Where KKR's credit team sees durable cash flow and downside protection

Whether the US Federal Reserve moves interest rates half-a-dozen times in 2022 – or perhaps even more – one thing is certain: rates are heading higher. Just what this means for investors has dominated financial headlines since mid-March, when Federal Reserve chair Jerome Powell lifted rates by 0.25%, the first rise since 2018.

In a recent interview with Livewire Markets, KKR portfolio manager Jeremiah Lane provided his outlook for credit markets as real rates begin to trend upward. Weighing the different types of fixed income assets – investment grade versus high yield, single B-rated versus triple Cs – he highlights the winners and losers so far.

Lane also drills into how the KKR Credit Income Fund (ASX: KKC) is positioned now, particularly within the fund’s concentrated portfolio of the team’s highest conviction ideas.

“We think it’s going to be an opportunity for us to take concentrated positions in a few names at cheap prices in single Bs and triple Cs, which are much less impacted,” he says.
“We're just looking for one, two, three, four, or five things that we think are cheap in the current market, and that have the characteristics that we look for, including durability of cashflow and downside protection.”

In the following interview, Lane also details a couple of corporate bond examples where his team has been able to take advantage by moving against the herd.

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Edited transcript

How will credit markets fare if the Fed’s expected level of interest rate rises in 2022 comes to pass?

Jeremiah Lane: We're moving to a point where we're expecting more rate rises than six at this point. Our internal call is for seven and some third parties are actually looking for nine hikes at this point. I think that big picture, we expect rates to go higher still. One of the things that we spend a lot of time talking about and looking at is real rates.

We have what's called the tips market in the US, which is the market-derived, real interest rate, and that rate is still negative. And historically that rate has only been negative when the Fed has been in a period of quantitative easing. So as the Powell Fed pivots to quantitative tightening, which we're expecting in the next couple of meetings, we think it's pretty likely that real rates return to being positive, and we think that's probably somewhere between 75 and a 100 basis points of upward pressure on 10 years.

Now, it's possible that inflation expectations could come down, which would mitigate some of that upward pressure, but we do think that rates are going higher. When you look at the first 60 or 70 basis points of move that we've had this year, it's caused a significant sell-off in the investment-grade market and in the high yield market.

But the composition of that sell-off is really all about interest rate exposure. So investment grade is off more than high yield because investment grade has more sensitivity to underlying rates and longer duration. Within high yield, double Bs are off more than single Bs and triple Cs because they have less yield and more duration, more sensitivity to changes in rates.

We think it's going to be an opportunity for us. We're focused on the single B and triple C part of the risk spectrum and the sensitivity that double Bs have to interest rates causes a negative sentiment on high yield overall. And when negative sentiment on high yield overall, we find opportunities to take our concentrated positions in a few names at cheap prices in single Bs and triple Cs, which are much less impacted.

How are you positioned to capitalise on this dynamic?

Lane: At its most basic level, KKC has two strategies. It has a traded credit strategy and a European direct lending strategy. The traded credit strategy is where we'll really capitalise on this dynamic. Our traded credit strategy is a concentrated portfolio of our highest conviction ideas. Typically, only 20 names comprise almost half of that strategy. So, we don't need to put together a diversified portfolio of many, many assets that has the attributes that we're looking for. We're just looking for one, two, three, four, five things that we think are cheap in the current market, and that have the characteristics that we look for, including durability of cashflow and downside protection.

We think our opportunity is just that negative sentiment that's come into the market causing, especially new issue loans and bonds, to price meaningfully wider than where they were pricing last year.

I'll give you a couple of examples. We recently saw a high yield bond come to market for an industrial flow control business – valves, pumps, things like that. When the banks underwrote that bond last year, they expected it to price at around 7%. Ultimately, they brought it to market three months later. In that three months, the Fed had moved to become more hawkish, and they ultimately priced it at a low 8% coupon, eight and a quarter, and instead of selling it at par, they sold it at 94 cents in the dollar.

So, we were ultimately able to lock in a yield about 250 basis points higher than the yield that the bond was expected to price just three months ago. That's one way we take advantage. We find companies that we like, companies that have the durability of cash flow and downside protection that we're looking for in everything we do, and then we take advantage of the moments when those companies, for whatever reason, have to price significantly wider. In this case, it's because of the negativity on the high yield market.

We also play a lot in the bank loan market in our traded credit space. The bank loan market has different dynamics. Usually, in a time like this, the bank loan market would be really hot. People would want exposure to floating rate products, and exposure to bank loans, where, as the Fed raises rates, their income will go up.

Right now, because of some technical factors about how banks are participating in that market because of some technical factors, the market has become very soft. And what we're seeing is bank loans coming to market today, pricing about 125 basis points wider on a spread basis than where they were pricing at the end of last year.

So, in both of those examples, we're able to take advantage by just establishing a new core position in those credits, validating that they have the characteristics that we're looking for and then playing offence by buying when the rest of the market doesn't want to buy.

What is no man's land in credit markets and why do you find opportunities here?

Lane: No man's land is an idea that we've been using for a long time. And what it really gets at is that there are two primary buyer bases that we see in the credit markets. There are index-oriented buyers who are just trying to slightly outperform whatever benchmark they've chosen to reference themselves to, and as the index moved lower on rates from six to five to four, they were willing to just transact at lower rates.

And then there's another bucket of buyers who are absolute return seekers. And historically, these absolute return seekers have tended to focus on opportunities yielding more than 10%.

Many years ago, when the high yield market was at 7% or 8%, if an individual security fell just slightly, it would start to be attractive to those absolute return buyers. They would start to be interested because it would become a 9% or 10% or 11% yield. But as the overall market began to yield less as we went through this sustained period of very low interest rates, the gap between the two market participants got bigger.

And so a new issue would come to market, maybe it would yield 5%. It would appear to be performing well, firing on all cylinders, something would happen. They lose a customer, they lose a supplier, management changes, whatever it might be. Something happens and it falls out of favour with the index buyers. The price starts to fall. Maybe it falls to 90 cents in the dollar and maybe that means it goes from yielding 5% to yielding 7%.

At that point, it's still not attractive to the absolute return buyers.

Our opportunity is to identify those things that are trading between 95 and 80, that haven't fallen enough to become interesting to the absolute return buyer, but have fallen out of favour with the index buyer. And we hunt a lot in that part of the market because we think it's a less risky way to generate some pretty attractive returns.

If we can bring our diligence capability to bear on those opportunities and we can find the thing that's trading at 85 or 90, that's yielding 7% or 8%, and we correctly assess that it could go back to yielding 5%, that could be a great way to earn a low double-digit total return, and much less risky than if you exclusively look at the beaten up credits that are on their own yielding 10 plus per cent.

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.