A bond manager’s front-row view of increasing debt, another round of credulous bond ratings, looser debt security and indiscriminate buying. Didn’t we see these same warning signs eleven years ago?
Venk Reddy, founder and manager of the $363 million Zeo Short Duration Income Fund (https://www.zeo.com/), frames his activities in simple terms. “When you lend to good borrowers, good things happen,” says the manager in the short-duration, high-yield space. “We view each bond as making a loan to a borrower, and ask ourselves: can the borrower repay the debt in the short time frame? We’d all like to think it’s more complicated than that,” he adds; “that what we do is buying or trading securities, but in reality we are just lenders to good borrowers.”
This very practical feet-on-the-ground mindset has led Reddy to see the overall bond marketplace more clearly than any manager I’ve talked with lately, at a time when bond investing appears to be leading the markets in an ominous direction. Having spent more than an hour with him on a tour of today’s fixed income landscape, I now believe I can see the outlines of the next 2008-like catastrophe.
Let me be clear: neither Reddy nor I are predicting such a thing. But stay with me for the next dozen paragraphs and see if you don’t see the potential for disaster.
First (and least alarmingly), Reddy has noticed increasing leverage in the corporate world, which is issuing more loans and bonds than he has experienced in his career. “It’s interesting how companies at earnings calls are talking about targeted leverage levels that are much higher than they used to be,” he says. “They’re aware that leverage is an issue that needs to be focused on, but sometimes those targeted leverage levels can get a little loose.”
Second (slightly more alarming in the context of 2008), the rating agencies have made increasingly forgiving ratings decisions, taking the word of company managements that they will (soon, we promise!) lower their leverage levels, either by paying down debt or by forecasting future high earnings growth rates.
“The rating agencies seem to be worrying about the negative impact of downgrading a large blue chip investment grade name that is held across a lot of portfolios,” says Reddy. “I don’t envy the position that they’re are in,” he adds, “but I do think that if they didn’t know the name or anything about some of these companies, they might not be as willing to trust their aggressive de-leveraging stories.”
Bottom line: a lot of company bond issues are sitting at BBB-level ratings, one rung above junk status, which might under more sober conditions be rated as junk. The ratings agencies are trusting the word rather than the deeds of companies. As a result, the non-junk bond markets are experiencing a downward “quality creep” situation. According to a recent article in Advisor Perspectives, the BBB-rated portion of the Bloomberg Barclays U.S. Aggregate Bond Index nearly doubled between 2008 and 2018. The Bloomberg Barclays broad corporate bond index now contains approximately 50% BBB-rated bonds.
Reddy compares this part of the situation to 2008, when the rating agencies were perhaps too influenced by the marketplace and the impact they might have if they issued unfavorable ratings. When we experience a recession, will those promises by corporate executives be kept? Or will deteriorations in earnings force the ratings agencies to issue downgrades on a big chunk of the investment-grade market.
If that happens, many institutional buyers who are restricted to owning BBB or above paper would have to sell, collectively, all at once, a big chunk of their existing holdings.
So if you believe there will be a recession eventually, and some of the optimistic corporate promises will be broken, the question becomes, who would buy this debt from the institutional buyers who have a mandate to sell. And at what price?
If you just stop here, you can see storm clouds gathering in the market sky.
Where will the buyers come from?
Reddy notes that, on the buy side, things have been changing as well. With the rise of indexing and ETFs, we have a large proportion of what might be called “indiscriminate buyers” in today’s bond market, when in the past the market was dominated by people who would have been paying closer attention to fundamentals. Even active buyers have become less discriminating. “There has been a lot written about hedge funds recently, how they are using high-yield ETFs in order to express their points of view on the high-yield market,” says Reddy. “People,” he adds, “shouldn’t be paying two and twenty to folks who are literally just writing betas.”
Meanwhile, he says, “indices and asset class exposures are inherently not risk-managed. It is not the mandate of a high-yield or a corporate bond index to not own the things that might run into trouble. It is in their mandate to have exposure broadly.”
