← Grant's Current Yield Podcast
Grant's Current Yield Podcast
LONG IN THE TOOTH
00:38:00
With special guest Dave Breazzano, head of credit at Polen Capital.
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Transcript52 lines
- [00:00]
A
Foreign Ladies and gentlemen, welcome to Current Yield, Grant's interest rate observer of the air. I'm Jim Grant. With me, as always is the great deputy editor of Grants, Evan Lorenz. And Henry French is where he ought to be at the sound control panel. And it's my pleasure to welcome you back. We have had a short summer break here at Grants. Actually, Evan, it's been going on for an embarrassing long number of days, has it not?
- [00:33]
B
Yeah, we missed the entire bear market that lasted for two days in August.
- [00:37]
A
We're celebrating part of that. We didn't miss it entirely. But you're right, we never haven't broadcast. We kept typing but not talking. And so today we have David Brezano with us at Poland Capital. David is the head of team for credit at Poland and serves as co portfolio manager of the U. S Opportunistic High Yield and U. S High Strategies. And Poland is the steward of no fewer than $66 billion with a B. What do you think of that, Evan?
- [01:08]
B
It's a, it's a big number even when you say it's low.
- [01:10]
A
Yeah. Before that, I want to, I want to tell the listening audience a little bit about something that's going to happen on Wednesday, September 18th. This won't take but a minute, David and Evan, I am going to be partnering with something called two Way. Two Way Community. And what's that? Well, it is a new interactive live, mind you, video platform in which you, the viewer or listener get to participate in the discussion. You can call in questions, you can say, who is this guy? So you can be part of a live conversation in real time via live Q and a. So Wednesday the 18th of September at 3pm Eastern. Time is the date and time, so do join me. It'll be moderated by moder Mark Halpern who was the founder of two way and former political director of ABC News. Donald Trump sent me an email this morning saying he loves ABC News. That's good, right?
- [02:03]
B
I heard he had good things to say about the moderators too.
- [02:05]
A
Yeah. So anyway, that's. Mark Halperin will be joining me or I'll be joining him, so don't miss it. And if you want to attend, just send an email to the following podcastranspub.com G-R-A-N-T S P U B.com and we'll respond to you with the registration links. That's Wednesday the 18th of September at 3 Eastern. All right, that's that. So without further ado, David, welcome.
- [02:30]
C
Well, thank you for having me. I'm looking forward to this.
- [02:34]
A
Well, we are as well. And I understand, David, that you have an interest in the fine art of lending and getting the money back once it has been lent. Is that true?
- [02:45]
C
We certainly would like to get it back, yes. I've been lending, lending my entire career and recovering and recovering quite a lot of it. Yes.
- [02:55]
A
Evan, where to begin? I think the, I mean, people always begin by saying, what's the Fed going to do? Reminds me of an imagined prelude to the World series when the TV personalities spend a full 30 minutes introducing the umpires on this one. Nice guy, scratch golfer, the home plate umpire. He went to school. Just like fact. David Brzean went to Union College. Yeah. And he went on to get an MBA at Cornell, just like actually our guest has done. But this is the imagined introduction of all of the empires who actually are not playing, they are officiating. David, does it strike you that the world is rather Fed centric, perhaps to a degree that it ought not to be?
- [03:36]
C
Yes. I think we are hyper focused on what really a handful of individuals who are not often unanimous will decide to do on interest rates. And at the end of the day, at least in my humble opinion, that's not the true driving factor of how one makes a return in credit. We make a return by lending money with an interest rate and the yield on the bond or the loan that we've purchased is what our return ultimately will be. But during the course between the time it's issued and it matures, the price may bounce around due to whatever the Fed or others do with interest rates. But at the end of the day, if we've done our work and it matures, we get the return we bargain for. And what happens in the middle is noise. So I think we're hyper focused often on that noise. And the big picture is we lend money, we have an interest rate and we get paid back, and that's what we bargained for.
- [04:41]
B
Dave, where are we in the current credit cycle to argue that we're in the salad days? Spreads on high yield bonds are very low and competition in private credit and leveraged loans is causing loans to print with very weak covenant packages and very low spreads as well. But on the other hand, we're seeing elevated defaults on leveraged loans that are above their long term average, which would suggest that we're kind of in the down part of a cycle. Where, where are we at right now and how do you navigate it?
