February 13, 2025 • 40 mins
Goldman Sachs is advising credit investors to protect against losses amid expensive valuations and rising geopolitical turmoil. “The cost of hedging is the lowest it’s been in probably a very long time — use that to your advantage,” said Lotfi Karoui, the firm’s chief credit strategist. “Look at that left tail of the distribution — the known unknowns, the unknown unknowns, the things that can take you off guard,” he tells Bloomberg News’ James Crombie and Bloomberg Intelligence’s Robert Schiffman, in the latest Credit Edge podcast. Despite this, Goldman is positive on the corporate debt market outlook, given very strong demand for limited supply, and sees opportunities at the single name level. Karoui and Schiffman also discuss “absolutely remarkable” value in mortgage-backed securities, the default rate, private market relative value, downgrade risk from a forecast pick up in dealmaking and European bond opportunities.
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Episode Transcript
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Speaker 1 (00:17):
Hello, and welcome to The Credit Edge, a weekly markets podcast.
My name is James Crombie. I'm a senior editor at Bloomberg.
Speaker 2 (00:23):
And I'm Rob Schiffman, senior credit analyst covering global technology
for Bloomberg Intelligence, who also luckily gets to co leader
are US High Grade and High Yield research teams. This
week's we're very pleased to welcome Lotfeekuwe, chief credit strategist
at Goldman Sachs.
Speaker 3 (00:40):
How are you, Lotfe I'm doing all right, Thank you
for having me awesome.
Speaker 2 (00:43):
Great to see you.
Speaker 1 (00:44):
Likewise, thanks so much joining us today. We're very excited
to grill you on all things credit, mortgages and structure products.
But just before we do, to set the scene, markets
have been whip swored by trade wars that will probably
fuel inflation and could also dent US growth. Both would
be quite bad for credit. Yeah, corporate bonds and loans
remained priced for perfection after getting squeezed a lot last year.
(01:04):
Debt spreads are pretty close to where they were in
two thousand and seven, just before the global financial crisis
blew everything up. If you only looked at credit market pricing,
you'd think the world was a very peaceful, calm place
right now, But the news headlines would suggest otherwise. There's
a lot of complacency out there. But I also think
that the very strong investor demand for bonds and loans
and then not a lot of net new supply is
(01:26):
actually keeping things artificially tight at the moment. So let's
start there a lot for what's your take. Should we
worry more about the trade war? Is it just an
equity markets story and our credit market's right to be
so calm?
Speaker 3 (01:37):
Well, I would say a couple of things. Number one,
I think you know, the resilience has been a common
theme across all markets, not just credit, and so the
headlines have notably intensified the last two weeks. And yet
if you look across the board equities facts, maybe raids
is somewhat the exception, and certainly credit have been very
very resilient. There is a few reasons for that. Look
(01:58):
you know, ultimately, and I think you you've introduced it
very well. You know, terriffs have macro implications, they have
micro implications. But on the macro side, everyone agrees that
it's a short term booster inflation and a long term
or medium term drag to growth. Markets can price that
a little bit, unless you know, you kind of take
things to extreme levels. At the micro level, they are
(02:21):
hit to earnings, right, and this is why you've seen
a stronger response on the equity side relative to credit.
How much of a hit are you going to get.
Let's assume it's a couple points of a drag on
earnings growth. That actually shouldn't move your credit metrics that much.
You know, when you think about interest coverage ratios or
net or gross leverage all a sequel, they could deteriorate
(02:43):
a little bit, but the magnitude of the deterioration I
think is not big enough to move spreads at least
in aggregate. Now, where you could see an impact is
really in terms of dispersion, both between sectors and particularly
within sectors. There's a lot of companies that have greater
exposure to tear as you know, take Canada as a
great example of Mexico is another good one. And so
(03:05):
we would view it as if it persists, and that's
a big if, as a potential driver of dispersion rather
than a driver or the absolute direction of the market.
Speaker 2 (03:15):
Well, what do you think we need to break out
of this resilient range. I mean, in my world, we
saw a deep seek. It had a big impact for
the first couple of days, inequities and spreads didn't basically
move at all, and we've sort of poo pooed it
with a lot of other people as well. But I
do get weary with tariffs. It seems to have a
(03:36):
much larger, bigger macro drag. So what's that headline we
have to be looking out for? And maybe with this
Trump administration, you know, people just look through almost all
the headlines, But where do you see that resilience starting
to break down?
Speaker 3 (03:52):
A couple of things. Look Number one, I think in
and of itself, you know, as frustrating as it can be,
but expensive valuations isn't a reason to be negative on
the market. And in fact, if you've been trading valuations
for the last four to five quarters, it's been a
terrible strategy. And so if you go back forty years,
there's been plenty of examples where you can stay within
a very tight range for quite some time without having
(04:14):
any repricing of risk premium. And so ultimately, to answer
your question, something needs to break, either a supply demand
and balance where you're just bringing too much supply to
the market and demand cannot keep up with that, or
signs of a rapid deterioration in the cycle called outlook
i e. Evidence that recession risk has gone up. We're
not there right now, right And so back to tariffs again,
(04:38):
I think it would probably take lingering headlines and growing
concerns among market participants that these terroriorts are permanent and
they're essentially impairing the ability of CFOs corporate treasurers CEOs
investors to make capital allocation decisions. It can happen, but
it's a high bar at the moment.