So if institutional buyers are selling the bond positions that no longer belong in their portfolios, the former BBB-rated paper that is now BB or B, the ETFs will also be holding this paper. Their NAVs will drop. This might trigger panicking investors to redeem, causing the ETFs to raise cash.
Chances are they’ll all be sellers at the same time as the institutions.
So who else is going to step in and stabilize the bond market prices? The market makers? Here, too, the dynamic has changed. “It used to be that JP Morgan, Goldman Sachs and Bank of America would use their balance sheets to provide liquidity to their customers,” says Reddy. “Somebody came to sell, they would buy the bonds, and then later on when somebody else came to buy, they would sell it to them—rather than, as they do today, matching up buyers and sellers in real time, the way an agency broker would.”
Why are they increasingly acting as agency brokers? “Because of the stress testing and all that,” Reddy explains, “the amount of the balance sheet allocated to market making is a lot lower than it used to be. People see this as a loss of liquidity,” he adds, “but I see it as just liquidity at a different price.”
That leaves a diminishing handful of buyers: the active fund managers like Reddy, who are not motivated to help out distressed sellers if there’s nothing in it for them. “If somebody needs somebody like me to show a bid, I’m going to show a bid at a level where I care, but the level I care may not be the same level as the market maker might have cared about,” says Reddy. “I might bid down, and a bond might trade down into my bid. There is still liquidity, but there is a lot more volatility.”
It doesn’t need to be pointed out that the volatility, for ETFs and hedge funds needing to raise cash to meet redemptions, is going to be on the downside, and it could be steep. This could be a significant market storm in the making.
Suppose you wanted to pour gasoline over this particular fire. Reddy has been watching, with more apprehension than interest, the dramatic rise in Collateralized loan obligations (CLOs) over the past few years. These debt pools look interestingly like the infamous CDOs that triggered the Great Recession, albeit with floating rather than fixed rates. Just like CDOs did with mortgages, an issuer gathers 100-225 or so bank loans to businesses, or possibly consumer auto or credit card loans, into a pool, and then assigns them to tranches. Under this structure, just like the CDO, all of the first defaults will impact the highest-yield equity tranche first, and then, if that tranche is exhausted, additional defaults start to impact the mezzanine tranches, and then up the line. The most secure tranches—the ones that are arranged to be last impacted by defaults—pay the lowest coupons and receive the highest credit ratings.
Sound familiar? There are two things that Reddy finds even more familiar when he looks back to 2008. First: ratings agencies seem to be rather generous in their assessment of the default risk across these loan pools. “A lot of the theoretical models, using historical correlation numbers, will say: hey, the correlations here are relatively low, and therefore your expected loss is this, and therefore this looks like a really good piece of paper,” says Reddy. “And a lot of the rating agencies will use these types of models as well.
“The issue becomes,” he adds: “when you take crappy credit, and the ratings agencies give it an investment-grade rating based on the theoretical models—that is where you run into trouble. First of all,” he explains, “you’re leveraging things that are already leveraged. And second, if the correlations are higher than you think—and in the case of 2008 we actually saw default correlations, correlations of defaults—that’s when you discover that you were simply hiding high-yield risk in investment grade packaging.”
In other words, investors and funds may be holding highly-rated paper that actually contains far more default risk than they realize—a debt bomb which could be triggered by the next recession.
And the magnitude of that risk is growing because the market is expanding. U.S. CLO issuance is up 60% since 2016—and up from essentially zero in 2009 and 2010. Moody’s Investor Services recently reported that 64% of speculative-grade CLO issuers—the borrowers who need to hold up in the next downturn for the CLOs to be solvent—had corporate family ratings of B2 or lower, a significant increase from 47% in 2006. Isn’t this another example of downward quality creep?
Meanwhile, again like 2008, many issuers and sellers of these packaged loans are profiting from their creation and sale without having any actual skin in the game—that is, without suffering, themselves, if the securities they’re selling were to blow up in investors’ faces like an exploding cigar. That, of course, reduces their motivation to rigorously evaluate and control the actual credit risk of the CLOs that they’re selling.
