2022 has hit investors with an unprecedented 1-2 punch of sharply negative returns in both the equity and fixed income markets, but our Strategic Income team feels the selloff has created attractive opportunities in high yield bonds.
Bobbing and Weaving
Investors have never endured the 1-2 punch of negative returns in both equities and fixed income in the same year as they have so far in 2022. It has been 14 years since the stock market has fallen as much as it has this year (in 2008, the S&P 500 lost 37%). But unlike this year, Treasuries returned a tidy +20% in 2008, as the Fed was aggressively easing in response to the collapse in real estate and the mortgage-backed bond market that pushed many banks and financial institutions to the brink of insolvency. If you sold stocks and bought Treasuries early in 2008, you would have been fine, but not so in 2022. It has been very tough this year to find anywhere to hide outside of cash. Since 1988, there have not been any years where the decline in the 10-year Treasury bond return was greater than 10%, save 2022 year-to-date. We have to go all the way back to 1974 to find a year where the returns were somewhat analogous to what we have seen so far this year, but given the global nature of economies today, the speed with which information moves, and the role technology plays in linking global markets, it can be argued that going back that far for purposes of comparison may no longer be valid.
We know that each cycle is different and this one has unique characteristics. We are in uncharted territory as global central banks are collectively hiking rates to levels never seen before. According to Jim Reid of Deutsche Bank, over the last 24 years (which is as far back as we have reliable data), the ratio of global central bank rate hikes to cuts has never exceeded 5:1 until recently, when it reached 25:1! Clearly, looking in the rearview mirror gives us an excellent view of what has happened but it rarely, if ever, tells us what lies ahead. Our economic tour guide, Fed Chair Powell, seems to be in no hurry to give us a clue where we are headed, nor how long the ride will last. Sadly, everyone wants to know…and they want to know NOW! Markets generally hate uncertainty.
While the Fed has been telling us that they have the tools at their disposal to adequately quell inflation without causing a recession, most analysts and experts seem to believe that is not the case. Most suggest that the Fed will continue to hike until something breaks…likely the economy, and only then will they take their foot off the gas and stop hiking rates. That has been typical of the Fed’s track record in the past, and the way the market reacted in the month of September suggests to us that more investors are beginning to think that is the most likely outcome this time as well. From an investment standpoint, however, just because more people believe that a recession is coming is not necessarily a reason to sell everything and go to cash. One would only do that if the opportunity set of investments was not yet appropriately compensating an investor while pricing in the probability of a recession.
With computers and smartphones allowing users to order food, clothes, furniture, beer, and just about anything else one can imagine at the click of a button, is it any wonder that we have all come to expect immediate gratification? This ride, however, is going to take a bit longer before we know where and when we will reach our destination. That will continue to make investors uncomfortable as they try to find these answers, but they will have to wait until we have more signs (read: data and better Fed guidance). Those with the patience to see it through and not rush to the side of the road have historically been rewarded by rebounding markets as blue skies reappear. Below are a few areas we are focused on in today’s market.
Inflation Expectations
By now, we have all been overserved a diet of inflation prognostications from many pundits and economists. It is impossible to know who will be right or wrong, so we would rather not try to make bets. Instead, we prefer to take what the market is giving us and try to make the best of it. Jim Bianco of Bianco Research observed that the recent multi-decade era of low inflation that seems to have ended with the pandemic was the result of four “bubbles”— cheap labor, cheap goods, cheap energy, and better technology. Each in its own way helped to keep prices down, which translated into a prolonged period of comfortably low inflation. Today, however, labor, especially skilled labor, is in tight supply, China is no longer pumping out endless quantities of inexpensive goods, and the combination of the Russia/Ukraine war and the pervasive anti-fossil fuel sentiment in the U.S. and Western Europe has pushed global energy prices up sharply. This leaves better technology as the last remaining anchor tethering prices and inflation to lower levels, and it appears that technology alone cannot do that job, especially given the semiconductor chip shortages and spiraling software costs.
