has been the backbone of the world trade ecosystem, as the global economy for decades now. So this is not new. We're not really creating a new way of moving cargos. So the question really then becomes - is how is the transportation industry in general being financed?

And therein you have to look at the traditional banks -- the European banks as you rightly point out -- who were the incumbent providers of capital to companies and corporations that needed these assets. So if you think about large corporations -- and by large corporations we can think about oil majors, minors, industrial companies - companies that produce goods in a different country and ship them to their customers and clients in other parts of the world.

They have always needed --and will always need -- a minimum number of transportation assets to move their products that they create or build to their end users. So if you're an oil major -- just to give you an example -- and you are drilling either oil or gas in Australia, and you have your customers in Asia, you have to move that product into Asia. And the only way you can be a viable oil major is you have access to ships that carry gas, gas carriers, crude carriers, product tankers, chemical tankers, et cetera.

Now, while these assets have been always critical to the core business of these corporations, because transportation assets are very expensive they've always been deemed to be non-core to their balance sheets. So traditionally what large corporations have always done is they have leased these assets from the traditional banks, kept their assets off their balance sheets, and yet had access to these assets for the entirety of their useful life or for the useful life of their products.

That was the historical way the industry was using these assets and they were being financed. The banks in turn really liked this asset class and space, because when you do enter into a lease with a large corporation, you are in many ways assuring yourself of the ability to make it pretty handsome return in the form of income and yield, and the only real risk you take once you enter into an employment is that of a credit risk.

So to the extent your counterparty --or the lessee -- performs from a credit point of view, you have -- to a high degree of certainty -- the ability to predict yield as it comes from these contracted sources of income. This was happening for 30 or 40 years. Everything was great.

And then 2008 came around, and we saw that the regulators in Europe and America started thinking about the risk that banks were taking on their balance sheet. And really specifically focused on assets that were being put on the bank's balance sheet wherein bank actually owned the equity in the assets. So we saw the introduction of Basel (unintelligible) in Europe. We saw the introduction of Dodd-Frank here in the US.

And the real goal of the regulator was to curtail the banks to taking the kind of risks they had always taken and been comfortable with, and for (unintelligible) like owning equity in assets like these, they were asked to take and put on more reserve capital on their balance sheets. So starting 2018, we started seeing banks withdraw from the leasing market. And there was a significant impairment of this common source of the capital and its ability to finance the industry.

To further add on to the to this situation the fact that transportation assets have a finite useful life. So in our industry most assets have 25 years as their finite useful life, and we tend to depreciate the asset for that 25- year period. So what that tells you is that every year 4% of the world's fleet of trains, ships, planes age out and get scrapped, which means they have to be replaced. So we all know that the world has seen hypergrowth in the past decade or so.

So if imagine an industry that has 4% of its assets needing to be replaced every year and then you further add on a global economy where is growth to the extent of 2% to 4% a year globally being felt over the past decade or so, you can see how 6% to 7% on average of the world's fleet of transportation assets will be replaced -- is being replaced -- and we have that data to suggest that over the next ten years, that number could be as high as $4-1/2 trillion worth of financing that will be needed.

So when you think about the perfect storm of opportunity, you've got the current source of capital leaving the marketplace. You've got regulation that has created this huge gap between an industry that needs funding. You've got an industry where the end users choose to keep the assets off balance sheet. And you've got assets that age out and need about $4-1/2 trillion worth of financing over ten years.

So we really looked at this as a very exciting new opportunity. And we decided to participate in this industry.

David Lebovitz:    And I think - it's interesting, because at the end of the day it really all comes back to supply and demand. And whenever investors can uncover opportunities with favorable supply-demand dynamics, that oftentimes provides a pretty healthy tailwind for the asset class in aggregate. And it sounds like this a space where the wind is certainly at your back from a replacement cost - or replacement perspective of these assets.

Shifting gears a little bit -- and I think you've done a great job of setting the stage in terms of why this opportunity exists and how we got to where we are today -- if I'm an investor, how do I think about incorporating transportation into my portfolio? You mentioned that you know it's - the majority of the income - the majority of the total return is derived from income, and that obviously makes it a bit easier to forecast what your return stream might look like going forward.