But didn’t post-Great Recession legislation prevent such a thing? “In the first quarter of last year,” says Reddy, “the Loan Syndications & Trading Association successfully sued the regulators to overturn those provisions in Dodd-Frank which required that the sponsors of structured products maintain some skin in the game. Before that,” he adds, “they had to have some of their own capital invested. They had to maintain what we call ‘retained risk.’ Now there is no risk retention requirement at all. They can package these things and sell them with no consequences, basically.”
People with an uneasy memory of the catastrophes of 2008 might wonder: why would the large lending institutions not want to invest in the products they’re selling as great investments to their customers? “It’s because they have these balance sheet requirements, capital ratios,” says Reddy. “The Fed doesn’t give them the same capital ratio treatment for CLOs on their books, for stress tests, than they do with what they regard as more stable assets. Before this ruling,” he continues, “they were less inclined to issue these things, because they had to retain some of the CLOs they created on their own balance sheets. Now they’re free to issue tons of them without any impact on their capital ratios.”
What would happen if the market freezes up, if defaults sweep through the equity and mezzanine tranches and encroach on what has been rated as AAA paper in the upper tranches? Funds, institutional investors and ultimately consumers would see the losses in their funds and ETFs, triggering redemptions in a wide variety of retail investment vehicles.
Who would be the buyers when the sellers come to market?
It’s helpful to remember that the 2008 stock market crisis was triggered, in part, by the evaporation of demand for CDOs that institutions and institutional investors were frantically trying to unload. The equity indices were impacted when they had to sell other parts of their portfolios to raise cash. This rush to the exits in the equities market caused valuations to drop, triggering redemptions in the equity funds and ETFs, creating more sellers in a spiral that finally required government intervention and bailouts.
Could forced sales in the bond market spill over into the equity market once again?
In addition to what may be mis-rated bonds and CDOs, Reddy is seeing a certain lack of rigor—both in the loan space and also in corporate bonds—in the covenants that are designed to protect those loan investors. “It takes someone who reads through the covenants to realize that they’re becoming weaker,” he says. “Right now, there doesn’t seem to be a lot of pushing back on the companies, where people are either refusing to buy the loans or refusing to allow them to issue them in the first place.”
This erosion of the covenant protections to debt investors has become so widespread that the industry actually has developed a term for it: “covenant-lite.”
“In the loan space, there are two kinds of covenants,” Reddy explains. “There’s an incurrent covenant and a maintenance covenant. An incurrent covenant says: if your leverage level is X, then you cannot incur new debt if it is going to take your debt above a certain level. Maintenance covenants say that you always have to maintain leverage below a certain level.”
In the high-yield sector, Reddy says, the trend has been to replace the more stringent maintenance covenants with incurrence covenants.
But that’s the least alarming part of the covenant lite movement. Reddy notes that companies with complicated organizational structures—a parent company and many subsidiaries—can designate restricted subsidiaries which pledge their assets to these credit agreements, and also unrestricted subsidiaries which are theoretically not issuing debt. “What is happening is that there are covenants now that are being put in that are very vaguely worded,” says Reddy, “which give companies the ability to take assets from restricted subsidiaries and move them to unrestricted subsidiaries.”
If the company then defaults on the loans, the bondholders who thought they had collateral find themselves holding an empty bag. “A large part of the loan market is unsecured debt masquerading as secured debt,” Reddy comments.
In fact, this shuffling activity has already impacted some debt investors. In April 2018, J. Crew won a partial court victory over its transfer of brand assets to a Cayman Islands subsidiary as part of a 2017 debt swap transaction. Dallas-based Neiman Marcus Group, meanwhile, transferred its highly-profitable MyTheresa online luxury retail unit to the Neiman Marcus corporate parent, which blocked creditors from making claims on the unit when Neiman Marcus bonds defaulted.