- [05:05]
C
Yeah, I would say this cycle we're long in the tooth in this Cycle. It's interesting compared with prior cycles in that the recession that hasn't quite happened, the downturn hasn't quite happened, has been predicted for longer than I ever recall in my career. I mean, we've been anticipating a downturn for a couple of years now. And what that has done is extended the cycle in the sense that what really gets companies and the markets into trouble is when things are going really well and companies are trying to keep up with the competition, revenues are going up, they're borrowing, adding capacity, building inventory, less focused on cost, they just want to grow. And then all of a sudden, when things turn quickly negative, they're caught off guard and they have a problem. Here we've been anticipating this recession that just is always a quarter or two out into the future. Now we will have one. We haven't eliminated business cycles and we're getting close. And you're, as you rightly point out, defaults are starting to tick up in certain parts of the market. But markets are not homogenous. There's sectors to them. Some are doing well and some are doing less well. And then the complexity of the credit markets has really expanded. In, you know, decades past, it was primarily focusing on public bonds. And then we saw the growth in a leveraged loan market and the explosion in popularity of CLOs. And both markets, the bonds and the loan markets, eclipsed a trillion dollars. And now in the last few years, private credit is all the rage. And that private credit market now is eclipsed a trillion dollars as well. So we have more segments to the market and the dynamics of each one of these is slightly different. So I'd be happy to speak to any of these. But that's a little bit of background of, you know, things are getting closer to an inflection point, but we're not quite there yet.
- [07:16]
A
David, what portion of the market offers you the best returns?
- [07:20]
C
That's a question we get a lot.
- [07:25]
A
Are we allowed to write, to ask trite questions on this podcast?
- [07:30]
C
I hope so.
- [07:30]
A
You just did. Let me put it this way. What risk adjusted returns are most appropriate to? Wow.
- [07:43]
B
Maybe just get a list of cusips.
- [07:44]
A
Yeah. All right, go ahead, David.
- [07:48]
C
Yeah, I would say you can make broad statements or look at in individual securities. And we like, we're bottom up fundamental investors, so we look at individual security. So we will at virtually all times see opportunities in each one of those three broad categories. So in our opportunistic strategy, we have a mix of publicly traded bonds, a mix and a component of levered loans, and a Healthy dose of private credit. And what we do is in each situation we look at the lending opportunity and determine where we in our opinion can get the most yield per unit of credit risk. And sometimes it's in one of those markets, but not 100% of the time. So we like to have the flexibility of navigating between the three broad categories and finding the best yield per unit of risk.
- [08:49]
A
Let me ask you this David. These are well, well combed opportunities, plenty of analysts, plenty of smart people examining opportunities are there departments of the market in which in fact there is little fundamental work being done. And therefore one would suppose there is opportunity where you know that where a diligent analyst can, can actually add value.
- [09:15]
C
We. Good question and we believe so. So our focus and before I founded my firm, which was called DDJ Capital Management back in 1996, I was at Fidelity Investments where I was portfolio manager for the Capital and Income mutual fund and then co manager of the distress investment area. And what I observed there is as our AUM grew, it became more and more challenging to take advantage of those inefficiencies that I saw in certain niche portions of the market which can be capacity constrained because one cannot effectively in our opinion deploy billions of dollars into these smaller niche places of the market. But, but we certainly can deploy the capital that we have at what's now pulling capital, credit. And where we see those opportunities typically is in a mid to small cap space, little bit smaller transaction sizes because the big guys can't really participate there. They can't acquire enough, make a significant enough investment to move the needle. So a large portion of the market, the big asset gatherers tend to shy away from that portion of the market. Also we see value in the lower tier of the high yield market, single B and triple C rated bonds and loans. And on a high level this is a very risky place to invest. But because of that factor, it discourages a lot of investors from participating in that part of the market. Plus there are non economic reasons why certain institutions choose not to participate in the market or are prohibited by regulation from participating in that part of the market. Insurance companies and banks have reserve requirements. So the lower the credit rating, the more reserves they may have to place against it. And some institutions just are prohibited from being there. So we believe there's a small segment of the lower rated tier of the high yield market that is either misrated or misunderstood or a little bit complex or the credit rating is a bit stale, hasn't been upgraded quick enough because there's no impetus to do that and we can find real value there. So that's what we seek to do, is to find these inefficiencies in the credit markets, which tend to be smaller deals and, and lower rated deals where we can get a good yield per unit of credit risk. And I'd be happy to go into more detail there, but that's broadly speaking where we find opportunities.
