The Active Investor: A Closer Look at Opportunistic Credit

Joseph Graham: Welcome to the Active Investor Podcast. I'm Joe Graham, head of the investment strategist group here at Lord Abbett. This podcast usually goes about 15-20 minutes. But I think there's been enough action in the market, enough to talk about. And we have two guests instead of one.

So we may go a little longer today. No promises.

Those guests are Andy Fox, who's our opportunistic credit investment strategist. Andy spends a lot of his day talking to investors about their credit allocations. And Adam Castle, who is a partner at the firm and a lead PM [portfolio manager] on our Credit Opportunities strategy, which just hit its five-year track record, [which has] been a fantastic strategy and part of the reason we wanted to have you guys on today, but also just because you're interesting, thoughtful guys. So welcome guys. thanks for being here.

Adam Castle: Thanks, Joe.

Andrew Fox: Thanks, Joe.

Graham: So, before we get started, I thought we'd outline the podcast first with areas we'd like to cover. So first, the current market backdrop for credit, and just opinions on credit. Second, a history on the development of the opportunity set for we're calling "opportunistic credit."

Thirdly, how investors are treating this space in terms of portfolio allocations. And then finally we'll end with an outlook and some best ideas and themes today.

So, let's get started. The first idea, the current market backdrop for credit, Adam, we'll go to you first. My experience is talking with clients in the last few weeks, there's been a decent amount of doubt, call it hesitation, on credit right now. Spreads are relatively tight. Rates are obviously elevated from previous years. So, people are worried about refinancing. I know that's a lot already to cover. But let's just dig into your view of credit today.

Castle: Absolutely, thanks, Joe. And it's great to be here with you guys. So yes, you are right. There's hesitation in the market and spreads are relatively tight. However, below the surface, we still find the market to be very investable. There's a very wide dispersion between high- and low-quality assets, and that continues.

The gap [spread] between the index in high yield [benchmark ICE BofA U.S. High Yield Constrained Index] and triple C's [CCC-rated bonds in the index], for example, is historically wide. And that's in line with a market that is late -ycle in risk tone. So what I mean by that is the market's paying up for quality, which is consistent with a view that the expansion is nearing its end.

So that's kind of the consensus, that the economy is going to slow down and potentially tip into recession. That's consensus. So that's actually a good thing for us, hesitation in the market, the wide dispersion between high and low quality. It's the contrarian view to say that the expansion can continue for several years.

If you look at more mid-cycle relationships [of spreads to economic conditions], triple C's would be 200 basis points tighter relative to the [benchmark] index than they are right now. So yes, the market overall is tight. However, not when you think below the surface.

Another thing to consider is the evolution of financial conditions. So, you can certainly look at a point in time previously where spreads were wider. However, a lot of the spreads are on assets that were underwritten during looser financial conditions, and so embed a certain amount of risk in them related to the weaker underwriting standards or lending standards that were involved at the point of origination.

Today, we are in a world of tighter financial conditions. And so, the assets that are being created are decent. 2023 and 2024 are going to be decent vintages [origination years] for credit. And I'm really speaking in broad terms. There are, of course, mini cycles of expansion and contraction that take place in sub-markets. But overall, we are in historically tight financial conditions.

Graham: Interesting. So, one point you mentioned there that triple C's are relatively wide compared to, say, double B's and single B's [BB- and B-rated bonds]. What are some of the problem areas that are contributing to that dispersion? What are the things that are out favor right now?

Castle: Absolutely. That is true. There are some sector-driven things. And they're not driven because of the fact that they are necessarily related to a particular sector, but more [because of] what is going on in those sectors from a leverage and from a dynamics point of view.

And I'd say first and foremost is telecom and media. It's been a really challenged sector. It's a very large sector as well, very over-levered, [capital] structures that had expanded to gargantuan levels during the expansion post-COVID, in 2021. And I think one of the drivers of the leveraging that took place was the predictability of revenues.

Cable & media tends to have a very recurring revenue stream. And that might be a good thing in good times. But here we are now in higher rates with a sector that is facing declining prospects with competition and rising, major capex [capital expenditure] needs. The turnover toward fiber or next-generation transmission is a very heavy lift. Not everyone's prepared for that. When you're going into a capex build-out phase as an industry with high leverage levels and rising rates, it's going to create some real problems.

