Processing the Pandemic

In 1969, Elisabeth Kübler-Ross postulated the five stages of grief and loss, including anger, denial, bargaining, depression, and finally acceptance. The Five Stage Model has become a widely-accepted roadmap for humans absorbing difficult news. It seems to us the credit markets are passing through similar stages before accepting the effects of the pandemic. Investors’ progress has been both accelerated and complicated by the enormous palliative effects of central bank actions, stop-start injection of monetary and fiscal efforts, and the vagaries of a strange Presidential campaign season. In March, banks, funds, and other investors reacted immediately to the rapid shuttering of offices and storefronts, and by month-end the Federal Reserve (Fed) had directed unprecedented amounts of balance sheet firepower at the volatile debt markets. The enormous rally that followed seemed like a case of denial to many investors, since it began as the pandemic crested, and the fundamental impact was just beginning. This furious rally continued until the first few weeks of the third quarter. While new issuance has continued at a record pace, and credit markets have fluctuated with the news cycle, at the end of the quarter investment grade (IG) credit spreads closed at the same level they first reached on July 17. For the structured credit sectors, which did not benefit like corporates and municipals from direct Fed purchases, issuance took longer to fully reignite – until July and August. Spreads have not yet retraced as fully as for corporates, and thus we continue to find value here.

Credit sectors handily outperformed in the third quarter, with lower quality sectors leading the way, such as BBB and BB corporates along with resurgent commercial mortgage-backed securities (CMBS), a sector that had lagged in April and May. Even so, very few sectors have outperformed comparable Treasury instruments (i.e. produced “excess returns”) year-to-date. One exception is so-called “traditional” asset-backed securities (ABS) with AAA ratings, such as those backed by prime auto loans and credit cards. Non-traditional¹ ABS (where we are generally invested), such as consumer loan ABS, business loan ABS, and dozens of other sectors, continue to lag Treasuries year-to-date with the rest of the credit market.

We look at credit markets through our valuation framework, which not only adjusts for the changing duration, sector composition, and credit quality of the index, but also places valuations into an apples-to-apples historical context. BBH’s valuation history for the Merrill Lynch U.S. Corporate Master Index, for instance, is displayed below. With unprecedented speed, corporate markets recovered from a paltry 7% of the index exceeding our “Buy” valuation² levels in January, to 97% in late March, to today’s level of 35%. We found ourselves eagerly buying large amounts of corporate credit in March and April at strong ‘Buy’ levels in our framework, then turning around in May to September and selling the same bonds due to their now-expensive valuations, as shown in Exhibits III and IV above.

Despite our efforts to find new and attractively-priced instruments, collapsing spreads and lower Treasury yields have brought portfolio yields down dramatically. Exhibit V shows the yield progression of three of our core fixed income accounts, ranging from highly credit-constrained (with a minimum Treasury component and strict ratings restrictions), to unconstrained (which owns some high yield bonds and loans). The unconstrained Core account still maintains a higher yield than before the pandemic, with increased spreads (light blue) making up for much lower Treasury Rates (dark blue). This reflects both our more conservative positioning in January and February, and the durable opportunities we are still finding in more pandemic-affected, lower-rated, sectors. This is exactly the outcome the Fed intends for us with its low rates and massive purchases of higher quality instruments – if you want some yield, you are going to have to provide capital to more risky entities (at least riskier on a market-implied basis). Below we discuss how our portfolios are shifting in this latest phase of the pandemic digestion process.

Who’s buying?

Most of you might answer this question with “everyone”, because it certainly feels that way. But it isn’t really everyone, because the Fed has barely bought any credit at all. The real impact of the Fed’s announcement remains its potential purchasing size – the combined credit securities purchase programs (SMCCF, PMCCF) have a staggering authorized potential to own $750 billion in securities, or around 3% of all U.S. private debt. But we would emphasize the word “potential”. As of the latest reporting date, the Fed had only $12.9 billion of non-government, non-bank credit on its balance sheet, practically all from the Secondary Market Corporate Credit Facility (SMCCF) (Exhibit VI). The direct lending Primary Market Corporate Credit Facility (PMCCF) has not extended a single dollar of credit, causing one JPMorgan analyst to call it the “Please Make Companies Come” Fund.

We have persistently observed that foreign investors are under-appreciated as a factor in credit spread movements given their enormous holdings. As our close readers know, we like to keep tabs on these flows, and we predicted last quarter that low hedging costs would turn foreign investment flows into USD credit positive over the summer. Foreign flows have indeed turned positive, as foreign investors have maintained share amid record USD corporate debt issuance (Exhibit VII). Fund holdings have also been growing, partly due to growth in fixed income index exchange-traded funds (ETFs).

