The bond market selloff is a prime opportunity, says KKR
No-man’s land sounds like an unusual place to find opportunities, but that’s how KKR’s Jeremiah Lane describes one of his team’s most fertile hunting grounds.
What is he talking about? In this context, the term refers to credit securities – bonds, specifically – that occupy the middle ground between index products (such as ETFs) and individual high-yield corporate bonds.
Ranking among the riskiest end of the fixed income spectrum, such products are often dubbed (somewhat unfairly) “junk bonds” because of their sub-investment grade moniker. High-yield bonds earn their place in the fixed income universe, alongside corporate bonds that are longer-dated investment-grade securities with either fixed-rate or floating-rate attributes. And, of course, government bonds.
It must be said, though, that it's important to get independent financial advice before making any investment decision. And no portfolio should be skewed too far in favour of any single asset class.
High yield bonds are one of the various parts of the credit landscape in which Lane and his team at KKR invest. And it’s where he currently sees good opportunities, in the space where neither index-oriented buyers nor absolute-return focused investors are paying much attention.
As shifting interest rates have seen these index returns decline, such investors are generally happy to simply reduce their number of transactions. But there’s another cohort of buyers who have a laser-like focus on absolute return. Such investors generally don’t get out of bed for a return of less than 10%.
“But as the overall credit market has begun to yield less through the sustained period of low interest rates, we’ve found the gap between these two types of market participants has become much wider,” Lane says.
As an example, he alludes – hypothetically – to a new bond issue that might hit the market with a yield of 5% “and appear to be firing on all cylinders, but then something happens.”
“The company loses a major customer or a supplier or has some management changes, which then sees it fall out of favour with index buyers. The yield might rise to 7% but it still doesn’t become attractive to the absolute return buyers – and yet it also doesn’t appeal to those index-oriented bond investors.”
That’s where Lane identifies securities that are trading at between 80% and 95% of their issue price. “It’s a great way to earn a double-digit return and is much less risky than exclusively looking at beaten-up credit securities that are yielding 10% or more on their own,” he says.
Why is high yield more attractive now?
As quantitative tightening kicks in, Lane thinks it is likely real rates will turn positive. This, in turn, could put upward pressure on the yields of US 10-year bonds, which he expects could rise between 0.75% and 1%.
Of course, inflation expectations might decline again (remember when everyone said it was “transitory”?). This would reduce that upward pressure on interest rates, but they would still rise – just not as much.
As Lane notes, the first 60 or 70 basis points of the Fed’s hikes this year have already seen parts of the credit market selloff – particularly the investment-grade and high yield segments. And in the high-yield segment, BB-rated securities are off more than their B or CCC counterparts, because they’re even more sensitive to interest rate movements.
“But that selloff is about interest rate exposure – investment grade is off more than high yield because it’s more rate-sensitive,” says Lane.
“We’re focused on the single B and triple-C part of the spectrum. And the sensitivity that double Bs have to interest rates causes negative sentiment on high-yield securities overall.”
KKR’s Traded Credit strategy – part of the Global Credit Opportunities Fund and European Direct Lending Fund that underlie the KKR Credit Income Fund (ASX: KKC) – is a portfolio of Lane and his team’s highest conviction ideas. Around 20 individual securities comprise more than half the total weight of the fund.
Lane believes the negative sentiment that’s knocked the high-yield market is an opportunity to find unloved or ignored corporate bonds that are cheap but also provide what they prize most highly:
- Durable cash flow
- Downside protection.
As an example, he points to mortgage-backed securities – bonds underpinned by bank loans, whose characteristics differ from those in other parts of the market. And they’re usually in red-hot demand in a market environment like the one in which we currently find ourselves. Why? Because as the Fed lifts rates, bank income generally rises.
“But because of some technical factors about how banks are participating in that market, we’re seeing bank loans coming to market today pricing about 120 bps (1.2%) wider on a spread basis than where they were pricing at the end of last year,” says Lane.
“We can take advantage by establishing a new core position in those credits, validating they have the attributes we want and playing offence by buying when the rest of the market doesn’t want to.”
Learn more about investing in private credit
For further insights from one of the world's most recognisable names in private equity and alternative investments, visit the KKC Australia website. And if you would like to find out how to invest in the KKC listed investment trust (ASX: KKC), contact the local KKR team at this link or call them on 1300 737 760.
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Glenn Freeman is a content editor at Livewire Markets. He has around 10 years’ experience in financial services writing and editing, most recently with Morningstar Australia. Glenn’s journalistic experience also spans broader areas of business...