Graham: So that's a sector-driven source of dispersion. Anything else besides sectors that's causing disruption in the marketplace?

Castle: Absolutely. There are parts of the real estate market that are weighing even on high yield. The health care sector has been challenged just given some of the issues around labor and costs while having very little pricing power. The largest payer in health care is the federal government. And so, operators, providers have been faced with tight labor markets for nursing and other forms of health care workers. Rising expenses along with the rest of the real economy with very little pricing power has led to some real strain.

Graham: Got it. Okay. No, thank you for that. Let's back up a little bit and turn to you, Andy. This area we're calling the "opportunistic credit," what Adam just described is decent amount of dispersion among the leveraged credit space that leads to a lot of opportunities in credit. But maybe give us a little bit of a history lesson on the last few years, decade or so, that led to some of these opportunities.

Fox: Yeah, it's been a decade plus at this point. And I guess if we had to pick a spot where things start to get a little bit interesting, and what we really see as the opening shot on the culmination of this whole things really is the GFC [global financial crisis of 2008–09] and the shifts that had to occur after that to at least attempt to avoid the sort of challenges we saw back then.

So Dodd-Frank's [the Dodd–Frank Wall Street Reform and Consumer Protection Act, enacted in 2010] going to be the one that's top of mind for everybody. And so I kind of put it in two buckets. You got the regulatory bucket, and then now we've got the more recent bucket of the death of ZIRP [zero interest rate policy from the U.S. Federal Reserve], I guess we could call it, as rates have changed.

So you think about the regulatory regime overall, if you wanted to boil it down to one thing, it's trying to find a way to insulate investors, depositors in the larger economy from challenges driven by that original sin of finance, which is the asset-liability mismatch.

Which, if you look at all the big train wrecks that we've had over the last, I don't know, pick however many years, it really comes down to that. You're seeing it most recently with the regional banks. Dodd-Frank's trying to fix that, Basel III endgame [the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements] will try to fix that in its way, really kind of dealing with capital charges.

And this is something that institutional and increasingly private wealth investors are really well acquainted with because there's a lot of private credit opportunity. And it's an area that we see significant amount of opportunity in as well. But why does that even exist?

That was traditionally like a commercial banking type of a job. And as the balance sheets got squeezed ever tighter with capital charges, it got hard. It got hard to lend to smaller companies, middle-market companies. You had some smart people that said, "Hey, you know what? We can eclipse or push aside some of that mismatch by, instead of using depositor money, let's go find investors and tell them, ‘You know what? Here's the deal. The term is seven-year lock. And by the way, the loans are going to be set up the same way. We're going to go out there and make these loans.’" And it made a lot of sense and it's obviously been extremely well accepted.

You could look at it as a disintermediation of a typical bank type of a function. What I think is very much forgotten, this is happening in tradable credit as well. So, if we look just a corporates, which is as vanilla as it gets, and we're thinking IG [investment grade] and high yield here both, that market has grown 3X since the financial crisis.

And depending on who you ask, there's numbers that range, but generally speaking, dealer inventories, just to pick one place, are about a tenth of the size that they were pre-GFC, with a much smaller market. So you kind of think about liquidity and the way that risk moves around the street, it is a little bit challenged.

Now when we talk about ZIRP and the going away of ZIRP, I don't know if it's gone to sleep. Maybe it'll be back some day. But the impact of the capital charges, the constraining of balance sheets, that's been a long-run story for the last 15 years.

But there's kind of a stay of execution in the sense that you could finance positions at a reasonable rate because base rates were so low. They're not now. So you start to see this acceleration of trends that were already in place. I'm sure we'll have a chance to talk about it.

But there's been plenty of circumstances where we've had motivated sellers in the marketplace. They are looking to move assets that they feel really, really good about that they were intending on holding onto. They're going to let them go. They're going to do it in a way that from the outside looks pretty uneconomic.

But they're not thinking about the economics. They've got externalities that they're dealing with. This is a great situation for an opportunistic credit strategy. I would take it a little bit further. If you think about the rise of things like index strategies where they kind of, sort of cracked that code in the fixed income markets, and there's been a significant amount of products that are either index or just a little bit of index-plus. That also occurred in an environment of ZIRP where you kind of have this lift on assets and differentiation. You could add value as active management, I'd like to say that we did by and large across a lot of our strategies.

