Lessons of Three Bear Markets in Credit

“History never repeats itself but it rhymes.”
                     — attributed to Mark Twain

We are in a bear market in U.S. corporate credit. September marks the fifth quarter of negative excess returns – negative returns relative to similar duration U.S. Treasuries – which now exceed the 2011 downdraft in magnitude. The energy and mining sectors have turned in two of their worst quarterly excess returns in the last 12 months, and prices in these sectors, and in many EM credits, reflect crisis levels of concern. Over the last quarter, spread widening has spilled over into many other sectors of the credit markets. The relentless negative returns over the last few quarters have been difficult, but most of it amounts to storing up future returns for thoughtful investors. Past episodes suggest that once corporate credit anxiety is generalized like this, and no economic downturn follows, a rebound to significant excess returns is approaching. Our valuation framework, based on identifying attractive spread levels which provide a healthy margin of safety, is signaling a broadening opportunity set in corporate credit and CMBS. In this Commentary we will revisit the 2002 and 2011 bear markets (we will spare you more verbiage on the Financial Crisis) and discuss the guidance they may offer for navigating this one.

The 2002 Bear Market

First let’s take a closer look at the credit markets in 2002. In the accompanying charts you will find the spread history, and how our valuation framework described the opportunity set. You will remember that in our valuation framework, “Buy” simply means that a credit is trading very cheap for its sub-sector, rating, and duration, inclusive of a generous spread cushion appropriate to that sub-sector’s historical volatility.

In the early parts of the millennium, investors endured a series of repeated blows, including: the Dot-Com Bust; the 2001 recession; the 9/11 attacks; the serial frauds of Enron, Tyco, and Worldcom; the realization that fiber communications lines were significantly overbuilt; and revelations of dubious accounting and corporate governance in communications, wholesale energy and consumer finance. Prominent bankruptcies and/or distress sales at the epicenter of the crisis included Enron, Worldcom, Qwest, Adelphia, Tyco, Global Crossing, Conseco, and even PG&E (although the latter created no creditor losses). As these events accumulated, spreads widened throughout the corporate credit universe, providing ample excess return opportunities for credit investors when spreads compressed rapidly in 2003. While there were plenty of landmines to trip up investors, a persistent credit orientation reaped substantial excess returns after the crisis atmosphere calmed. Excess returns to credit turned strongly positive from late 2002 forward, and cumulative excess returns were positive by mid-2003.

The 2011 Bear Market

In 2011, investors grew increasingly concerned that a Greek, Irish, or Portuguese default would cause a chaotic defection from the Euro, or ripple through the global banking system. The first dramatic moves involved banks with operations or exposures in Southern Europe and Ireland, but in the fourth quarter of 2011, spreads widened generally, enveloping such Europe-remote issuers as U.S. industrials and even U.S. CMBS.

In 2011, we recognized that, just as in previous crises, problems in a particular sector were causing investors to sell credit generally. Opportunities that met our “Buy” valuation criteria rapidly went from 32% of the IG Corporate universe to 71%. We were cautiously optimistic that there would be a strong policy response to save the Eurozone as it was, but didn’t feel it was a certainty. So we focused on spread opportunities more at the periphery of the crisis, particularly Nordic banks, French Banks, U.S. Banks and Financials, and some global industrials with European end markets. These were credits that might perform poorly should the Euro break down, but would still survive and service debt. In addition, several of the U.S.-oriented sectors that widened out, like REITs and Property-Casualty Insurance, offered excellent values, while remaining mostly free of Euro-related worries. As we all remember, the ECB mounted a vigorous policy response, and markets responded very rapidly in 2012. What sometimes gets lost in memory is the degree of political uncertainty around the ECB’s response beforehand.

This Bear Market

Which brings us to 2015. This bear market has been brought to us by declines in the energy complex, concerns about emerging economies levered to oil and commodities, and a worldwide leveraged M&A boom, visible once again in the Telecom sector.

Emerging economies, particularly in Latin America, but also Russia and Asia, have rlied heavily on commodity exports for growth, hard currency, and current account stability. For them, an enduring collapse in oil and commodities is indeed a systemic threat. They depend on their resource industries for jobs, current account balance and even their municipal budgets and social safety nets. As oil revisited its December lows this past August, investors began to worry about the resource recession becoming systemic in emerging markets, further punishing dollar borrowers by weakening most EM currencies. Unlike 2011, a huge policy response is probably not forthcoming (apart from, perhaps, stimulus in China), suggesting the cycle may play out more slowly than 2011.

