Why a recession is not priced into credit markets (and why it's not a bad thing)

KKR's Jeremiah Lane discusses the key risks for credit investors this year - and what the big "R" word means for your money.
Hans Lee

Livewire Markets

Everybody from professional investors to retail punters has a view on this question:

Will there be a global recession in 2023?

Some research houses like Deutsche Bank have had a US recession pencilled in as far back as early last year (a view largely informed by the inverted yield curve). Others like Goldman Sachs believe the Federal Reserve can pull off an economic miracle - keeping unemployment low while killing inflation. 

KKR sit in the middle of this spectrum. As Jeremiah Lane tells me, the conflicting data makes it a tough call. The house view, at least, is that there is an "elevated possibility" of a US recession but that it's not a complete certainty.

But experts are one thing and so are the financial markets. It's been often said over the last few months that equities have still not priced in a recession. Lane says that's also true in the credit market. But unlike in the equity market, that's not necessarily a bad thing.

In the final edition of this series of Expert Insights, Lane runs through the key risks investors need to keep in mind this year if they want an allocation to credit. 

Note: This series of videos was taped on Wednesday February 8th 2023.


LW: Is the credit market pricing in a recession?

Lane: When we look at spreads available in the market today, they are not to a point that they typically get to as a recession or a material slowdown is coming. If you look at historically the spreads that were achieved in the financial crisis, the spreads that were achieved in the energy selloff in 1516 or the spreads in COVID, all of those moments in time had substantially higher spreads than what we see in the market today. 

So, I would say that that indicates to me that the high yield market is not pricing in a significant recession. I think that that's probably appropriate.

I think that given the strength that we still see in the economy, given our assessment of the earnings reports that are coming out of companies that we're invested in, we see slowing. We don't see so much slowing that it's creating big problems for companies and some of the slowing, I'd say frankly, we see as healthy. 

We see some businesses that have struggled with labour availability, with supply chain consistency, product availability, et cetera. We see some of those problems getting alleviated by the fact that we've got some slowing in the market and business can go back to normal from how it was disrupted during COVID.

LW: Are you concerned about the current corporate earnings environment?

Lane: On the most recent earnings season, I would characterise as better than expected, and I would say that that is a continuation of how the last couple earnings seasons were. You go back to the middle of the last year, we thought that as the Fed really started aggressively raising rates, we were going to more quickly see earnings deterioration and quarter after quarter numbers have held up better than we were anticipating.

One of the reasons I think that's happening, and I'll give you an example of a sector, is what we're seeing in the healthcare sector. So, in healthcare, historically healthcare has been a recession resilient sector, people need healthcare services regardless of what's happening in the economy. When you look at healthcare in 2022, it was a really difficult sector. Healthcare businesses, because of the way healthcare is paid for in the US it's a complicated payer mix. You have some government pay payments, you have some insurance company payments, you have some self-pay. 

Typically, prices for all of those healthcare services are set at the beginning of the year, and then they are just constant over the course of the year. The government doesn't let you change the price that it's willing to pay in the middle of the year. In turn, healthcare services are relatively people intensive to deliver. And so, what the healthcare services business struggled with is that they were had consistent pricing over the course of the year, but they had huge wage inflation for what they were having to turn around and pay doctors and nurses.

As we roll into this year, there's actually been a lot more labour supply in nursing than we've seen since the pandemic really started, and that's starting to take some of that wage pressure out of the system. We see that business, which had a very difficult 2022 going back to it's healthier long-term structure. 

That's an example of how we think that some of the cooling of the economy and some of the cooling of inflation can actually be a real positive for the businesses that we're tracking. 

LW: Does the soaring cost of financing bother you?

Lane: It doesn't bother me per se. I think that it really goes back to what I was saying about the inflation impact is that it does put some onus on our analyst to really understand whether or not the businesses were invested in are appropriately set up to deal with a substantially higher cost of funds.

So, going back to the middle of last year, we asked the analysts to go through and survey our largest 75 investments across our leverage credit platform and look at how hedged they were.

  • Did they have substantial amounts of floating rate debt? 
  • Had they put in place interest rate swaps to turn it into fixed rate debt? 
  • Had they set up their capital structure to have a mix of floating rate debt and fixed rate debt? 

I would tell you that candidly, the results of that analysis was that a lot of companies had not really set themselves up to deal with elevating interest rates. However, fast-forward to today, one of the big trends that we're seeing right now is we're seeing companies refinance loans, which are 100% floating rate with a mix of loans and bonds, and so they're mixing more fixed rate debt into their capital structure.

It's also interesting that right now if you have a one-month floating rate or a three-month floating rate loan, you're paying around 4.5% on the base rate. If you actually swap that into a three-year fixed, you can actually substantially reduce your cost of funds because the market is expecting the Fed to stop hiking and start cutting. 

We are seeing actually more companies layer on some hedges to take advantage of that reduction in cost of funds that they can get. So, I like that we can earn higher interest rates. It means that we can deliver a better total return to our investors. It does create a requirement that we appropriately diligence the cash flows, the businesses we're invested in to make sure that they can handle where interest rates are moving to.

Learn more about investing in credit

KKR Global Credit Opportunities Fund (GCOF) provides investors with exposure to KKR Credit's flagship opportunistic credit strategy in an Australian unit trust hedged to AUD.

For further insights from one of the world's most recognisable names in private equity and alternative investments, visit the GCOF website

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Hans Lee
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