But there was a fair argument to be made, because you saw the dollars going there, that, "Hey, you know what? I think this is a pretty indexable, efficient area of the market. Maybe I'll just go ahead and do that." And that worked for a very long time.

Graham: And I see what you're saying here which is that, okay, the capital has been removed from bank balance sheets. So, there's some constraint there. But because of zero interest rate policy, everyone sort of won anyway. A rising tide lifted all boats. And so, you could index this area of credit. So, what's changed now? I guess you're saying the death of ZIRP is what's changed.

Fox: Yeah, you can see it. We see the news stories with some failures this time last year. Certainly, you've seen plenty of activity from some of the regional banks as just one example we could pick on where they're just looking to get ahead of this a little bit and shore up their balance sheet.

They're going to be letting go of some assets. And you can see even this idea that Adam brought up that there's going to be more dispersion within fixed income. Even if you look intra-market, that's true. High yield's pretty tight right now. We've been flirting with [the index spread] getting inside of 300 [basis points].

But as Adam said, [spreads on] triple C's are still pretty wide. That tells you that double B's [spreads have to] be pretty tight. Now, that's an area where you have a lot of managers that are more index-focused. They spend a lot of their risk budget there. So, it catches a bit of a bid [from investors]. But our expectation is that this volatility will continue to cause that variability.

Graham: So in addition to the variability, intra-sectors and across sectors, I would think this also causes a lot of variability in terms of time, where things trade tight for a while, but then have these mini blow-ups in different areas.

Fox: You bet.

Graham: So that's kind of been the experience over the last few years is those--pretty rapid--

Fox: Looking at it right now, we could go through a litany over the last couple years--

Graham: Let's go through some of those--

Fox:  --things that happened. And I just want to say before we do, our strategy overall for opportunistic credit is not predicated on our ability to see around corners. We've got a view just like anybody else. But the reality of it is when dislocations happen, they become dislocations for the very reason that nobody saw it coming.

So trying to figure out what's going to blow up and then just buy that when it does is a pretty bad strategy. It's kind of a mean-reversion strategy, I guess. That is not at all what we we’re doing. But maybe we can talk about how we've reacted to the market. We have that list of things that we like in various sectors because of the breadth we have at the firm.

Castle: That's right. I think defining opportunistic credit is key here in helping I think the listener understand what it is for us and our investment team. And for us, I think it's defining an investment process and then defining a flavor of risk-reward that we're seeking for a given strategy.

And we do have a few strategies within our opportunistic credit umbrella. And bringing that process and that risk appetite to the credit market and then investing where the opportunity presents itself. That's a little bit different than being dedicated to an asset class or being dedicated to a specific sector or industry.

We're dedicated to a process and a risk appetite. And we have a certain proprietary method of screening for securities that fit based on our process. Things like having a variant perception, having a return expectation, and wanting a catalyst. These are the ingredients to how we do that.

One of the core aspects of our approach is achieving convexity, forcing a discussion about upside and downside. And that gets to exactly what Andy was describing about we're not just looking at a base-case yield. If you're doing private credit or thinking about carry, that coupon is going to be your yield.

And your base case might be a 90% confidence. And there's a 10% chance that you're going to have some kind of process or distress situation. We're thinking about assets more that have more of a different type of base case, something in the 30-50% probability range, but have meaningful upside catalysts to them, so a wider range of outcomes.

That can happen through total return related to price, related to spread duration, or actually creating equity-like instruments. There are a number of ways that we can do that. But the emphasis there is on the screening process and a philosophy on investing.

What ends up happening is varying degrees of sector composition over time. We leverage the capabilities around our firm. And you mentioned the pandemic, I believe. I think what's really crucial, if you look at the performance of the opportunistic credit strategy, Credit Opportunities Fund, the upside capture going out of the pandemic was significantly higher than any product that was wed to a particular asset class.

So if you were in bank loans, or you were in high yield, you experienced a draw-down as did our opportunistic credit strategies. But the return back to normalcy was more or less predictable by asset class. But the ability to rotate between given a particular process around return and risk-reward and catalyst led to a material shift in composition over time and upside capture that was really a combination of numerous individual asset classes--

Graham: I see--

Castle: --capturing their upside in a rolling fashion.