The growth of foreign and funds investors suggests more turnover and perhaps continued spread volatility.

Meanwhile, in September investors pulled money from credit, and from high yield funds in particular, as coronavirus flare-ups in various parts of the country made the news, and concerns about a second wave in the fall became top-of-mind (Exhibit VIII).

Who’s issuing?

The answer to this question might also be “everyone”, but there were some distinct patterns in credit issuance as it developed in the third quarter. Continuing second quarter trends, issuance broke new records, and corporate borrowers continued to prefer longer issuance at these historically lower rates. The duration of the indexes lengthened as a result. Unfortunately, this means that companies have been able to shift the asymmetric risk of rising rates increasingly onto the shoulders of investors (Exhibit IX). Holding long durations, when spreads and coupons are so low, increases downside risk, so buying at cheaper valuations is increasingly important. Issuers have also been moving down in rating as well, which is another reason our less-restricted accounts have been able to obtain larger positions in lower-rated debt. In a welcome change, ABS issuance came back to life in the third quarter (Exhibit X), allowing our sizable appetite for value in these sectors to be met. We purchased $1 billion of ABS in the quarter. Issuance is increasingly dominated here by the non-traditional ABS sectors.

This bull market isn’t happening for no reason. By and large, investors have been buying credit not only due to the low Treasury rate environment, but also fundamental company performance, which has generally been strong. Companies in more cyclical industries have built up huge cash and liquidity buffers to get them through the pandemic, and many issuers whose debt securities swooned in March and even April have performed well. For instance, many business and consumer loan ABS have maintained debt service on their senior tranches and even paid down substantial amounts on their fixed pools, returning capital to investors at par. The Hertz rental fleet securitizations, overcollateralized by a sizable pool of autos, performed as expected through a Hertz bankruptcy challenge and have already accelerated 60% repayment of senior tranche investors’ principal. Even airlines received a combined $158 billion of government bailout money globally (about $50 billion in the U.S.) and continued to make partial negotiated payment on their leases. Short-haul air traffic rebounded rapidly in Asia, but more slowly elsewhere. Retail sales are even up year-over-year, although the mix of goods and on-line vs. in-person sales continues to shift.

ABS fundamentals

We noted in the 2Q Strategy Quarterly Update that monthly reporting and our issuer conversations from Spring sketched a picture of persistent credit strength in ABS. Third quarter data confirms this (see Exhibit XI). The monthly non-payment rate (i.e. the unpaid percentage of scheduled principal and interest on loans and leases each month) is a useful performance metric for comparing ABS subsectors. The teal bar represents a typical level of credit enhancement, or cushion as percent of total loans, for ABS notes by subsector. The red bar represents the range across issuers of the highest monthly non-payment rates we observed this year, by subsector of the ABS market. These occurred in March and April. By May and June, recovery had commenced. With the benefit of another three months of data, we can now add the black bar, which represents September’s non-payment rates.

The patterns of non-payment rates across subsectors are revealing. Importantly, for all but student loans and aircraft ABS, credit enhancement levels comfortably cover non-payment rates. Given a still elevated unemployment rate, consumer subsectors like auto and personal consumer loans continue to perform surprisingly well versus the Great Financial Crisis (GFC) and issuers’ own stress cases. Commercial ABS subsectors have generally performed well given the depth of the economic downturn, with the exception of small business and aviation. Asset types with large corporate lessees, like heavy equipment, railcars, containers, fleet lease, cell tower, and venture debt, continue to experience low, stable lease non-payment rates that are now below 3%. These are well-covered by available credit enhancement. Through September we have seen incremental improvement from the well-contained rises in April non-payment rates.

The greatest performance improvements we’ve seen this Summer, though, have been within small business lending. Smaller businesses face difficult conditions – a September Yelp survey indicates that about 100,000 have now permanently shuttered. But we’ve witnessed a notable recovery this Summer across issuers like OnDeck Capital and National Funding, Inc. Their non-payment rates on loans peaked at 15% to 25% in April, but through September they have retreated to a more normal 5% to 15%. With new loan originations down temporarily in the Spring, the revolving trusts for these ABS accelerated principal paydowns to investors. In just four months, their senior notes are now mostly paid down and the junior tranches expected to be retired through year’s end. These swift and orderly paydowns, even as collateral performance has remained reasonable, serve as a useful demonstration of the protective features of ABS structures.