So can you talk a little bit about how you think about this slotting in? You mentioned transportation as the third leg of the real asset stool. So do I think about this as real assets? Do I think about it as more of a credit allocation? How should I think about this in the context of my portfolio when putting the pieces together?

Anurag Agarwal:    That's a great question, and I think it's very important to -- firstly -- try and separate the two bookends that are ways in which one can invest in the transportation sector. I think traditionally before this opportunity to really invest in the larger transportation assets that can generate this income-based yield - I think most of what the investor community was used to seeing was that the transportation space is generally associated with investment that was more in the private equity style of investing.

So I think it's important to establish the bookends. And a simple way to think about it is when you think about global logistics -- and we think about global logistics as being a hub and spoke model -- the spoke side of that equation -- which is the smaller asset - the feeder assets - the swing capacity assets -- are the types of assets where you've seen traditionally more private equity style investing. You've seen more volatility and you've certainly seen a situation where all your return in that style of investing comes from asset appreciation.

So there's a distinction one makes when you think about what strategies you're investing in based on the size of the asset, situation of the employment of the asset, and most importantly the source of the return - which in this case is asset value appreciation.

Now what about the other bookend here, which is more the hub asset, the larger assets? It's very important to establish that the larger assets tend to be known also as critical supply chain backbone assets. These are assets which get embedded into the core supply chain of a large corporation. So really they get more likened to office space. You know, you need office space to run your business.

Same way you need these assets, otherwise your supply chain breaks. They also have much longer durations of employment. So what you tend to see is five years, ten years, as long as 15-20 years in these contracts. And duration gives you protection against market volatility. And then finally 95-plus percent to your earlier point actually comes from the contracted income from the lease.

So there is no relying on asset value appreciation - which again on the one hand lowers the amount of return you can make. But it also offers stability and offers the ability to generate predictable yield, that comes from these leases. So let's think about now how does an investor allocate a strategy like this in their portfolio? So out of the gates, we are talking about a strategy that has got real assets.

So we have transportation assets -- hard assets -- which are being used to generate contracted income-based yield. The natural home for this strategy is real assets. So what we have found is for those investors who are very familiar with and like real estate and infrastructure in particular, this is a great complement, because it is not as correlated to those two asset classes. It actually allows for a fair amount of diversification within the real assets pocket.

And oftentimes transportation assets get deemed as moving infrastructure assets. Because if you think about it, an airport is a fixed infrastructure asset. The planes that service the airport are transportation assets, so that's moving infrastructure. The same is true with ports and ships, and so on and so forth. So real assets is a natural home.

The secondary interesting way to think about the strategy is from a credit point of view. Because of the strong reliance on the credit quality off the counterparty or the corporation or the lessee, your ability to generate that income -- which is the source of your yield -- is purely predicated upon the credit performance of your lessee, once you enter into a lease.

And if that lease has a long duration --which it does in these cases -- the strategy starts feeling like a bond portfolio. Because in many ways one can draw the comparison of a basket of leases that has corporations as counterparties in them with long duration based terms to those leases, to a bond portfolio of corporate bonds issued by the same lessee as issues with similar durations to those bonds.

In fact if you think about the pure credit side of things, it is an apples to apples comparison to compare the current exposure you would take as a lessor to the same corporate credit as you would if you were to go out and buy a corporate bond with that corporate credit being an issuer. So that creates a very interesting opportunity to think of this strategy from a private credit point of view.

And what we have seen is the lease structure outperforms the underlying bond yield to us on average between 400-600 basis points. So while you are investing in a strategy that is not publicly available -- it doesn't trade publicly like a bond does -- there is some degree of illiquidity attached to it. You're certainly getting paid for that, because you're getting a 400-600 basis points premium bombs over that bond spread.

And then the last way to think about it is along the same continuum from a fixed-income point of view. If you are willing to take corporate credit risk - so just pick a name oil major space. If you like Shell, if you like Exxon, if you like Mobil, you like BHP Billiton - as a strong corporate credit in your bond portfolio, you could access the same credit and get a much higher yield for that credit.

So we've seen some investors think about this from a fixed-income point of view, where you could lower your exposure to these names in your bond portfolio by taking exposure to those credits via a leasing strategy. So this is one of those strategies that actually checks a few boxes. But I'd say real assets being one, private credit being two, and then in some cases there is orientation to think about this as fixed income.