For much of the past year, investors seemed to think that a short period of rate hiking would bring inflation under control, but that always seemed too convenient for us. Until recently, they (including the Fed) were underestimating the possibility of more persistent, higher inflation. We felt that there was more risk in a rising yield curve causing collateral damage to equities. We have seen this play out very rapidly in September as the entire yield curve shifted sharply upwards and equities have been weak. Rates between 2-10 years along the curve rose about 65 to 80 basis points at the realization that a Fed policy pivot was nowhere near. We are not ruling out the possibility that the Fed may be successful in the short term, and that some of the shocks in the financial markets this month may help bring inflation under control more quickly. But we still do not think it would be prudent to bet on that outcome by increasing duration, because if we are wrong about the persistence of inflation and the length of the rate hiking cycle, there could be more sizeable markdowns coming. We would prefer patience.
Stress in the Gilts and Swaps Markets
The reversal of negative government bond yields in the eurozone over the past 18 months has been predictably painful and even more pronounced than the U.S. Treasury selloff (given that they started from a higher price dictated by a negative rate policy). For perspective, the 10-year U.K. Gilt and the German 30-year Bund have declined in price by an astounding 35 and 42 points, respectively! A combination of rising U.S. rates, a strong dollar, the proposed “mini-budget” unfunded tax cut policy put forth by the U.K. government, and the corresponding collapse of the British pound and spiraling fuel inflation on the continent ahead of the winter heating season are all culprits spurring this decline.
It appears to us that this confluence of factors created a level of volatility that is well above normal and has spilled over into the swaps market, which may be why the Bank of England decided to intervene in the bond markets while raising rates, a highly unorthodox action. Another possible factor may be reports of various levered gilt-related derivative trades, initiated during the negative yield regime. These have been especially popular yield enhancers for U.K. pension funds that were unable to meet their actuarial assumptions during the negative rate environment of the recent past. Many of these schemes are now required to either post additional collateral (a margin call), or be forcibly unwound, further exacerbating the volatility and price weakness in gilts. The size and scope of these levered trades is unclear, but we do not believe they present a systemic risk currently. Unwinding leverage rapidly is rarely painless and will likely cause more losses for U.K. pension fund managers. Gilt and U.K. swap market volatility could persist, along with further sterling weakness until the rest of these levered trades are closed out. While we do not have any direct investment exposure to either the pound or the U.K. Gilts market, we are keeping a watchful eye on them for any material spillover effects on the U.S. Treasury and corporate bond markets. Presently we see only a modest impact.
Where We See Risk and Opportunity
Over the past several years, private equity as an asset class has gained popularity and produced outstanding returns for investors. The combination of stable markets, low interest rates, significant growth in the collateralized loan obligation market, and an increasing risk tolerance from investors has enabled private equity sponsors to generate very attractive returns for their investors. It would be foolish to posit that we know the halcyon days for private equity are over, but it does seem fairly obvious that the game is going to get increasingly more difficult. Billions of dollars of investor capital have flowed unabated into private equity funds over the past 14 years. According to the Harvard Law School Forum on Corporate Governance, as of February 2022, private equity firms had approximately $2.3 trillion of dry powder to use for acquisitions. The competition for deals has become fierce, which suggests that prices for target companies will remain elevated. On the flip side, financing these transactions has gotten materially more expensive as funding costs in both the leveraged loan and high yield markets — the two key funding markets for private equity — have risen sharply this year. In addition, with the significant declines in the public equity valuations and the virtual collapse in the SPAC market, which had provided an additional path to the public markets for companies, it is likely that many private equity portfolios will have to mark down existing holdings and possibly own them for much longer, which will lower portfolio turnover and potentially reduce their returns. Lastly, since private equity-backed companies tend to be the most highly levered companies, and economic slowdowns generally impact equity values of levered companies more than unlevered ones, even a hint of a recession heightens the perceived risk of bankruptcy for these entities. That does not bode particularly well for private equity returns, nor for the performance of the bonds issued by these companies.