Corporate fundamentals

Record new issuance has allowed many companies to extend near-term maturities into the future and increase liquidity buffers. Even the rating agencies are slowing the pace of negative credit rating actions. For example, S&P downgraded 296 credits in the quarter, which is a 68% increase over last year, but slower than the quarterly downgrade average of 770 across the first two quarters of the year. Pandemic-affected sectors such as energy, travel/aviation, and discretionary retail were particularly hard hit. Default rates reflect a similar industry profile, as the energy and retail sectors comprise 29% and 12%, respectively, of credit defaults this year. Although the Corporate credit picture is clarifying, we are again cautious, noting that $300 billion of BBB-rated credit remains on negative outlook for potential downgrade to high yield. We expect downgrades and defaults to continue at this slower trend for 2020, but ultimately extend further into the quarters of next year.

Meanwhile, we are pleased to report that, despite our focus on credits with higher spreads, only eight issuers across our entire $43 billion inventory have been downgraded from investment grade to high yield in 2020, and two were actually upgraded into investment grade.

While we certainly expect more negative fundamental developments, we do not agree with predictions of an unprecedented wave of credit losses, or a systemic financial crisis from bad loans.³ It is true that businesses are highly leveraged, but it does not necessarily pose a problem for all borrowers, and high yield credits are not at record debt levels. Goldman Sachs tracks the net leverage of the median credit in IG and high yield (HY) as shown below. Using the median is important in looking at net leverage, as some of the giants, like Apple, have huge cash balances. As you can see, record leverage levels are not matched with record low interest coverage in investment grade. This is important because IG credits have mostly termed out their credit and are not immediately exposed to rate risk, should it emerge. HY credits have more rate risk, but their leverage is not quite at a record.

To be clear, we anticipate continued downgrades and defaults as the pandemic wears on, especially after years of loose terms and reaching for yield. But we do not expect defaults to far exceed their peaks from other cycles and anticipate that the credit enhancement and equity in structures like high grade collateralized loan obligations (CLOs) and business development company (BDC) debt will continue to protect investors at these levels from impairment.

Opportunities remain, but they are in the corners…

As always, we assess the durability of our credits by developing realistic and conservative downside scenarios, and we attempt to filter out weaker issuers that might not survive such strenuous conditions. This allows us to take advantage of sectors that are experiencing cyclical or event-drive stress while remaining confident our principal will emerge intact. Below, we provide some examples of sectors and issuers that are offering exceptional yields in today’s credit market.

In the exhibits XIV and XV, we illustrate the weighted average spreads we are realizing in different subsectors of the IG corporate and ABS markets, as held in an unconstrained Core account. As you can see, earning attractive spreads of over 180 basis points mostly required moving down to BBB in the corporate sector. However, in ABS, there are examples of similar spreads through the rating scale all the way from AAA to BBB. In both cases, we are not limited to one or two sectors, but several where values are attractive, and we are quite comfortable with a handful of credits where the issuers are durable or have provided ample collateral.

As our clients know, we don’t aspire to look like the index, and we would not have developed as strong a long-term track record if we did. As the opportunity set has narrowed and moved into a few corners of the credit market, we have developed some sizable concentrations in high-spread sectors with durable issuers. In the appendix which follows, we review seven subsectors, each of which make up more than 5% of the unconstrained Core portfolio, and together constitute nearly 44% of the portfolio.

In each case, there are certainly factors that are driving spreads wider, or holding them wide, some of them technical, some fundamental. But in each of these subsectors, we believe we have a strong grasp of the potential downside, and we are taking advantage of the sector weakness to invest in durable credits⁴ that we believe are likely to survive even a very difficult future scenario for the rest of this recession and the pandemic. It is our hope that this gives you a window into how our credit selection strategy has evolved in this stage of investors’ pandemic trauma.

Conclusion

We are still in the first half of the pandemic’s effect on the world economy. With another fiscal package highly uncertain, and prospects for continued hotspots or even a second wave, there will be more bad news on the business and consumer credit fronts. Nonetheless, the pandemic will ultimately end, and even without the Fed there is abundant capital to support the survivors of this recession, even in sectors like lodging and air travel. In this phase of the pandemic-driven credit cycle, while market-timing investors are still in the “bargaining” or “denial” phases of processing the pandemic, we are sorting out the long-term winners, many of which still offer compelling credit value. The ‘no-brainer’ values of April are gone, but we typically find this phase of a credit cycle the most interesting and energizing. We look forward to sharing it with you as we meet virtually over the coming months.