- [12:05]
B
And just bring it back to kind of your view on the cycle. You said that we're kind of long on the tooth and you agree that spreads are relatively narrow. How does your kind of view of the cycle, how do you overlay that with how you actually invest in the market? Are you taking a more defensive stance? Are you avoiding some of the, I guess, more risky, lower rated credits that might have trouble? If the economy does have its eventual.
- [12:27]
C
Recession, we certainly have to be hyper focused on credit quality. And we're fortunate in that our style tends to be a more concentrated approach to lending or credit investing. For example, in our opportunistic strategy, we typically have 70, 80, maybe 90 different issuers maximum, whereas other large high yield funds could have 4, 5, 600 names in their portfolio. So we, we run relatively concentrated portfolios by market standards. And our mandate is more flexible where we can own, as I said earlier, public bonds as well as loans, as well as private credit. So our investable universe is, is much broader than some other more constrained products out there as well. So with the ability to do tremendous amount of thorough research and really know our names, we can get comfortable that having 70 to 90 names in our portfolio is more than adequate diversification. And we know those names very well in our opinion. And we have a universe of thousands to pick and choose from. So with that as the backdrop, we can model out what we think the future cash flows should be for our particular company that we're looking to lend money to. And then with sensitivity analysis, make sure that they can withstand a significant, a reasonably significant decline in revenues and what that does to their free cash flows and what other calls on their cash flows they might have, rent payments, capital maintenance, capital expenditure requirements and other obligations and so forth. And again, drill down to make sure that the companies that we select, we have a high degree of confidence that they can withstand a significant economic downturn. And then we also diversify across sectors. So even if we do have a downturn, not every sector of the economy is going to be affected equally. In fact, some sectors could perform quite well in a downturn versus others that are more severely impacted. So it's all Part of the analysis. So yes, we're hyper focused on our belief that this cycle is fairly long in the tooth. And we have to recognize that every day that passes we're getting closer to an economic downturn. We don't know exactly how it's going to impact each of the sectors or what magnitude, but we can make certain extreme assumptions to make sure that we're still protected on the downside. And then look at, you know, whether the company is secularly challenged and has real fundamental problems with its business model or is more secularly challenged. Whereas yes, it could experience a dip in revenue, but it will recover shortly thereafter along with the cycle. And whether the company is a high cost producer in its industry or a low cost producer, market leader, good brand, bad brand, good management, bad management, and so forth, all those factors to determine that we believe there's a high likelihood we're going to be paid back even in economic downturn.
- [16:13]
A
David, tell us, give us an example if you would please, of a, of a particular company that is misperceived by the market and offers this opportunistic return after which you seek.
- [16:25]
C
Yeah, I'll give you an example without naming names, but I think the concept will be pretty evident. An example we like to use is typically any company that has six times debt to EBITDA will receive a triple C rating because it's viewed by the agencies in the market as highly levered. And in many cases a company with six times leverage we will acknowledge is highly levered and more vulnerable than less, you know, higher rated companies would be. But there's a difference between a six times levered company in a stagnant declining industry, brick and mortar retail, or in a high capital intensive industry, steel producer, which has an enterprise value perhaps of say seven or eight times total enterprise value. The loan to value is very high. It could be north of 80, 90% loan to value at that leverage. There's a difference between that type of company and one where say a private equity firm paid 15 times EBITDA for a company and put six times leverage on it, that company is maybe only 40% loan to value. There's a huge equity cushion there. And the reason the private equity firm can justify a 15 multiple is because it's a high growth business with low capital expenditure requirements and throws off a lot of free cash flow because of that dynamic. And so the free cash flow that it will throw off can be used to pay down debt or fund growth opportunities to continue the growth of that company. And then is if the company has double digigit growth. Yeah, what started out as six times levered in a couple years is only five times and then it's four times levered and then it gets upgraded. So the difference between those two triple C rated companies is significant but they still carry the same rating.