David Lebovitz:    So I think that that's really interesting and it sounds like if I were to kind of synthesize that it would be the diversification benefit of real assets coupled with the income you can get from more credit-oriented strategies. I want to jump and talk a little bit about how you see the space evolving going forward and some of the risks.

But before we get there, there was one other thing that I feel like we need to touch on, since fixed-income has come into the conversation - which is the relationship between this strategy and the movement in interest rates, and your ability to determine lease terms given a backdrop of rate uncertainty. Can you talk a little bit about that dynamic?

Anurag Agarwal:    Sure. And that is a question that oftentimes gets asked around, how is this asset class - how does it behave in an environment of rising interest rates or falling interest rates - as we seem to be in right now? But I think quite simply, here is where we can compare transportation and its behavior to what we tend to see in the real estate space. So investors may be familiar with the idea of cap rates. And cap rates tend to be fairly correlated to inflation.

So what one tends to see is, in environments where there's inflation, to the extent that inflation is being driven by organic growth, you will see a fairly healthy correlation between cap rates and inflation. Transportation is no different. In fact, I'm sure everyone can relate to the fact that when there is inflation, you see gas prices go up, and you see your cost of transportation go up. As it goes up with air travel -- which is the most common form of how our investors feel it in their everyday lives -- you certainly see it in the commercial world as well.

And there is a correlation there where lease rates tend to behave like cap rates. So for the most part, where you know to capture that inflation, yes the lease rates reflect the in rising interest rates. Now, there are two other elements where inflation can come into play, and rising interest rates can be a factor. The first is in the cost of fuel. So no surprise - the highest cost for this industry is fuel.

But when you do enter into these leases, the lease structures are such that you pass on the fuel costs to the lessees. So as a lessor -- as the owner of the asset that has purely leased the asset -- you're not responsible for the fuel. So think of this again as Hertz. And you go out and rent a car from Hertz, or from Avis. And you take a full tank and you return a full tank. And you are not concerned -- as either one of those car rental companies -- of what the price of gas is on that day.

So we tend to take a similar approach. We just don't rent for a day. We rent for anywhere from 5 to 15-20 years. So you get protected on the commodity itself. And then the last way you can get impacted -- like in all real asset-based businesses -- we tend to take a certain amount of leverage that we that we add on to optimize our total return. That leverage for the most part comes in the form of my (unintelligible) plus terms, which is what the banks will traditionally do.

So interestingly, the same banks that cannot own the asset from an equity point of view are still very active in the lending of debt to these assets, because they still like the business. What oftentimes we end up doing is we swap out of the floating rate structures to fixed rates. So the goal is we are aware of the fact that there is an impact of what happens with rates, but we are fairly well protected in the way - either these contracts are written or in the way we manage that exposure ourselves.

David Lebovitz:    Excellent. And I think that that's actually a perfect transition to my last question, which is - is the space that again -- coming back to where we started --is still kind of new for a lot of investors. It seems like a pretty compelling story here, both from a fundamental standpoint, an income standpoint, the stars almost feel aligned in terms of how to plug this strategy in your portfolio.

How do you see things evolving going forward? And what are the risks that you're cognizant of? Obviously trade war has become a dinner table term over the past twelve to eighteen months. How do you think about that as a risk? How do you think about risks more broadly in the form of slower growth, deteriorating demographics, and how the space - how transportation broadly will evolve given that backdrop?

Anurag Agarwal:    It has become dinner table conversation, but it's also become a very important conversation entirely for us. So I will start off by saying that we live in a world now where there is certainly - one feels a heightened feeling of macro risk that comes from the geopolitical environment. We are in - we hear about these trade pacts and tariffs that are related to them that impact the flow of goods all over the world.

So let me sort of start with addressing that, and then I'll move on to some of the other risks that one needs to think about when you look at transportation as a sector or asset class. What we've noticed so far -- and we have going on a little over two years' worth of data -- around how the underlying markets have absorbed information and/or how the country that are either producing or receiving goods have chosen to address the trade war tensions, is that the goods are still moving.

