Clash of the Credit
In a battle of Investment Grade vs. High Yield, we discuss credit opportunities for institutional investors.
David Lebovitz: Welcome to the Center for Investment Excellence, a production of JP Morgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes. Today's episode is on Clash of the Credits and has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist and host of the Center for Investment Excellence.
With me today is Lisa Coleman, Head of the Global Investment Grade Corporate Credit Team within our Global Fixed Income Currency and Commodities Group, and Jeff Lovell, Senior Portfolio Manager on our Global High Yield Team. Welcome to the Center for Investment Excellence.
Jeffrey Lovell: Hi, David. Thanks for having us.
Lisa Coleman: Hi, David. Thank you. It's great to be here.
David Lebovitz: Well, we're glad to have both of you here. So, looking forward to a really interesting conversation today. You know, credit is certainly front of mind for pretty much every client that we've been speaking to over the course of 2023 thus far. Before we dive in and talk a little bit about what's happening at the sector level, I wanted to start out by just getting to know you both a little bit better. So Jeff, maybe we'll start with you.
A bit of a newer face on the podcast - I actually think that this is the first time you're joining us. Can you tell us a little bit about yourself; where you fit into the GFIC organization; and how you arrived at your current role?
Jeffrey Lovell: Sure. Happy to. So I joined JP Morgan in 2004 on the high yield team after about ten years at another asset manager. Our high yield team is based in Indianapolis, Indiana, where I live with my wife and three daughters. Over the course of my career I've spent about 20 years in research and ten years in portfolio management. I've loved both roles. And in the 19 years that myself and our team have been here at JP Morgan, high yield assets under management has grown from $3 billion to about $50 billion today. And our team manages for institutional accounts - think pension funds; for high yield funds; and then as pieces of strategies like income funds, core plus, and GBOs that have allocations to high yield.
David Lebovitz: Awesome. Well, glad you're joining us today and I certainly have some questions about what's going on in high yield. So, I'm looking forward to unpacking that. Lisa, you're probably a bit more of a known quantity to our listeners on the podcast. You lead our global investment grade corporate credit team. What is it that you enjoy the most about managing money? And what's kept you managing money for as long as you've been doing it?
Lisa Coleman: Sure. That's a good question. Some days I do wonder. But I will say what I love about managing money is it's kind of like problem solving or puzzle solving at its best, right? Because you get so much data that gets thrown at you every day, and you're trying to figure out does that information that you're getting, change your investment thesis? And how do you pivot to recognize when perhaps you have the wrong thesis?
And I guess the other part I would say too is, I think managing money can be one of the most exhilarating experiences, particularly when your thesis is right, but also on the flip side, one of the most humbling experiences when you find out that what you were thinking is disproven by the data that comes out.
David Lebovitz: I think that that makes a lot of sense. Somebody asked me the other day in a client meeting, what's the one thing that you learned during the pandemic, so over the past three years? And there have certainly been some humbling experiences, I think, for all of us. And some good experiences for all of us over the course of the COVID campaign. But let's dive in here and kick off the conversation.
So Lisa, maybe sticking with you, recession probabilities are rising. The case for investment-grade credit and looking up in quality is resonating more and more with investors. You know, when you look at your asset class today, I'd be curious to know where you're seeing the most opportunities today and some of the ways that you think investors can take advantage of those.
Lisa Coleman: Sure. So you're absolutely right. When you look at the yield on the investment grade corporate market, now roughly around 5-1/4%, it certainly does look appealing to people. But I think one of the challenges for us, and I know we've talked about this in the past, is looking at things on a spread basis. Sometimes that can be a little bit more challenging. And in particular, given the very strong spread rally that we've seen this year in investment grade corporate bonds, we're not really getting a lot of compensation for recession.
I think that works out to being something under 20%. So all-in yield looks great, spreads look a little bit tight. So one of the challenges for us as managers, is to find sectors of the market where we think there's still good value. And we keep coming back to banks. And there are really three components that we look at in the banking sector - the Big 6, so the US money center banks, the regional banks, and then of course the Yankee banks, which are European issuers that have come to our market to borrow.