- [18:38]
B
Six times. Leverage obviously is a high level of debt for a lot of companies. And if we kind of look at the typical pre2022 LBO, I think they were levered like 6 to 7 times on adjusted EBITDA. On actual EBITDA you probably add an extra turn or two in there and a lot of these companies have been struggling. As the Fed raised rates a little over 500 basis points. The investment banking advisory firm Lincoln International in its second quarter report said that the average private equity sponsored company had a 1 times fixed charge coverage ratio. And that means that the typical PE company is only covering its interest expense and capital expenditures one time with ebitda. So they have very very little room for things to go bad if the economy does have a recession. I mean the yield curve's been inverted for two years which has historically been an indicator of bad things ahead. What happens to this large cohort of heavily leveraged companies that were bought back when rates were zero?
- [19:34]
C
Yeah, a lot of those companies are under extreme liquidity pressure, many of them and you've alluded to this earlier in our discussion, the companies that were predominantly floating rate debt financed so levered loans where if, if a company had say 100% of its capital structure floating, many of those companies saw their interest expense double because so for the old Libor now, so for effectively went from 0 or 1% to over 5%. And if it was S plus 500 and the base rate goes up 500 basis points with what the Fed did, all of a sudden the interest expense or the coupon did doubled. And yeah, the company might have had a significant cushion when they issued the debt, but when their interest expense doubles, all of a sudden that cushion erodes and they're as you say one times coverage. The companies that had a significant portion in fixed rate debt that issued bonds, particularly those that did it, you know, post Covid when interest rates, you know, were, were exceptionally low. We see some high yield companies with 3 or 4% coupons, which is unheard of today, but they exist. And those companies had locked in a low interest rate for a period of years and now the maturity of those bonds is approaching. So the Runway they had to address the rising rate environment is shrinking, but it still exists for some of These companies and what they've been trying to, trying to do is when there's windows in the new issue market is to refinance and extend their maturities and maybe lock in a higher rate but not a killer interest expense rate. And if it's private equity, sponsored, there are things that, you know, if the PE firm really likes the company and it's a high multiple enterprise value, they theoretically could put in more equity to right size and optimize the balance sheet so that the company isn't stressed. But because of the dramatic increase in interest expense that largely impacted the floating rate levered loan market instantly. That's why you're seeing the tick up in default rates in loans, which is very different than what we experienced 10, 15, 20 years ago where loans on average were considered better quality than bonds. Today, the dynamic has flipped and we've got to factor that in to our outlook and our analysis. The loan market exhibits in many cases higher risk dynamics than the fixed rate bond market now. And we can go into some statistics that are quite interesting going forward.
- [22:51]
B
Well, going back to Jim's question at the beginning, does this make you more interested in borrowers that have bond heavy balance sheets or are you more interested now in loan heavy balance sheets? Be given that they've already suffered the pain and if the Fed cuts rates then they might actually get some balance sheet relief. Like does this make one asset class more attractive than the other?
- [23:09]
C
It can in the aggregate. But then there's some interesting dynamics on the bottom up. One, looking at individual companies directly, we've counterintuitively, we've seen our exposure to floating rate loans decline probably over the last year because we've seen better opportunities in bonds. And I'll give you an example of, you know, what's sort of driving that. When you have lower coupon bonds in a rising rate environment, the bonds traded down to a discount. So there are many fixed rate bonds that are trading below PAR because a 4% coupon bond in a 5 or 8% interest rate environment for that particular rated credit will be at a discount. And so it creates an interesting opportunity for us because if we can buy that bond at call it 90 cents on the dollar and it's got several years to maturity, there will be a pull to par as it gets closer to maturity. Not only do you get that coupon, but you also get some appreciation in the price. And what's interesting is most companies don't wait until a bond or a loan matures before they attempt to refinance it. They want to do that at least a year prior to maturity because once you're inside that one year window, it becomes a current liability because it's got less than one year to maturity and it goes into the working capital portion of the balance sheet, if you will. And the accountants and auditors of that company may be concerned and give it a going opinion concern if it's a significant dollar amount of maturing debt inside that year, so they want to take it out before a year. So when you calculate yield to maturity, you're doing it to the maturity date, but if it gets taken out a year or two prior to maturity, you get to pull to par that much sooner and it's incremental return. So that is the opportunity that we see in a significant portion of the bond market that isn't immediately obvious when you do the yield to maturity calculation. And so as a, as a result it created an opportunity that we felt we should take advantage of by gradually increasing our fixed coupon bond exposure, but then selectively looking at loans where they've already successfully absorbed the interest rate increase. And we're comfortable that it's less likely the Fed is going to raise rates from this point forward, most likely in a market saying they're likely going to decrease rates. The market anticipates that and is already factoring in what the Fed likely will do. And so that's reflected in SOFR which has declined and in the 10 year treasury bond which the yield has declined and so forth and caused companies to be able to refinance on a current basis today at fairly attractive rate.