Andrew P. Hofer
Portfolio Co-Manager        

Neil Hohmann, PhD
Portfolio Co-Manager

Paul Kunz PhD
Portfolio Co-Manager

Appendix – Description of Key Investment Concentrations

BDCs (“Financial Other”)

Business Development Companies (BDCs) are low leverage finance companies that originate direct loans to middle market companies across a diverse range of U.S. industries. BDCs, like real estate investment trusts (REITs), are SEC-regulated investment vehicles, and investors benefit from full transparency of holdings and operations, as well as a hard, statutory limit on financial leverage. The BDCs we invest in have large well-established credit platforms generally ranging from $5 billion to $40 billion in size with highly experienced direct lending teams. These include Blackstone, Blackrock, Ares, Golub, and Franklin Templeton

The unsecured debt of BDCs is at a very low leverage point for a financial company that has such stable asset performance. The debt-to-asset ratio for the BDCs in which we invest is generally near or below 50%; i.e. leverage is only 1x or less. As result, the resulting coverage of unsecured debt by unencumbered

assets of the BDC is high and can range from 2.5x-5x. Furthermore, the BDCs we invest in have substantial liquidity in cash and available credit lines, generally amounting to 10% to 20% of total assets.

Electric Generation

We focus on utilities that have strong regulatory relationships with a track record of good cost recovery either through real time riders or frequent rate filings. We also focus on utilities that have limited their non-rate regulated operations and have maintained healthy balance sheets. We focus on merchant generators that are critical pieces of infrastructure for their region with low starting leverage and stable cash flows. We tend to look for merchant generators that have some form of hedging, contracts, or other mechanism to maintain stable cash flows during weak commodity periods.

After initial spread widening in March and April, spreads for regulated electric utilities have steadily compressed. The compression has primarily been driven by strong existing balance sheets of most rate-regulated utilities as well as substantial liquidity. Operationally, electric utilities have benefited from being able to pass through COVID-related losses through multiple channels. They have either been allowed to directly pass on the costs associated with COVID through rate riders or they have been given permission by their regulators to place those costs into their regulated rate base and recover them in their next rate filing. Additionally, volumetric declines from commercial and industrial electric usage has been modestly offset by residential usage as many have switched to work-from-home arrangements.

Banking

We invest in banks with balance sheets that are strong enough to withstand severe economic downturns. These banks are well capitalized, have good asset quality with adequate reserves, solid liquidity, diverse sources of revenues, and well-respected management teams. The mid-March to early May widening in spreads allowed us to add bank bonds to our portfolios at very attractive spreads. Subsequently, they have tightened considerably.

The banks we invest in entered the coronavirus-induced economic downturn in a much better financial condition than they did during the GFC in 2008. Stress tests for large banks are routinely done to assess their ability to withstand severe economic downturns. Their regulatory capital ratios are generally between 2-3 times the levels at the end of the first quarter of 2009.

Asset quality has improved, with stronger underwriting standards, particularly for retail mortgages. The securities portfolios of the large banks have far less level 3 (marked-to-model) securities, and stronger risk controls. Loan losses were near multi-year lows prior to the pandemic, and the banks have markedly increased their loan loss reserves during the first half of 2020.

Property & Casualty (P&C) Insurance

We favor non-monoline businesses, management teams with a strong history of price-sensitivity in underwriting, prudent reserving practices, access to capital markets, and an investment approach consistent with the company’s underwriting posture. Our holdings include mostly large hybrid North American, Bermuda, and Swiss insurer/reinsurers, a title insurance company, a coastal property specialist. We have moved down in the capital structure in some of the large hybrid companies.

Investors have driven spreads wider due to large pandemic-related losses, increased storm and wildfire frequency and severity, and rising reinsurance costs. This is the second year of substantial price increases across most lines of business – companies describe this as the best “hard market” in the last 20 years, and these rising prices will be good for profitability. P&C companies are also accessing both the equity and debt markets easily, raising additional capital for the hard market. Finally, Covid losses are emerging as an earnings event, not a capital event.

Healthcare

While temporarily suspended non-essential services and increased expenses for COVID patient care drove industry margins down, government funding and service resumption have begun to stabilize profitability. Indeed, most of the service providers in our portfolios have already reached near pre-COVID patient volumes and net patient revenues. We believe that our strategy of focusing on market leaders provides protection against the leading credit concerns, such as the ongoing reimbursement pressures which may be exacerbated by political change.