Graham: Yeah, I think that's an interesting point because to your point earlier, Andy, private credit is some of the answer here of--

Fox: You bet.

Graham: --filling in the gap in financing. However, what that lacks is this ability that you're describing, Adam, that to rotate amongst asset classes as things are in motion, which in the pandemic it was relatively rapid--

Castle: That's right.

Graham: --that sort of motion. Tell me about some of the shifts you made in the portfolio around that time in the post-pandemic period.

Castle: And it's a wonderful case study. It was four years ago. But it speaks so well to our process in practice which is why I think it's a great example to talk about. If you think about the environment we are in, typically a recession beginning is forecasted by certain market participants, but not others.

Right now we're in a perfect example of that. Some think we're at the end of the cycle. Some do not. There are buyers and there are sellers. In the pandemic, there was virtually zero confusion. The global economy was shutting down. That created a sort of uniformity of opinion and kind of a singular correlation across all these asset classes and a draw-down across virtually everything.

It took a centralized approach to shore up markets and to shore up liquidity. And I'm talking about central banks as well as governments. So we saw fiscal and monetary response. And that was done really globally. Each government had their own approach to the fiscal side, but the monetary approach was more or less zero interest rate policy and a host of other asset purchase programs. When you roll out things like that in a centralized manner, they impact the simplest asset classes first well before they impact the more complex asset classes.

Because the transmission from central policy through the markets is going to be complex for certain types of assets and straightforward for others. And so, you saw an immediate recovery in investment-grade corporates followed by a recovery in high yield corporates. Securitized products, for example, did not enjoy a very quick recovery. It did recover. But it took several more months. So that speaks to--

Graham: I see--

Castle: --the way our opportunity set evolved coming out of the pandemic. We had a portfolio, multi-sector, going into COVID. We took a look at our CLO [collateralized loan obligations] positions and our ABS [asset-backed securities] positions, and we felt that the prospects of a material recovery in NAV [net asset values] were going to be poor in the near term.

We sold a bunch, moved that into corporate opportunities where we had a very clear line of sight, whether it was due to a reopening, due to a change in policy where liquidity conditions had a higher chance of recovery. And then later in the summer of 2020 when things started to normalize in corporate credit, you started to see our securitized product composition increase. And that's due to our screening process where all of a sudden more things are showing up with the upside/downside base case scenario-based analysis putting that into the portfolio.

Graham: I see. And then just fast-forwarding a little bit. Inflation and rising rates became the story. What does a portfolio, or what does a strategy, like an opportunistic credit strategy, do in that situation?

Castle: Absolutely. So just as COVID was a surprise to markets, the fact that inflation was not transitory and dramatically so, I think was also a surprise. And you had a pretty decisive move by the Fed giving us more than 500 basis points of increases in the overnight rate during this hiking cycle so far.

Inflation was one of these major risk factors for markets where we had to take a look on the corporate side at pricing power and expense management. And the same would apply to the U.S. household sector where the U.S. consumer faced the same circumstances.

What is their income increase potential? What's the labor market look like? What is happening to real wages? And then what are happening to financial obligations and the other forms of expenses that U.S. households have to undergo, combined with a fiscal stimulus program that was going to be rolling off as we handed off from fiscal/monetary to the real economy?

There was a ton of controversy around all of that. And so the opportunity set was probably the richest it has ever been in the history of our strategy during that period of time. There was no particular asset class in 2021 or 2022 that you could say from a top-down level had what it took or had that special stuff.

It was very bottom-up. What you ended up noticing though on the surface was cyclical fluctuations between corporate-type securities and structured-type securities. And that relates a lot to the frequency of credit market risk tone shifts that were happening during the tightening cycle.

Graham: I see. Interesting. So I can anticipate a challenge here, which is a portfolio that's as dynamic as this, or a strategy that's as dynamic as this, might be difficult to place into an asset allocation. I know Andy, you spend a lot of time on this. How do institutional investors look at this in terms of asset allocation? And then, does that differ from the private wealth market for example?