“These are the kinds of things that no one is really going to realize until bankruptcies happen,” says Reddy. “I regard those as more insidious than a simple downgrade or upgrade,” he adds, “because people think they’re getting a security that is higher on the capital structure, when what they really own is just glorified unsecured debt. When we start seeing a down economy and more of these covenants coming into play, the recovery rates will be much, much lower than people are expecting.”
Losses trigger redemptions, which—in an increasingly passive world—trigger forced redemptions, possibly of issues that were not thoroughly vetted to begin with, and if those cannot be sold, then equities or more marketable securities go on sale. If that triggers additional redemptions, who knows what kind of storm to expect?
Currently, the Zeo Strategic Income Fund’s one-year duration portfolio is yielding 4.34%, and the goal at today’s rates is roughly 2% over one-year Treasuries. Are the markets really so inefficient that active investing in corporate bonds will deliver almost exactly twice what comparable Treasury securities are yielding?
The short duration, Reddy says, allows him to create an absolute return profile for advisors’ clients: short durations mitigate interest-rate risk, since the portfolio is constantly being reinvested. This allows Reddy to focus his fundamental research on mitigating the biggest risk that affects high-yield bonds: the risk of default.
“In the high-yield space, the rates are set so that the winners are expected to pay for the losers,” Reddy explains. Reddy’s mission is to identify the subset of short-term issuers who are in the best position to stay solvent—not for the long term, but for the next year or two. “We look at cash flows, leverage, the trends of leverage and the underlying strategies of management,” Reddy explains. “We look at assets.”
Buying exclusively short-term bonds allows Reddy to focus his analysis of corporate solvency with more precision than the credit ratings agencies, which have to take a longer-term perspective. “There are certain metrics that the rating agencies look at: margins, cyclicality, seasonality, and those are generally good things from a rating agency’s perspective,” says Reddy. “But we focus on a company’s ability to repay in a short time-frame,” he adds. “Do you have defensive characteristics? Do you have large moats to your business, so we can have some confidence that the short-term solvency is good?
“If you do the work to identify the good credits in the short-term universe,” says Reddy, “those credits are generally underpriced because they carry high-yield ratings. There are times,” he adds, “when the credit rating and the credit risk don’t match.”
As one example, Reddy cites a company whose bonds he no longer owns, which had investment-grade credit metrics, but whose bonds carried a single-B rating. Why? The issuer was too small for the rating agencies to follow it. “When they issued, multiple years before that, that’s when the issuer paid the rating agency to do an issue-level rating, and they rated it a single-B,” Reddy explains. “It was never revisited since then.”
As another example, Reddy cites Haines brands as a good example of a bond his fund used to own. “Yes they have a tight margin; their product doesn’t command high margins,” he concedes. “But they have the ability to pass through costs, they have extremely high levels of cash flow, and in general they have low leverage because they recognize that, for a company of their type, that is the prudent way to go. And so in that case,” Reddy adds, “I look at that and I say, here is a company that is very stable. They are not going to get an investment-grade rating from the rating agencies because they have tight margins, but they have the ability to pass through costs. So those margins are pretty stable.”
Haines is a BB-rated company. Reddy is looking at its 5-year bond, which has a spread of 200 basis points over comparable Treasuries. “Right now, that is too long for our portfolio,” he says. “But in a couple of years, when it comes into the range that we’re looking for, this credit will be high up on our list. I am not making a 20-year bet on these companies,” he adds. “The short duration gives me more visibility into the underlying fundamentals.”
Reducing default risk
Identifying mismatches between the rating agencies’ long-term bond ratings and companies’ short-term fundamentals is one area where the active manager has an advantage. But Reddy points to potentially a much bigger advantage.
Reddy says that there are not many great short-duration high-yield credits in the marketplace, and the larger ETFs that manage in this market are at an inherent disadvantage because (as noted earlier) they have to buy the bad and the ugly with the good—somewhat indiscriminately.
