Why KKR prefers credit over equities right now

In 2022 and into 2023, we have been seeing an increased amount of market events (i.e. downgrades, earnings misses, unique financing solutions, etc.) play out in traded credit markets and causing a reset in terms of pricing for certain issuers. Alongside that, market liquidity and trading volumes continue to be thin creating a fragile market.

Macro outlook

There have been two key drivers for markets:

1. The Fed which has raised rates to 5.125% and will pause after one or two additional hikes. Our view is that the combination of failing banks, marginal declines in inflation, and the high absolute level of rates (the Fed is going above the two percent real rates threshold for the first time in a long time) is giving the central bank the ability to pause and digest its recent body of work.

2. Stress in the banking sector. This was a classic asset- liability mismatch. Some banks had extended duration by investing in longer-dated bonds. If held to maturity, there would be no issue. But when they had to sell securities to meet withdrawals, the banks realised those losses. SVB and Signature were also outliers in that they grew their deposit bases very quickly and a high % of those deposits were uninsured.

We expect that this pressure will not cause systematic issues. Yes, it will cause pressure & we will see defaults tick up coming off historic lows, but we believe defaults will occur in a more idiosyncratic fashion.

The key difference in a company’s ability to sustain and perform in this environment is whether or not the company is a price maker which can pass along the impacts of higher costs and inflation to the end consumer.

Amidst all the moving pieces, one big theme in markets today is the lack of consensus. This is exemplified by the KKR Macro team calling for 10% earnings contraction on the S&P for 2023 vs. the Street predicting flat.

Looking at the economy: sticky inflation (in particular labour), bank runs, the Fed, corporate earnings, etc. - there is very little confidence being expressed in the market.

Credit Markets Review

Overall, credit market fundamentals have held up better than expected and credit markets have held up pretty well.

Looking across ~1,700 credits, revenue and EBITDA continue to show strong growth (though revenue is outpacing EBITDA as the impact of inflation continues to weigh on margins). Notably, there are winners and losers as it relates to defending margin (price makers vs. price takers). Thinking ahead, tightening lending standards certainly will have an impact and ultimately could help drive the economy into a recession. However:

a. Corporates are still doing well (though we expect further pressure on earnings)

b. The consumer is generally healthy (though we see some pressure building, in particular with lower income consumers)

c. And while the housing market has clearly stalled, there’s just not a lot of forced selling.

Additionally, it is important to consider the composition of the market and where things sit to assess risk.

In the HY Bond space, the market is as ‘clean’ as it has ever been historically. More than half of the high-yield benchmark is composed of BB-rated bonds as of early May 2023, compared to 29% at its lowest point in early 2001, and over 85% of the market is rated B or better (Exhibit 1).

Exhibit 1: High Yield Bonds Rated B Or Better

At the same time, the size of the firms issuing debt has grown steadily over time. Size matters, as we have seen that larger companies generally tend to weather periods of volatility and economic uncertainty better than smaller companies. In the early 2000s, the EBITDA of the average high yield issuer was between $250 million-$300 million. In the fourth quarter of 2022, the average EBITDA reached $1 billion for the first time.

Secured bonds as a composition of the market also sit at a record high (~30% of the market, Exhibit 2). Secured bonds also have enjoyed higher historical recovery rates of 55% vs. 40% for unsecured bonds in the event of a default.

Within the loan space, loans have held up relatively well given the challenging environment namely due to the floating rate nature of the instrument in this rising rate environment.

Exhibit 2: % of HY Market that is Secured

Credit Markets - Expectations Moving Forward

Ongoing volatility: Although spreads have tightened modestly year-to-date, we expect continued ongoing pockets of volatility that will present interesting opportunities. For example, high yield spreads gapped out ~60bps around the SVB collapse that rattled investor sentiment. These events reinforce our belief that flexible pools of capital have more ways to win in the current environment.

Additionally, there are structural inefficiencies in the market that we believe will exacerbate these pockets even more, creating opportunity. This is exemplified in the buyer base for high yield bonds where ~40% of the investor base access the market through daily liquidity vehicles, which can drive large and quick pullbacks in reaction to negative headlines.

Continued attractive technical backdrop: The market is structurally short supply. Through Q1’23, we have seen historic low issuance within the traded credit market, with just $54bn and $67bn in new issuance in the high yield and bank loan markets, respectively, leaving the market ~$30bn under supplied based on our estimates. This is a continuation of the material drop in issuance we saw in 2022.

Additionally, trading levels are still historically cheap, creating compelling forward return opportunities. Across a 10-year period in U.S. high yield, spreads have been lower 61% of that time, yields have been lower 90% of that time and price levels have been higher 90% of that time.

With issuers still in need of capital and attractive entry points, we believe it is a very compelling time to take advantage of the current technical and deploy capital.

Fundamentals continue to remain stable: Of the names we cover, revenue and EBITDA growth continued in spite of a weaker macro backdrop. A key trend we did observe is how inflation and supply chain has impacted different issuers - ‘price takers’ versus ‘price makers’. We believe this trend reinforces our investment theme of keeping it simple, choosing names with durability of cash flow & downside protection, and investing in a nimble but convicted manner.

Conclusion

Given the backdrop, KKR is favouring its keep it simple message, preferring credit over equities and emphasising the importance for durability of cash flow & downside protection.

In periods of increased volatility and macro headwinds, there can be indiscriminate selling that can create high dispersion amongst sectors, asset classes, and issuers. In this type of market environment, we believe GCOF benefits from its flexible investment strategy and ability to allocate capital tactically.

Managed Fund

KKR Global Credit Opportunities (AUD) A

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