Fox: Yeah, sure. That's a good question. I just want to, before we get into that, and I think this related, highlight some of the things that Adam said, particularly about the way that we think about benchmarks and so forth. I'm a monolithic, high yield guy. We have those strategies.

And we're quite good at it, for anybody listening. If you want to take a look at them, looking for a high yield manager, we've got some very good ones. But generally speaking, when you're thinking about high yield or any asset class, your core manager and so forth, your starting point is, and what you're offering the clients is, "Give me high yield risk. Give me Agg [Bloomberg U.S. Aggregate Bond Index] risk. Give me this, that or the other."

So, a natural place to start is with that index. What is the opportunity set? Your first cut through it is probably to say, "Let's get rid of the things that I really don't feel so great about, things I don't like." Fixed income can be a game of, "If you don't lose, you win." If you cut the losers out, you're going to do great.

And then the other side of that is the things you underweighted, now you've got some excess capital. When are you going to go buy the things that you like? And you construct it that way.

Opportunistic credit is completely different. We start with nothing. It is an absolute empty box. We don't have to own anything. We don't have to own any sector. We've got capabilities that we think are likely to always be well represented within the portfolio. But to Adam's point, that first jump as I'm thinking back to the beginning of the pandemic, we ended up buying stuff that you would look at it from the outside and say, "This is never on the menu for opportunistic credit."

In that moment it was. And we had the capability to have a view and find idiosyncratic risk specifically within investment-grade corporates. Now, how could you be idiosyncratic there? We had specific names which I don't have time to go into right this second, but that we felt that if anybody was going to make it to the other side of the pandemic in reasonably good shape, they were the ones. Now the trades you could have done would have been, if you're trying to shoot the lights out and just find the best absolute return you could find, obviously buying high yield, was great.

That would have been the move. Buy the most beat-down stuff you could and just wait for the Fed to ride to the rescue. We're not going to do that. We're looking at individual line items, looking for the best risk-adjusted return that we can. So, with that as preamble, one of the things that we think about, and I think this is consistent for both private wealth and for institutions, is this a replacement for regular-way credit?

Because the volatility profile certainly is in line. The credit profile is very much in line with something you would think about like pure high yield. High yield is an asset class that lives on either side of B [the “B” credit rating]. So do we. So, it's a very nice complement in that space, in some case a replacement.

If you buy into the idea that there's going to be more differentiation in markets as we come off of ZIRP and indexing or index-like. It doesn't make as much sense. And you really want a bespoke portfolio where the focus is on the 90 to 110 best ideas from across the department of a very strong fixed income manager. That makes a fair amount of sense. I do believe, and we hear this, again mostly on the institutional side, but to an extent on the private wealth side, complement to private credit. And when I say complement, I really see it as the other side of the coin.

There's practical and philosophical reasons why it makes sense. From a philosophical standpoint, if you recognize the reason private credit exists and why it's been so successful, is because it's kind of a better mousetrap from being on bank balance sheets.

And it's a great opportunity for investors to get involved. The volatility differentiation we see in tradable credit for the reasons we talked about earlier, it's just the other side of the same story. So philosophically, it is a concept, it is a force that investors have already bought into. They don't need to be convinced.

From a practical standpoint, it works well because we can monetize the trade. And this is not a knock on private credit. By design, they're not looking to capture capital appreciation. It's not really flexible, looking to go from asset-backed to IG to high yield and so forth.

So, from a return stream standpoint, from a relevant liquidity standpoint, those practical differences make it fit rather well. And then the last one, which incidentally, Adam, we were at an event talking to institutional investors, and we had a quiet moment to actually talk, which you do get to have sometimes, and Adam's comment was, "It's nuts. We're capturing so much of the cash flow relative to equity that you have to ask the question: What's the direction of travel in people's allocations?” And you're seeing that. This has got to be a year ago, year and a half ago, that we had this discussion.

Graham: Explain that a little bit.

Fox: So just the point that if I'm looking at even a secured loan, and there was a point in time at that time it was probably like B's were giving you [a yield of] 13% or something crazy. And you had just come out of the cycle that they were very often in the fives [5%] range. It's all about who's capturing those cash flows. For a very long time, equity was capturing all those cash flows, maybe arguably more than they should have. Rates are low. So--

Graham: I see. Because rates are so low.