What we have noticed for the most part is that there has been little to no impact when it comes to how the markets on the transportation side have gotten affected. And the reason for that simply is that while there may be a significant impact between the trade that two countries could be you negotiating or discussing, the goods tend to be sourced from either another part of the world, or what oftentimes we actually see is that the goods actually delivered through an intermediary country, where there isn't a trade tariff or a trade embargo situation.

Also it's important to look at which goods we're talking about. So for the most part when you think about subsectors within transportation, in the shipping space when you think about a country like China you're really looking at the import of iron ore - which tends to dominate a lot of their consumption. Coal is the other part -- from an energy point of view -- that they tend to import a lot.

And from an export point of view, they tend to export a lot of containerized good, because they are for the most part the factory of the world. Now what we've seen is that - and there is some level of grain commodities as well. Soybeans - I know we've read about US soybeans going into China. We've seen very little change in that behavior. A lot of the iron ore actually comes from Australian and Brazil.

Similarly to that, the coal as comes from other countries outside the US. What you're really seeing is that it's the US that is importing all the containerized goods. And some of those goods certainly have reduced in their volumes. But in the context of global trade -- in the context of the volumes of global trade -- we are still to see any meaningful impact to the need for transportation and assets is now going to change dramatically.

I think we can all agree that the world has adopted a model of producing goods in low cost environments and consuming them in high cost environments. And as long as that trend is true, I think you will see what tend to often think of as an expansion -- versus a compression or a contraction -- of the distances that the average cargoes and goods need to travel.

Another good example I can give you is that in the energy space, we're seeing a lot of focus on gas as being a notorious source of energy. But if you look where all the gas is mostly extracted, it's either in Canada up in the tar sands or in the shale here in America. But most of the gas gets consumed in Asia. And India for example is the world's largest consumer of LPG.

So what you're seeing here is another commodity that is emerging as a very viable and meaningful source of alternative energy, but it needs to travel significant amounts because it gets extracted in a continent (unintelligible) America but gets consumed in Asia. So we keep seeing these kind of other (unintelligible) macro trends, which also makes it interesting to think about the demand side for transportation assets.

David Lebovitz:    Excellent.

Anurag Agarwal:    Just moving on some of the other risks, just in how one assess and thinks about the risk you're taking and the commensurate return you should be expecting, which is really I think the framework one should deploy. If you are going to focus on (unintelligible) style investing that we spoke about earlier, then you should be willing to take risks - because then you are effectively investing in assets that are not focused on income generation.

So I think the litmus test should be, where is my return coming from? If your return comes from asset value appreciation, then you will take a certain amount of market risk, and you should expect higher return. In the kind of yield-oriented strategies we're talking about, I think you really focus on the duration mission as being a critical component of the underlying leases that are attached to the address you're investing in.

So you should always think about, am I getting sufficient duration? Duration dampens a lot of that market volatility and risk. So I would say the first risk you should think about is that of shorter term durations of employment versus longer term durations of employment. The other thing naturally becomes credit, because once you enter into that employment you are taking credit risk, and that credit risk is directly associated with the quality of the corporate credit you're doing business with.

So again, higher the quality of your counterparty's credit profile, the bigger the corporation, the bigger that balance sheet, the more it is investing (unintelligible), the more predictability gets associated with that contracted income, which eventually becomes your yield. The third is a strategy that effectively keeps investing in assets over a long period of time, you don't want to take any (unintelligible) risk.

One of the other elements where risk could be felt is if a large part of a transportation portfolio renews at the end of its first lease is at a time where the markets may not be favorable. Because you are subject to that market risk when you are looking for the next employment for the assets. We tend to think of that as a risk that can be managed. The way we think about managing the risk is by laddering the duration of our leases in our portfolios.

So what we try to do is we take we take the view that as long as no more than 10% to 15% of a portfolio renews in any one given year, it does not necessarily then bring (unintelligible) risk. And if you look at the history of transportation from rates point of view, we've never really had expensive periods beyond two or three for years where the markets have been severely depressed.

So it gives any portfolio the resiliency to basically manage its renewal of leases when you are disciplined enough to not take a lot of concentration around your renewals.

David Lebovitz:    Excellent. Well, Anurag thank you so much for joining me today on the Center for Investment Excellence. Lots for our listeners to chew on, and hopefully we'll have you back again sometime soon.

Anurag Agarwal:    Thank you very much. It's a pleasure being here.

David Lebovitz:    Thanks.