- [26:42]
A
So David, private credit was initially a kind of a niche small thing. Non bank lenders would, would negotiate one on one with closely held companies and do enough credit work to make themselves very comfortable with an obscure credit. And the loans would not be marked to market necessarily was all kind of a, an inside private game, hence private credit. But what is happening is that this once niche market, very one on one and private is now becoming rather more like public bonds. So you find one company is building a trading desk to trade once heretofore illiquid private credit names. You find another company that is going to work on an exchange traded fund for these very formerly private credit loans. There's a tendency in credit generally towards degradation during a cycle, right people, there's more competition, there is more liquidity and the sweet part of the cycle, there's less attention paid to credit quality because you have to put the money out, because you have to keep up with the Joneses, Dows, and the Joneses tell us about the dynamics in private credit.
- [28:01]
C
Yeah, that is a very interesting dynamic and it's had a, an impact on the other markets that we were talking about. So to kind of put it in perspective, I actually started my career in 1980 in the investment department at New York Life doing private placements. So I started in private credit and watched the public markets evolve and then become more and more popular and then watch the leveraged loan market evolve and grow. And now we go full circle where private credit is now the rage and billions and billions of dollars are being raised to go after that market. And you point out a significant factor which is as the money is raised, there's real competition to put that money to work. And what we're seeing, and again, this is a generalization, but all that money that's in private credit and also in loans is, is cannibalizing some opportunities that otherwise would have been in the public bond market. And there was a piece written in the last couple of weeks which amplified on this and the dynamic that we think is unfolding is some of these riskier transactions that would have been done in the loan market or in the bond market are now getting financed in the private credit market. So what was once a popular area for us to find value were second liens in the leveraged loan market. The second lien market is shrinking and those lending situations are going into the private debt market. Some of the riskier bonds in our opinion are being financed in the private debt market. So when you look at the statistics for the high yield market, double Bs are almost as large a portion of the high yield market as there ever has been. Approaching 50% of the overall market. Typically they were under 40%. And Triple Cs are near their lows as a percentage of, of the high yield market. In the old days it would not be uncommon to have 20 plus percent of the high yield market rated triple C. Today I believe it's less than 10%. So the composition of the high yield bond market is higher quality than it historically has been. And one steps back and says, well, where, how did that happen? Where did it all go? Well, the plug is all the money raised in private credit. Well, the companies in each of those markets are borrowing money. When a, when a CFO of a company decides I need to borrow money, they hire an investment banker. They do their research and they determine where can they get the best terms. Is it in the public bond market, Is it in a floating rate loan market or is in private credit? And Wherever they get the best terms, it's not just interest rate, but it could be covenants, maturity and timing of the transaction and so forth. That's where they go. So if the. There's a lot of money in private credit and companies are a little bit lower rated, you don't necessarily have to be rated to borrow in private credit. I mean, a lot of the private credit, they don't need a rating. So there's no statistics to show what's actually there. But we know that the public bond market, triple Cs are near their low as a percentage of the overall market. So they have to have gone somewhere.
- [31:51]
B
Can I ask you what this means for the next credit cycle? So the claim of a lot of private credit firms is that private credit is just a better mousetrap. We are able to negotiate first lien loans with companies on a unilateral or with only a couple parties in the room. We get better covenant packages. And oh, by the way, we also get like a higher interest spread than, you know, if a company went to the bond market. So everybody seems to benefit. But you've rightfully pointed out that private credit's been taking down the riskier deals. I think that they've basically taken anything that would have been rated B minus or below in the leveraged loan market. They've taken the riskier bond deals. What happens to private credit and private credit firms in the next downturn?