And so when I think about this also in the context of looking at the fundamentals, the technicals, and the valuations for these institutions, we can create a picture that makes it look very attractive. So for example, on fundamentals, whether you're looking in the US or you're looking in Europe, capital is high, especially given where we were at the time of the GFC, the financial crisis. All of these institutions are benefiting from higher rates through an uplift to net interest income. And both in the US and in Europe, we're coming off a period of very low credit costs, so certainly they're well set up for normalization of credit.
Now, the reason we think there's been an opportunity to invest there, is that the technicals have not been constructive, meaning that through most of last year, we had a considerable amount of issuance by these institutions. So that really caused spreads to widen very considerably. They had to meet regulatory requirements for senior debt, and we found that with the US banks for TLAC, and then also for the European banks for something called (MREL).
In the US case, we expect these issuance needs to slow down, and in fact, banks have not issued very much, at least in the Big 6 space this year. And European banks, it's been rather front loaded. And so we expect that to diminish as the year goes on, which brings us to the final point, which is valuations. And I think the greatest valuation opportunity is in the area of the Yankee banks. Because when you look at the credit spreads that these banks are giving us relative to that of the broader index, they're still trading wide of where the broader index is. And we think that's a real opportunity to take advantage of.
David Lebovitz: Awesome. Well, it certainly sounds like there are a number of things going on within the financial space and the Yankee Banks in particular. I'll come back to you later on some of the areas that you're trying to avoid. But it sounds like a pretty interesting opportunity, particularly given how unloved the banks have been in general across both equities and fixed income over the past couple of years.
Jeff, maybe shifting gears and coming over to you. Again, people look at high yield, they tell me that the carry looks attractive. The all-in yield is excellent. Default rates - they're still historically low. They have begun to move higher. This suggests to people like me that maybe we're in store for some spread widening down the road. But how are you thinking about navigating high yield in 2023, particularly given what the Fed did over the course of 2022?
Jeffrey Lovell: Sure. Yes. First, let me start with default rates. As you said, the 1% current environment is really unnaturally low, and that's come about for a couple of reasons. First of all, in 2020, we had a default rate of about 6%. So when the world shut down, that really pulled default rates forward. So instead of having maybe a smoother default rate, we had a chunk in 2020. And then as the economy has recovered in the past couple of years, that has resulted in this really low environment of default rates.
So we do think in 2023, we are going to see a more normalized default environment - 2% to 4% would be our expectation. Now, we think that that's going to be idiosyncratic. It's not going to be big chunks of sectors that have defaulted like maybe prior cycles. But it's going to be more over-levered companies, companies that really lack business resiliency. You can think about a company like Party City that defaulted recently; really commoditized products subject to internet displacement.
So stresses were staying in the market, but they're really kind of here and there. You're seeing some in media, in retail, in tech. So while we expect defaults to rise, the market with spread levels in the mid 400s, is really pricing in about a 3% default rate. So spreads usually move in front of default rates. And I think that's what we're seeing today. As we enter this year, you know, fundamentals are solid, even in the face of a slower economy.
Debt levels have maintained at low levels. Management teams, because we've had such a short cycle between COVID and now, there's not a lot of excesses built. Management teams have been pretty disciplined on keeping leverage low. Cash flows have rebounded to beyond 2019 levels, even the slowdown. So there are pockets of strengths and weaknesses. But overall, it's a pretty resilient set of companies in high yield.
So fundamentals are solid. When I think about technicals, technicals are strong. So supply has been very low. The market was so open in '20 and '21 that about $900 billion was issued in that timeframe, which is about 2/3 of our market. So companies refinanced; there's not a need to come to market; and with rates and levels having backed up, they're not coming to market except really when they need to refinance.
We've also seen a moderation of outflows. I think you saw a lot of outflows in 2022 from high yield. That's really moderated as again, we've kind of repriced the market. When you're in the mid-8s, I think that becomes more appealing. And we've seen fewer outflows. And then finally on technicals, convexity is appealing. The average price of the high yield bond is 88 cents on the dollar. It gives you downside protection if the credit weakens, and it gives you upside opportunity if the credit improves, or if a company is acquired.
So yes, as you said, today, I think we're seeing valuations much better now that we're in 8-1/2% yield vs 4% a year ago. And the power of carry is back. So 8-1/2% gives you good compensation for credit risk. And in what we see as a moderate default cycle, you can have good returns from here.