We are beginning to see examples of waning investor appetite for the bonds and loans of companies backed by private equity sponsors. Many deals that were backstopped and bridged by investment banks in late 2021 and early 2022 are getting the cold shoulder from investors as banks try to unload them from their balance sheets. This is already causing very large losses at the banks and private equity firms may find it increasingly difficult to get commitments for future deals until markets improve. We have deliberately eschewed these kinds of deals for the past several years as we have long believed the irresponsible amounts of leverage that had been piled on top of questionable adjustments to EBITDA projections, coupled with very loose covenant protections, could eventually lead to bad outcomes for bondholders. The piper has arrived and wants payment. There may be an opportunity for this market segment in the future, but we prefer investing where our incentives are aligned with owners and management, rather than playing poker with a marked deck.
Anecdotally, we are also starting to see some signs of economic slowing across various industries as a few bellwether companies are beginning to issue cautious forward revenue and earnings guidance, and order books for future periods are beginning to shrink. The increase in mortgage rates from the mid 2% area to near 7% is also putting a damper on home purchases and is beginning to slow the rate of new housing starts. Since home buying has a high multiplier effect in the economy, we expect to see softness ahead in the sectors that benefit from home buying, like appliances and furniture. We hope this is a sign that rationality is creeping back into corporate budgeting, and security prices are finally beginning to reflect a more cautious outlook. Importantly, it suggests to us that the overheated temperatures of the equity, Treasury, and corporate credit markets that we saw in late 2020 and 2021 in response to massive pandemic stimuli have cooled markedly. Excessive risk-taking, which had pushed valuations of both deserving and undeserving companies to stratospheric levels is abating. However, we do still see passive trading vehicles that often transact across a broad swath of bonds with little regard for fundamentals of the underlying companies. As a result, we have frequently seen large markdowns caused by relatively few bonds trading as these funds raise cash. This presents an attractive opportunity for smart issuers to shore up their balance sheets by opportunistically repurchasing debt at a steep discount, and while many investment grade companies have been doing so for the past several months, we are just beginning to see high yield issuers follow suit. Unfortunately, as we have said before, it is impossible for us to add to existing positions at lower prices without temporarily marking down those positions. The price declines we have seen to date are finally creating attractive opportunities for us as yields approach levels from which future expected returns in high yield bonds look attractive. Therefore, we have been selectively taking advantage of opportunities to add both yield and ballast to the portfolio.
Today, following the extremely weak markets in September, we think that many high yield bonds are already discounting a “hard landing,” or a fairly severe recession. Should we be able to avert the worst-case scenario, investors who are able to take a longer-term view should be very well-rewarded for their patience. Over the next 1, 3, and 5 years, a few of the companies with highly levered cap structures and poor business prospects will be forced to restructure. They will be the victims of 10+ years of easy money, overzealous private equity owners, and over reliance on continuing Fed support. But they will be the exceptions and not the rule. Many companies that are run by responsible stewards of capital and have managed their debt loads wisely will be able to adapt to the changing economic conditions and will likely be able to either pay off or refinance their debt when due. Importantly, many of the bonds of these healthy companies have traded down more than we would have expected, given the deliberate rate normalization by the Fed. Currently, our average weighted bond price is around $86, which means that in addition to the coupon income we are receiving, as these bonds pull back to par over the next few years, we expect to reap additional returns as well. Given our overweight in shorter-maturity bonds, we hope these will revert to par faster than longer-dated maturity bonds, which could baseload returns for years to come as they move gradually back to par.
Keeping it Simple
Despite our 105+ years of collective investment experience, we have never lived through the confluence of stock and bond market pain that we have endured this year. We are always learning, but one thing remains constant: we believe keeping things simple is the best way for us to produce steady long-term returns while still being able to sleep at night. One lesson we have learned over the past 20 years of managing this strategy is that investing in good companies that generate free cash flow and whose incentives are aligned with ours is a winning formula. Being appropriately compensated for the risks that we take and not following the crowd also helps.
We remain steadfast in our quest, we thank you for your continued confidence and support, and we look forward to hearing from you.
© Osterweis Capital Management
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