3 defensive asset classes to bolster portfolios in FY23
Soaring inflation, hefty interest rate rises, and worsening consumer sentiment have seen the possibility of a US recession become the greatest "will-they-won't-they" plot twist of FY23.
And while KKR's Jeremiah Lane does not believe we are there yet, he's been patiently watching for unemployment to go higher, wage inflation to abate, and worsening economic conditions to convince him otherwise.
So where are Lane and the KKR team finding opportunities amid the deluge of market headwinds?
He points to three fixed-income asset classes as interesting areas for the year ahead, each with the ability to bolster the defensive portion of investors' portfolios and generate some much-needed income, to boot.
In this Expert Insights video, Lane provides some background on the opportunities within each of these spheres and delves into what a "real" recession could mean for credit markets.
Plus, he also names the asset class that he believes will outperform in FY23 (and why it could outstrip the returns of equities and high yield), and his choice is sure to surprise you.
Note: This interview was recorded on the 15th of September. You can watch the video or read an edited transcript below.
Where are you finding opportunities right now?
Jeremiah Lane: There are, I'd say, three areas where we're seeing particularly attractive opportunities right now:
1. Short-duration loans and bonds
These are loans and bonds that mature in 2024 or 2025. We like the short-duration options because they just have less exposure to moves in rates. If we end up being wrong and Powell has to raise rates dramatically higher than where they are today, the fact that these mature in a couple of years will mean that they'll be relatively insulated. They will still be somewhat exposed, but they'll be relatively insulated. That's been a big theme in our portfolio and it's something that we can express across different industries and across all of the different asset classes.
2. Primary issuance
Primary issuance is interesting because, in some respects, the primary issuance tends to be longer duration, so it's really the opposite of the first theme. We're seeing primary issuance price at least 100 basis points wide to comparable existing risk. One of the things that we can do is we can rotate out of a piece of risk that we already own into a newly issued loan or bond and typically pick up 100 basis points of total return with most of that return coming in discount, so we're able to buy at a lower price.
Convertibles, historically, haven't been a big part of what we do, but in early 2021 the convertibles market was very, very strong. Equity valuations were sky high, and the convertibles market was offering companies the chance to borrow at a low-interest rate but the conversion price premium was dramatically above where the stocks were trading. It was very attractive.
Fast-forward 18 months and most of those equity prices have collapsed. All of a sudden, if you were invested in the convertible in the hope that the equity would work, you have basically a fully out-of-the-money equity option. What we're able to do in the convertibles market is we're able to buy exposure at a high-single-digit contractual return (so if it just pays us off at maturity, we'll get a high-single-digit return. It's a low coupon, but a high-single-digit contractual return).
Then, what we've observed is that often these businesses don't want to pay off at maturity. The last thing they want to do is send the bondholder the face value of cash at the end. They want to refinance, and what they do is they come to the market and they offer to re-equitize the convertible bond. They offer a deal where they will change the conversion price and put an equity option back into the bond. In exchange, you give them a slightly longer maturity; a year longer or two years longer.
What we've seen happen is when they offer those types of deals, the price of the convertible jumps. It's an interesting opportunity where we can get an acceptable return, high single digit, and we think we have some really interesting optionality around getting a much higher return driven by the ultimate event playing out a lot sooner than people expect.
Do you believe the US is facing a true recession?
I think a lot of people look at the technical recession that we've already had in the US and they say, "That's not a real recession," and I'd say to some degree, we agree. When you think about the unemployment rate, the unemployment rate is still sub-4%. If you want a job, you have a job in the US right now. That feels very, very different from all prior recessions; all prior "true" recessions. Even some moments that didn't turn out to be measured recessions had substantially higher unemployment rates than what we're seeing today.
What we're looking for is we're looking for unemployment to go higher. We're looking for wage inflation to abate. Ultimately, if labour is not available and companies are having to pay higher and higher rates to secure labour, and that's putting a lot of upward pressure on their expenses, it's going to be difficult in this environment for them to pass all of that along.
We think that unemployment will be a key indicator. Labour inflation will be a key indicator. General slack in the economy. Those are the things that we're looking for before we're ready to say that the US has had a true recession.
What would a real recession mean for credit markets?
A real recession would mean all of the things that we expect to happen. It would mean a higher period of defaults. It would mean more downgrades from investment grade to high yield; more downgrades from B to CCC.
We look at the market and we say, "A lot is already priced in." We're already at attractive levels from a spread standpoint, from a yield standpoint, and from a price standpoint. And that's attractive versus the last five years and the last 10 years.
If you're not building diversified portfolios, if you're just targeting a small number of idiosyncratic credits, we think you can invest really successfully through that environment, and we have historically.
When you go back to the moment when the market really sold off around energy in '15-16, that was a particularly profitable moment for us. When you go back to the significant selling that we saw as part of COVID, that was a particularly profitable period for us. So, to the extent that we get that uncontrolled selling associated with fear of a recession or fear of a downgrade wave, we think that that plays to our strengths. That's not a moment that would scare us. That's a moment that has us licking our chops.
Which part of the fixed income market do you think will outperform in FY23?
Which asset class ultimately performs the best is going to really come down to the trajectory of the Fed. Where we sit today, we like bank loans. Bank loans don't have direct exposure to the increases in Fed rates.
If the Fed ends up raising rates dramatically higher than people expect, that'll be okay, even good, for bank loans because you'll get an upside participation via a higher base rate, whereas high yield would trade really poorly.
I think that where high yield could end up doing well is if in the next 12 months we really put in the ceiling on Fed funds and where the 10 year's trading and then we start to see inflation really normalise and come down. When I weigh the two, I prefer exposure to bank loans. It doesn't have that embedded risk that the Fed needs to take rates way higher, and it has a really attractive return relative to what it's offered historically.
We look at bank loans today. We think LIBOR will go to 4% and spreads on current portfolios are approaching 4%. Certainly, the portfolios that we're building. We're getting about 8% cash on cash. A diversified portfolio of bank loans today is in the mid-90s. We can do better than that in a concentrated portfolio. You put it all together, we think that you can get low-double-digits in the bank-loan market, and you can do that without downside risk from the Fed going way higher on the Fed funds rate.
Could bank loans outperform equities in FY23?
I think bank loans could definitely outperform equities. I think that high yield could outperform equities. Equities are in a difficult spot. We think earnings are going lower in the near term, we think P/E ratios are high, and I think there's a real risk of downside to equities. You saw it just the other day when the CPI reading ended up coming out higher. People all of a sudden had to rerack their expectations of near-term rate hikes.
There's no rule that says that that's the last time that that's going to happen. We think that that could happen again. If it does happen again, I think the high yield is going lower, and I think that equities are going lower.
So that's what we think is attractive about bank loans right now. It's a very uncertain environment in terms of where rates are going. That puts the risk on equities. That puts the risk on high yield. It doesn't put a lot of risk on bank loans, and that's what we like.
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Ally Selby is a content editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your...