- [32:29]
C
Yeah, that's a very good question. In the old days, what you said was generally true. Yeah. And we, we've been in pri, you know, I've been in private credit my whole career in ebbing, flowing, you know, greater or lesser amount based on relative value between the different markets. And we've always been in private credit at what's now Poland Capital Credit. But we would only do it if we got those terms that you just mentioned. If we got a little bit better covenants and we got a higher yield spread for the liquidity risk that we were assuming, if we didn't get that, then we wouldn't do the deal and we'd move on and buy something else or lend somewhere else. Now, with the money that's been flowing, we've seen situations, we've seen billion dollar quote quote private credit deals that have been done by, you know, a dozen lenders that competed with a publicly underwritten deal where the company decided to go to that private market syndicate and borrow the money because it was they could do so on better terms than they could have gotten in the public markets. So we've seen that happen already where it's cannibalizing and competing with the public markets. So de facto that's telling you that from the borrower's perspective, they got a better deal going, so called private. So the yield premium and the special covenant, the tighter covenants apparently weren't there. And also we've been looking at doing private credit deals and it's gotten very competitive where we have to really be selective because we lose out on a proposal because somebody else is willing to do it with less covenants and a lower yield than we're willing to do it. So there is that competition. So what's likely going to happen is the overall quality of that market. And again, it's a blanket statement not every manager is going to have this. But on average there's a high probability that it's of lower quality. And when the downturn and the defaults start to tick up across the board, that market might experience some unfavorable outcomes that might shock or surprise some of the limited partners or investors in that market that they didn't quite expect.
- [35:08]
A
That won't surprise. It won't surprise the listeners to Current Yield Grant's interest rate. Observer of the Air I hope not.
- [35:15]
C
I hope not.
- [35:16]
A
David, I think there's a career for you in diplomacy in if this buying low, selling high stuff doesn't work out. I like the way you phrase there might be a problem. And rather than saying that this is going to, this is so going to hit the wall.
- [35:28]
C
Yeah, yeah.
- [35:29]
A
But it will, right.
- [35:32]
C
For some of those managers. Yes.
- [35:35]
A
Right.
- [35:36]
C
Evan?
- [35:36]
A
Every last single one.
- [35:38]
B
Well, there's always one that survives and it becomes the biggest one ever. So I'm going to bet that at least one will make it through.
- [35:44]
C
Yeah. And they'll be the hero. They'll be the smartest person in the room.
- [35:50]
A
David, thank you for showing up today and for informing us and the listeners to this podcast. It's been altogether wonderful. So thank you.
- [35:59]
C
Well, thank you for having me.
- [36:01]
A
Just don't change a thing, David. Keep on making these distinctions and keeping away from the crowd and doing the things you have been doing your whole career. That's my advice.
- [36:12]
C
Well, I appreciate it and thank you so much.
- [36:14]
A
Okay. Well, I have mentioned the the two way conversation on Wednesday, September 18, but I also want to tell you about the annual Fall Grants Conference which is coming up on October 1st. That's at the Plaza Hotel. You can show up in person or you can get on the live webinar, but it's October 1st and it is truly a star studded group of speakers. We've got where to begin. Bill Ackman. That's the letter A that alphabetically if I can do that. Bill Ackman, Stan Druckenmiller. Oh Scott Besant. That's a B. Scott Besant. Sean Filer, Michael Green, Robert Roboti, Boaz Weinstein. That's a W. I think that is a 2W but topics will range from I don't know. Oh Bill. Bill's got a nice title. It's Harvard Corporation. Buy, sell or hold. That's Bill Ackman. Here's SEAN filers making 15% the hard way. Emerging markets and resource investing. And here's Boaz's title. I like this one. Making a dollar out of 85 cents over and over and over. Well it's giving me an all day event and you must be there. So please visit grantspub.com events and sign up. It's not free. Ladies and gentlemen, thank you for listening on behalf of Evan Lorenzo and Jim Grant. This is Grant's interest rate observer of the air the current year Talk soon.