COVID-19 and the Loan Market

We expect to see a combination of anti-viral medications and vaccines develop over 6 to 12 months globally. We are seeing daily positive articles on the effectiveness of anti-virals from other countries. Vaccine development appears to be moving very quickly, and there is potential for a vaccine to get to people as soon as the end of 2020. If people think effective treatments and vaccines are imminent, life could go back to normal, and in this case, that could mean coming out of our protective shells into a world powered by loose monetary and fiscal policy. Historically, markets have tended to anticipate upturns about six months before they occur. As a result, we think markets could start looking better over the very near term if things get particularly good with vaccines and antivirals or, more likely, in about six months as markets anticipate an eventual vaccine about 12 months after development began. It may be hard to believe now, but a year from now we may be talking about when to remove stimulus so the economy does not overheat.

Loans may be closer to “stupid cheap” than overpriced

Unlike the great financial crisis (GFC), which seemed to threaten the end of the financial world, this crisis feels particularly curable. We may have a couple of quarters of down GDP, but the potential rebound should be far closer than in an average recession. That means the current price action in the loan market, at least, is a lot closer to "stupid cheap" than overpriced, in our opinion. Here's why: bank loans are not about whatever value people feel like putting on them (that's what equities are), they are about being paid back, historically in an average of 3 years. One way to think of their value is to focus on the odds of each loan being paid back, one by one. Because they are senior and secured by collateral, bank loans tend to trade near par most of the time, because the odds are good that most of them will be paid back. Well guess what—we believe most loans priced in the 80s today will be paid back too. In our view, they're not trading in the 80s because they won't be paid back; in general, they're trading in the 80s because people are scared or are trying to trade in and out of things to maximize their investment return. When people get scared, they often tend to focus less on rational investment prospects and more on feeling better at that moment. This is why a lot of investors sell at the bottom and buy at the top.

Three roads back to par

Why am I saying loans are fundamentally cheap right now? Because there are three roads back to par for loans:

  • Road 1 is the most likely, in our opinion: Markets start to recover in 6 to 12 months and loans get bid back up to something close to par by collateralized loan obligations (CLOs) who typically love to buy paper at a discount.
  • Road 2: The world is far worse than we or others expect and there is a wave of bankruptcies of decent companies that have had their revenue temporarily decimated. These companies will likely be valued at a higher amount than the bank loans, which have to get paid off first. Capital would be raised to pay us off so that we don't get the equity.
  • Road 3 - It's a terrible world and capital is not raised to pay off the lenders. Then we get the equity, and should the company come out of bankruptcy, we would get the value of the whole company, which could be MORE than par.

We think loans are in a special place in this world, where we have many paths back to par under many reasonable circumstances. Prices are currently below where we think they should be in a normal recession, and normal recessions typically take a lot longer to resolve than this crisis should. We believe loans are cheap fundamentally, and fundamentals generally come through in the end. Currently, I don't think stocks are cheap fundamentally and they have to contend with all that momentum money sloshing around. High yield is not at recessionary spreads, in my opinion, which might be rational but implies that loans should not be either.