Fox: Yeah, it falls down the capital structure. Who does it go to? It goes to equity. That's not the case anymore. And you see that. You see that in institutional investors' allocations where they're very loaded up on equity. And it made a lot of sense in that environment.

And they kind of pared back their fixed income exposure meaningfully. And if you just ask yourself that question, "Who's capturing the value that's coming out of this structure, the value that's coming out of this company's capital structure?" The direction of travel is absolutely towards fixed income.

So, I say the preamble, and with some hesitation, there's no replacement for equity. And I'm not going to make that argument. But if you're thinking about the relative opportunity offered by the two from an asset class standpoint, is it replacement for equity? No. But is it something that you should probably be turning the dial a little bit towards? Probably yeah.

Graham: Yeah. No, that's really interesting. And I think that goes back to our first point or Adam's first points on the credit market today and just why even though spreads are relatively tight in some respects of the credit market or some aspects, there is a longer-term thesis here for credit that it should capture more value.

I thought we could end with where we are today. It's kind of where we started, but more of an outlook on economic growth, on inflation, how that might affect your views on credit.

Castle: Absolutely. I kind of call this the "Set it and forget it ‘showtime grill’ type of year." This idea that constructive higher quality portfolio or a high conviction portfolio. I would consider opportunistic credit to be very high conviction, but as you know at Lord Abbett, we have a wide range of portfolios. So, construct something that you want to hold, have a bit more risk than you think you should relative to consensus out there, and ride through volatility, use mean reversion to your advantage.

I do not think that this is a time for true late-cycle behavior where you want to sell every chance you get, get closer to home. I think that would be a mistake. Some examples: There's clear examples of reflationary forces presenting themselves. You have a Fed that has pivoted. No, they haven't cut [rates] yet, but they have verbalized to the market a willingness to cut and if anything, a tolerance for the data running a little bit hot without any more hikes. So the patience level that they're exhibiting is higher than I think the market thought six months ago.

The [U.S.] household looks good. I won't say they look great. But there's a lot more good than bad. Consumer credit, yes, it's expanded. But it is actually still quite healthy in terms of low [percentages] relative to GDP, relative to income.

Credit looks actually quite good. Leverage looks good too. Household leverage is very depressed. The labor market continues to hum along. Real [inflation-adjusted] wages are actually growing at a very nice clip right now. That's thanks to the kind of relaxation of inflation that we've seen. So, you are seeing top-line labor, or I should say, wage growth.

Now there are some negatives. Default rates on consumer assets have ticked up a bit. I'd say they're higher than what we would have expected based on the health of the labor market. That's something to watch out for closely. But it speaks to the opening comment, which is high conviction or high quality, and use mean reversion to your advantage, take profits when the markets give you those windows, buy the dip effectively, to use a trite phrase, when the market provides you with that.

I'm not necessarily saying that that's a “soft landing.” I think it's actually more a case for the Fed walking the markets towards having a little bit higher level of interest rates for longer and a higher level of inflation for longer. That's why I say reflationary. And you do see whether that's kind of down-in-quality credit. The capital markets are wide open right now for a lot of that and other examples.

Graham: I see. No, that's interesting. So it's soft-ish landing to more of the no landing sort of reflationary--

Castle: Absolutely--

Graham: --scenario. And that's one thing just to comment on that. I think credit, people don't think about this enough that it actually does pretty well in an environment like that because the real value of indebtedness is going down. And so to the extent you have pricing power and can earn more because of that pricing power, your debt is get smaller and smaller in real terms.

And we certainly saw that over '22 and '23 that credit did well while other assets, in some cases in '22, did poorly, in '23 did better. But credit just sort of plugged along.

So thank you both for joining. I thought it was a really interesting conversation. So thank you for that.

And for listeners wanting to learn more about Lord Abbett's views on the markets, please visit the Insights section of Lordabbett.com. We actually have an article on opportunistic credit that touches on a lot of what we discussed here today. Andy Fox wrote it. Please check that out, also on our website. And we have a series of monthly videos on our opportunistic credit strategies.

And lastly, we'd also like to hear from our listeners. So if you have any comments about today's podcast or ideas for future podcasts, we welcome your thoughts. Please email podcasts@lordabbett.com.

And so we'll leave it there. This has been the Active Investor Podcast. And thank you for listening.