Why this default cycle is different and what it means for asset allocation

In April 2023, the financial world was left shaken when a slew of banks - including the global systemically important bank (GISB) Credit Suisse - fell into balance sheet troubles. The collapse of one of the world's largest institutions raised serious concerns about the risk of another Global Financial Crisis. 

Those concerns have been largely laid to rest and most experts, like KKR's Jeremiah Lane, believe that the risk of a severe recession or bank crisis in this current cycle is "very, very low". 

Not only does Lane think the risk of another crisis is ultra-low, but he also thinks this year will see a "vintage" set of returns for conventional credit markets.

So what has Lane so confident? In this episode of The Pitch, Lane gives us his thoughts on where we are at in the economic cycle, why he thinks we won't see a run-of-the-mill default cycle, and how it all informs his investing approach.

Edited Transcript

Sectors with rising defaults

Lee: What are you seeing in terms of defaults and why does it matter for non-credit investors?

Lane: I think it's been interesting. A year ago, when I was on the road talking to investors, a lot of investors expected that classic spike in defaults, a spike in spreads. and a lot of companies cycling together at one time. And our view is that people were right - that a lot of sectors would cycle. But what people got wrong was that those cycles were happening asynchronously. They were happening out of time with each other in different sectors, one at a time.

If you go back to the end of 2021, throughout 2022, a lot of consumer businesses were struggling with a decline in post-COVID demand. They were also struggling with the cost of importing goods from China - which squeezed profitability, that sector cycled and now has fully recovered.

If you look at the last five or six quarters, you saw healthcare businesses in the US really struggle with the availability and cost of nurse labour, and they don't have any pricing power. They can't change price mid-year and so a lot of those businesses saw big declines in margin. Now, there are some signs that that's abating.

Two sectors right now where we're seeing weakness are the chemicals and packaging businesses. I don't think we have found a bottom yet in that in those sectors. And then, looking forward, we think that there may be some weakness in home building over the next year. But all of that is to illustrate that we're not seeing that classic historical spike in defaults this cycle, we're seeing these companies in different sectors struggle at different times.

That's one of the reasons why we think the economy's been as resilient as it has been and that things have chugged along better than people expected. It's one of the reasons why last year ended up being such a strong year in the credit markets.

What is the risk of another bank run occurring?

Lee: No economic recession is now the base case for the US, but what are the chances of a corporate or balance sheet recession occurring this year?

Lane: I think that the chance of that is really low. We do see problems in the banking system and we do think that several parts of the real estate market are really challenged. A lot of those loans sit on bank balance sheets, but one of the things that I've taken away from my time in the credit markets is the next problem is never the same as the last problem.

People were really fearful last year. First Republic failed. Silicon Valley Bank failed. Signature bank failed. And I think the government now appreciates the risk to the system and the risks that are embedded in banks and are taking appropriate steps to make sure that, any problems that happen in the individual bank don't spiral out of control and cause systemic problems.

Higher for longer rates

Lee: How does a “higher for longer” rate environment impact where you find opportunities?

Lane: I think that one of the the big results of higher for longer is just the the basic yields available in loans and bonds are much, much higher than they've been for a really long time.

I think that you'd have to go back to before the financial crisis to be able to find this much yield in a portfolio of well-performing leverage loans outside of a moment of stress and so that's a really big change.

There is a lot more return on offer right now than there has really been in a long, long time and that means that we can, we can do things a little bit differently. We don't have to take as much risk to deliver the same amount of return to our investors. We call that keeping it simple. It's easier to find and to put together a portfolio that will deliver what we've promised investors, than it has been for much of the 2010s for sure.

To learn more about the KKR Global Credit Opportunities Fund (AUD) ("GCOF (AUD)"), click the link here. You can also find out more about KKR CREDIT INCOME FUND (ASX: KKC) here.