David Lebovitz: Excellent. So it sounds like both of you across your respective asset classes, respective sectors, are finding opportunities. I want to come back to where you're seeing risk. Lisa, maybe we'll start with you. You talked a lot about financials and the banks earlier on as an area of opportunity. I'd love to know if there are any areas of the market that you're actively trying to avoid.
And then Jeff, to you, you mentioned that risk in your space is feeling increasingly idiosyncratic. Are there kind of commonalities and maybe we can flush out a little bit more of what I think you were getting at. Are there commonalities across the companies that you view as being higher risk? But Lisa, maybe start with you in terms of what you're seeing.
Lisa Coleman: Sure. So, you know, it was interesting listening to Jeff just now, because as with high yield, our corporate fundamentals still look pretty good. And when you look at where we were a year ago, when we were running with very high revenue and EBITDA growth at 20-year highs, I think we would all have to agree that that was unsustainable. And now as the economy has slowed down, we would expect to see a more normalized run rate. And so where we think we're coming in now for the fourth quarter results that we're in the midst of, 9% revenue, 6% EBITDA, that still looks pretty good.
And that's for our median company. And even if we look at weighted averages, it's roughly in that same ballpark. So to your point, where are we avoiding? We're not really seeing any meaningful sectors that we feel we need to avoid. Rather, things are more idiosyncratic. And if I could just kind of give an example of what's changed, and I'm sure Jeff has some views on this as well, we can look at the energy sector.
So one would have thought, gee, if we're getting poised for a downturn, that's an area we really want to be careful about. And yet, when we look at what's gone on with our energy sector, looking at integrated independent producers, we're now seeing leverage at less than one times, which is almost unheard of. And, you know, these companies have such a discipline when it comes to CAPEX and the like. And really what they've been able to engineer is the ability to satisfy both bondholders and shareholders.
So bondholders by repayment of debt, getting that leverage down to the levels that I mentioned. And then for equity holders, giving excess cash flow to them in terms of share repurchases and dividends. So I'm not saying that we're seeing this in every sector that we're seeing leverage down to much lower than that of the index. But I think here's an example of why it's more difficult today, to think in terms of broad sectoral spaces.
And maybe just one more point on what we're avoiding - I think in the past, you have been rewarded as an investment grade manager going into a downturn, to avoid the fallen angels. And that's one of the things that when we look in historical periods, it's usually been sector driven. We can look at energy in the past, we can look at autos. But we're just not seeing this broad based weakness. And rather, things are really quite idiosyncratic.
So a couple of examples - there's a large chemical company in our space that did an acquisition. Probably timing was a little bit off, but made strategic sense. This is a company that if we do run into a more pronounced downturn, we would expect them to migrate from our space to Jeff's space. And some also say, looking at the aerospace and defense area, another large issuer that in a more meaningful global downturn could potentially be downgraded. But again, we're not looking in these spaces for a broad based, really deterioration.
David Lebovitz: Very helpful. J eff, maybe over to you. So kind of a similar question. Again, you mentioned that like Lisa, a lot of idiosyncratic risk in your space. But maybe just respond to what Lisa said about investment grade, and give us a little bit of perspective about how you're navigating some of those risks.
Jeffrey Lovell: Sure, yes. I think what Lisa referenced earlier, its fundamentals really apply across investment grade and high yield. Fundamentals are what they are. We have different compositions to our markets, which makes for some different views of relative value. For example, financials in high yield, we generally are underweight financials, right? There's a lot of subprime lenders with that cohort of the economy that has really faced a depletion of savings and that's a weaker part of financials and mortgage brokers. So financials are not as attractive in high yield.
Energy - I would echo Lisa's comments on energy. Energy companies are really living within cash flows; have really gotten very disciplined around low leverage. So energy has come back to be a more high quality sector after really the bust that it had a few years ago. You know, I think it's interesting that now that we're in earnings season, just to see the amount of dispersion that we're seeing in results. In high yield, the most positive sectors are part of this theme where the consumer still has the preference for experiences vs goods.