New energy, commodity, and emerging market credits are falling to distressed prices on an almost daily basis, especially since the summer’s double dip in oil prices. We have small exposures directly to EM end markets, energy, and metals. Although modest in size, they have performed awfully, undermining returns during the third quarter. More importantly, while the fundamental credit cushions we have relied on when purchasing these credits have protected us this far, they have severely eroded. The overwhelming majority of our credit exposure, however, is in sectors where fundamentals are not as sensitive to emerging markets and energy. In 2013, we began to purchase fewer and fewer corporate bonds as valuations became expensive, and the bulk of our new purchases since 2013 have been in structured sectors (consumer and business asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS)) that are not facing fundamental challenges today, and have generally outperformed corporate credit. (See “Excess Returns” exhibit).

It is difficult to predict what will happen to resource credits, especially if prices remain low as they are now. Throughout 2015, we have found it difficult to find new exploration and oil service credits that offer a credit margin of safety in this environment, despite compelling quantitative valuations. We find that many energy companies came into this crisis carrying too much leverage already, and oil prices seem to be sticking at the levels we used to stress-test these credits in the first place.

But that doesn’t mean we haven’t taken advantage of widening spreads. Following our playbook from 2011, we have been looking at adjacent sectors that are related to energy and materials, but are less levered to direct commodity price exposures. Here we have had more success finding investments, and we have been able to add electric generation and pipeline credits at quite generous yields.

Following the summer turmoil, we are increasingly excited about the valuation opportunities arising in sectors even further from the center of the crisis. Up until the last quarter, we avoided the Cable/Telecom sector, remaining a spectator for this year’s M&A carnage. We very recently purchased Charter Communications senior loans. In our view, we are backing the right management team after completion of their long-sought merger with TWC. Higher Beta, non-energy credits such as REITS, CMBS, and U.S. consumer credit have also widened out as the market swooned. We are seeing very compelling valuations in these sectors and have been picking up new opportunities at a deliberate pace. New bonds are appearing at all ends of the size and quality spectrum. For instance, we recently purchased (2024 maturity) bonds of AA+ rated Apple Inc., the world’s most profitable company with far more cash than debt, at spreads greater than 1.15% over U.S. Treasuries, up from 0.6% in 2014. Similarly, spreads of A- rated Marsh & McLennan 2021 year bonds were at uninteresting levels of 0.7% at the end of 2014, but have widened to 1.3% over U.S. Treasuries on volume and currency translation in their global broking business. We see no great threat to Marsh’s long-term solvency and find the bonds compelling investments. We are buying bonds of REITs such as Westfield Properties and Digital Realty, which became too expensive in 2013-2014, but have retraced with the market. We don’t know when the market will calm down, but we are confident that these valuations will look excellent with hindsight.

Asset-Backed Securities have offered unusually attractive new issue opportunities in this turbulent environment, even as they have not experienced the secondary spread widening of Corporates or CMBS. Our investment in ABS has grown to now represent up to 35% of diversified portfolios. We participated, for example, in a one-year senior equipment lease ABS from seasoned lender Newstar Financial at a yield 3.3%. More seasoned, short-maturity ABS should represent a dependable source of cash for the value opportunities arising in Corporates and CMBS.

In sum, we cannot know when this bear market in corporate credit will end, and we do not try to call the turn. Given that a government policy response is unlikely in the energy sector, spreads may continue to move wider amid continued weak commodity prices and further EM fallout. Prior cycles suggest that many of the opportunities we see widening sympathetically today, some far removed from the most severe stresses of this cycle, will offer substantial excess returns ahead. We are confident that history will rhyme again, and could reward investors with a credit orientation.

Markets, Sectors, and Rates

Since the market tone has been very similar for the past year, it should be no surprise that the things that have worked and not worked in the portfolio are very similar to the prior quarters. Our value preference for structured product and loans over corporate bonds of most ratings has proved to be profitable; our limited exposures to oil and emerging markets have performed very poorly; while we haven’t seen a rise in rates as we expected, our credit exposures of short ABS and longer corporate and CMBS credit are “barbelled” across the yield curve, which has contributed positively to performance over the past year.

The excess return on triple-B rated bonds has averaged -1.2% per quarter, and the lone positive quarter ended March of this year barely registered at +17 basis points of excess return. The Citi Corporate Investment Grade (Treasury Rate-Hedged) Index is down 4.6% since last June, losing 2.14% in the last quarter alone. These indexes are close to a round trip over the last three years.

Similarly, the interest rate environment hasn’t changed much since the ‘taper tantrum’ of 2013, with a flattening trend still dominating. Rates over 7 years have rallied, while short rates have moved higher. The members of the FOMC have become incrementally more dovish over the past few months and decided not to raise rates in September. Markets now suggest only a less than 40% probability of one or two rate hikes by year-end.

As always, it is an honor to be your investment advisor, and we look forward to discussing these matters with you in the fourth quarter.

Sincerely,

Andrew P. Hofer
Portfolio Co-Manager

Neil Hohmann, PhD
Portfolio Co-Manager