Of course, stock ETFs also buy indiscriminately; if they follow an index, then they have to own what is in the index in proportion to their market capitalization. But Reddy says there is a big difference between fundamental bond investing and fundamental stock investing. With stocks, the difference between a good investment and a bad one will be an incremental difference in performance. With bonds, however, the difference between a good investment and a bad one is almost binary: it is the difference between continuing to get your coupons paid until maturity vs. the company going into default where the investors are left somewhere in the back of the line to receive interest due plus their principal.
In an efficient market, the higher yield will offset the impact of defaults on total return. But what if, through analysis and research, a manager could eliminate the companies that pose the highest default risk, and simply pocket the extra return?
“If you were to take your 50 or 100 favorite stocks out of the S&P 500, there will still be a fair amount of correlation with the index,” Reddy explains. “But in debt, the downside risk of debt is asymmetric due to the default risk. If you were to select the 80 best credits from the 400 issues in the short-term index, you would have effectively lopped off the portion of that 400 that is really the source of the biggest drawdown risk—the bad credits that have a much higher chance of defaulting.”
How does this translate into an advantage for an active manager? Reddy’s fund is small and flexible enough that he can buy bonds that wouldn’t be appropriate for the larger indices. But that’s actually a small part of the advantage that Reddy believes he enjoys. “If you look at SJNK [the SPDR Bloomberg Barclay’s Short-Term High-Yield Bond ETF], for example, with north of 400 credits, you have to buy crappy credits if you are going to buy 400 short-duration high-yield bonds,” says Reddy. “That is not a criticism. It is just a statement of fact. There are just not 400 good bonds out there.”
Believe it or not, Reddy is able to identify another advantage he feels that he has over the ETFs that operate in his space.
“Because it is a short duration portfolio, our bonds are constantly being redeemed or maturing, and we are always looking to redeploy that capital into whatever the current environment is,” he explains. “A volatile market gives us the opportunity to redeploy capital in higher yields.”
In the short-term space, the biggest source of volatility is not interest rate movements, but investor sentiment; that is, are investors net buyers or sellers of the larger ETFs on this particular trading day? When they are net sellers, the larger ETFs are required to unload their holdings to raise cash. On days when investors are net buyers, the short-term bond ETFs need to buy in proportion to the index weightings. Buyers and sellers who don’t have that mandate, who can be flexible and watch the price swings and buy when others are selling and sell when others are buying, enjoy a wind at their backs that buyers of the broad index ETFs don’t enjoy.
“That was the story of December and January,” says Reddy. “That was where we got tremendous opportunities, where ETFs were forced to sell because they had to raise cash for redemptions. Because we know our investors, we don’t have to worry about that as much. Our relationship with our advisors is if somebody needs capital for some reason, if there’s a private equity deal they need to participate in, we’re usually given a heads-up a couple of weeks in advance. We have never been in a situation where there was any disorderly activity.”
“I can look at my screen and see five or six different Bloomberg chat conversations between different dealers, where I say, I know I’m low, but the right price is down here, and if somebody is going to pay higher, that’s fine,” Reddy adds. “We need to be patient because we know it will come to us. Sometimes I have a situation—I had one the other day, there was a motivated seller, and we just had to stand our ground. It took a few days, but the seller came to us and we did the trade and that worked out.”
More than a year ago now, I participated in a webinar with a couple of active managers in the bond space and an executive who is now with Northern Capital, a relatively new player in the planning space which buys bonds on behalf of advisors and helps them improve on bond ladder arrangements for their clients. To my surprise, and I think to the audience’s as well, the panelists I was moderating were much more concerned about warning the audience about forces that were building in the bond market than they were about touting their own funds or services.
My conversation with Reddy felt the same way; it took roughly an hour for me to force him to talk about his own fund and his own management activities, and when he did, he seemed to believe that—in this current environment, at least—the value of active management, and careful bond selection, was almost too obvious to talk about.
Neither of us is predicting another 2008. But after talking with Reddy, I think I know where the potential for the next major downturn is quietly building—yet again—with institutional creation of securities with no skin in the game, with credulous rating agencies, with models that assume 2008 would never happen again, with indiscriminate buyers who don’t have a market of buyers if they have to raise cash.
I’m a little nervous.