So the sectors that are booming in high yield right now are gaming, lodging, leisure, airlines, where the consumer still wants to spend, still wants to travel, still wants to get these experiences. So all those sectors are well beyond pre-COVID levels. And now as a corollary, spending on goods remains negative. So weaknesses that we see in the high yield market would include retail and consumer products. So retail has faced kind of a double whammy. You've seen lower demand and at the same time, inventories are uncomfortably high.
So in 2021, when there were major supply chain disruptions, retailers did not have enough inventory. The knee-jerk reaction in '22 was to order, order, order as much as they could. And they have a lot of inventory and then demand slowed down in the second half of '22. So retailers have slowing demand, and then they're forced to really be promotional to get their inventory out the door. So they're seeing really weak margins in the fourth quarter for sectors like that.
And I think for high yield, there's this big range in the middle then of really just kind of resilient sectors, communications, healthcare, that are really showing resiliency. There's that middle of the market.
Lisa Coleman: If I could just chime in and add on something that Jeff had said earlier, he's absolutely right. And one of the things that we've been struggling with is how to benefit from this resurgence of spending for services. And unlike Jeff, we don't have a lot in the way of unsecured airlines, but we do have secured airlines that we're able to take advantage of, and also the lessors, which I think give you an opportunity to build on a resumption of more international airline travel.
And then one other point, and Jeff is absolutely right, you do not have a lot of financials. But I think there is one opportunity that does span both of our spaces from a ratings perspective, and that is on preferred securities. Because while these are issued by investment grade financial institutions, what we do find is because of subordination, you can actually get a BB type rating on some of the securities. And we think that that's just a really super attractive space.
If you look at what the securities are yielding at an index level, it's about 7-1/4%. If we take into account the tax advantage, because a portion of the income counts as qualified dividend income and gross that up at 70%, you can be looking at maybe another 50 basis points or so higher. And I think on a default adjusted basis, the yield for the high yield market more broadly may not compare as favorably to what we might get in this subset of preferreds.
Jeffrey Lovell: I think that these nuances that we're talking about really show why there are a lot of synergies in working in our two asset classes, working together, right? Especially we had so many fallen angels and then rising stars that we've both really been able to leverage the other teams to get opportunities in those spaces.
David Lebovitz: Well, I couldn't agree more. And I think what started as the clash of the credits has once again reaffirmed for me that bonds are back in 2023. And so maybe one final question to both of you, a little bit of just 30 seconds on the biggest risk to your central thesis for this year. You know, what could happen that would make you go back to the drawing board and reevaluate your game plan for 2023?
Jeffrey Lovell: Well, I'll start for high yield. So when we entered 2022, high yield was yielding low 4%. And so I think it was very clear to us that there was not a lot of value in the low 300 spreads, the treasury below 1%. And so we were very short duration; we were very short risk. And that really played out in '22. As the market is repriced today, we're much more market-like in our risk and in our duration. So for us, it's back to security selection. That's what we have to get right.
You know, we have a team of 22 research professionals, an experienced PM team, so we're set up well for this environment. But it is a security selection environment for us in 2023.
David Lebovitz: Awesome. Lisa?
Lisa Coleman: So my worry is that the Fed may be forced to go higher in rates and in their tightening than what we anticipate. And looking over the past week, clearly the market began to reassess some of its assumptions in light of the employment data. But if you look at the spread, and I'll talk about this from a spread perspective, not an all-in-yield perspective.
But if we look at the spreads where they are today, inside of 120 basis points or so, the distance to actually price in a deeper recession that could ensue if the Fed really has to lean hard on the economy and employment, means that we could be getting at least an 80 to 85, 90 basis points back up in yields using the past as prologue. So that to me, is the greater risk. At this point, we are pricing in a recession, but not a deep recession. But I think that might be something that notwithstanding the health of corporate balance sheets going into it, looking at historical spreads, we could see a more meaningful move wider.
David Lebovitz: Excellent. Well, once again, all roads lead to the question of recession. So Jeff, Lisa, thank you both again for joining me. This was an awesome conversation and I look forward to having you both back on the podcast sometime again soon.
Lisa Coleman: Great. Thank you.
Jeffrey Lovell: Thanks very much.
David Lebovitz: Thank you for joining us today on JP Morgan Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Recorded on February 13, 2023.
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