Spreads on the taxable not-for-profit hospital systems, such as Bon Secours Mercy Health and Orlando Health, continue to be wider relative to their ratings, as these are taxable municipal bonds which, due to a smaller investor base, typically must offer higher yields. Also, some credits we hold continue to have excess spreads due to company-specific reasons. For example, InnovaCare, the leading health insurer in Puerto Rico with a growing business in Florida, still offers a Puerto Rico premium which, given that almost all its earnings before interest, taxes, depreciation, and amortization (EBITDA) comes from the federal government, we do not believe is appropriate. Likewise, spreads on Mednax and Tivity Health still reflect the significant corporate restructuring and management changes both companies have gone through; we believe that they are stronger credits at this time than these spreads may indicate. Finally, AdaptHealth was new in the bond market this summer and some of the initial issuer premium it had to offer lingers, even though the dollar price of the bond has risen by over 4% since issuance. All these illustrate our strategy of purchasing durable credits at attractive yields.

Aircraft Leasing (“Finance Companies”)

While spreads in the aircraft leasing sector were initially hit as hard as the airline sector, investors have begun to realize that the business models of these two sectors are very different. The key differences are that aircraft leasing companies have more flexible cost structures than airlines, and they also have bargaining power over suppliers and customers by virtue of their scale and customer diversity. These tenets of their business model have been severely tested since the beginning of 2020, and the largest industry lessors have responded well to the challenges.

Our investments in the sector have been focused on the largest lessors because they have the most financial flexibility. That flexibility derives from proactive efforts to lower leverage and to protect the balance sheet, combined with creating long liquidity runways. AerCap, Avolon, Air Lease, and ACG Capital are among the top-10 leasing companies globally and have deep relationships with original equipment manufacturers (OEMs), airlines, and capital providers. They were able to push their aircraft orders back, and in some instances cancel orders altogether in order to conserve cash. They drew down the entirety of their revolving credit lines and renegotiated their financing terms with banks to bolster cash availability. Finally, they have been renegotiating rent deferments and payment terms with airlines, which has led to some of the highest collection rates in the industry.

Our liquidity stress tests for these credits suggested that the above-mentioned lessors have adequate liquidity sources to address their full cash needs for the next two years. As a result, we became comfortable with short maturity lessor debt that was yielding around 8% for BBB- rated bonds with less than two years to maturity. We also stressed the collateral value that supported the secured term loans for some of those issuers and increased our exposure to existing loan positions. As more information became available from these lessors in the quarter, we learned that our initial stress scenarios were overly conservative, and that these issuers have even greater liquidity runways than estimated. In mid-summer, these issuers started to test the capital markets with new bond deals, and we participated in many primary deals with yields around 5.5% for 5-year tenors that trade today in the 4.5%-5.0% range.

Personal Consumer Loan ABS

Our investments in personal consumer ABS issuers have been focused on brick and mortar (i.e. branch office) lenders with long operating histories, strong management and ownership and a focus on effective servicing delinquent borrowers. Our investments typically have credit enhancement of 30%-50%, sufficient to absorb even depression-level losses and still repay us. Historically, brick and mortar consumer lenders have been able to limit ultimate losses in downturns with successful servicing. Brick and mortar lenders’ net losses and delinquencies have tracked similarly to credit card trust performance, showing continued strong performance. Unsecured consumer loans typically realize low recoveries following defaults, so borrower engagement through servicing programs is essential to prevent losses.

The economic recovery since the peak of the pandemic shutdown has led payment rates on unsecured consumer loan ABS to improve significantly. Stimulus and enhanced unemployment benefits initially supported borrowers; however, lenders were quick to provide payment deferral and loan modification programs to impacted borrowers. The end of the Coronavirus Aid, Relief, and Economic Security (CARES) Act stimulus and uncertainty around further stimulus may create economic drag that causes unemployment to rise or more financial pain for borrowers, especially those that have already lost their jobs. However, any further pandemic effects on unemployment are likely incremental, and unemployment is the key driver of consumer loan performance.

Current low levels of delinquency and high levels of cured deferrals suggest that significant incremental delinquencies and losses due to the pandemic are unlikely. This creates a survivorship bias in the remaining loan pools, which is an important credit positive. For new originations, lenders have tightened underwriting standards, increased interest rates and tightened employment verification. Origination volume decreased significantly in Q2 but increased in Q3 as lenders are continuing to be more selective in extending credit. This should cause new originations to have stronger performance than recent vintages.