Speaker 2 (05:00):
Dig more into tariffs and specific bottoms up analysis, But
you know, I've seen you use words like uninspiring spreads
or valuation conundrum. So this whole concept of resiliency looking
through not just tariffs but credit valuations, what has to
(05:22):
happen for that to break out? Like we're we're at
near historical tights. I know, yields in particular end up
making you know, high yield and left loons a little
bit more attractive. But like, what gets us out of
this Goldilock scenario?
Speaker 3 (05:37):
Well, I think one of the primary drivers of that
resilience and to your point is the strength of demand technicals.
But you know, fixed income, not just credit has income again, right,
and the last time that happened was about twenty years ago,
And so yes, spreads are tight. Yes, valuation is uninspiring
(05:58):
if you're a spread investor, If you're a total turn
investor and care about the all in yield, it's not
that bad. You know how IG has an average yield
of five and a quarter to five and a half percent.
High yield is around seven and a quarter to seven
and a half percent. That's a pretty decent value proposition
in a world where actually, you know, the fault risk
(06:19):
will likely remain on the benign side. So that's number one.
Number two, expensive valuation isn't really a problem for just
credit as an assea class. I mean, on some estimates
you have thirty five percent of the SMP five hundred
that has a negative equity respirace. I mean that is
a valuation conundrum in and of itself. Now, the difference
(06:39):
I guess between credit and equities is that the equity
market can overshoot valuation constraints quite some time. In credit,
you have a natural lower bound, like you can't go
below a certain level, and in fact, that was very
surprised after the election by the number of conversations I
had with investors implying that you can overshoot basically historical valuations,
(07:01):
that you can have even IG spreads go negative on
some high quality parts of the market. I disagree with that,
but you know, it felt a little bit of evaluation frenzy.
I think back in November, we've corrected some of it,
and so the point is, you know, something has to break,
either in terms of fundamentals or technicals, and at the moment,
(07:22):
I would say strong demand technicals have the upper hand
in credit, There's no question about it. By the way,
you also see it in the flow data. That's probably
the most real time indicator you can look at. But
week after week, new money keeps going into the asset
class across the board, you know, leverage, loans, high yields
IG and then I guess the last shift that's been happening,
(07:42):
and I think it's one that's a little bit underappreciated
by people. If you take a step back and think
about this sort of transition to higher cost of funding environment.
You know, some people have been concerned about what that
means for credit quality. But the flip side of that
is that for credit portfolios, it's been increased the amount
of coupon payments over time, and that's capital that's on
(08:03):
autopilot mode, and it's capital that acts as a self
stabilizing mechanism. Basically, there's a reason why every time you
widen a little bit by three, four or five basis wants,
the market buys the dip immedity, and the reason is
that you have that embedded d eye power in portfolios
that is there ready to be deployed as soon as
you have these sort of temporary episodes of lightning.
Speaker 2 (08:24):
Got you? I'll let James jump into just one second.
But if you're basically arguing that we're in just a
carry environment with low volatility, it argues you move down
the credit curve. I guess that's your preference for left
loans over high yield. But where does everyone go wrong?
(08:44):
Like if it seems like that's obviously consensus, what has
to happen? Like what what are those those tails? What
are the black swans?
Speaker 3 (08:55):
Like?
Speaker 2 (08:55):
When?
Speaker 3 (08:56):
When? When? When? When?
Speaker 2 (08:57):
You when you go to bed at night and you're
where could I have messed this one up? That's what
I think we're all sort of looking for we see
these headlines, we see one or two days of all,
but then it sort of goes away like are we
just so strong? Are technicals and fundamentals so strong that
just really realistically doesn't happen.
Speaker 3 (09:14):
So I wouldn't get complacent, obviously, but I think those
headlines tell you something, which is the distribution of risks
is a lot more two sided that many have thought
going into the year. And so yes, we do have
faith in sort of a scary view and force cognizant
of the fact that valuations are a lot more expensive,
spreads are tighter. So whatever excess return to treasure is
(09:35):
you got to generate, it will feel mechanically lower than
twenty twenty four, and for sure twenty twenty three. But
we'll also be advocating to spend money on hedges. You know,
just take look at that left tail of the distribution,
the non unknowns, the unknown unknowns, the things that can
sort of take you off guard a little bit. But
you know, people can plain all the time about tight spreads,
(09:58):
but vall is very low. Actually, the cost of hedging
is the lowest it's been in probably a very fantastic point,
use that to your advanders, spend spend some money on
hedges and wait for better days, you know, wait for
that valuation reset and kind of revisit the pieces.
Speaker 2 (10:14):
What products are you using for those?
Speaker 3 (10:15):
Ce the xig cd X high yield, but macro products
in general very liquid, very liquid, I mean dogfs too,
although there's a rates component into that. But yeah, there's
a wide range of hedging solutions actually that are available
to investors.
Speaker 2 (10:31):
Gotcha.
Speaker 1 (10:32):
The low hanging fruit for a lot of our guests
at the moment is the private side of the market.
Everyone loves to talk about private debt and a lot
of people still see a lot of relative value there
versus public I know it's kind of hard to do
apples to apples comparisons between the two. But what's your
view right now of the value that you know people
are talking about in private and how does it compare.
Speaker 3 (10:52):
Well, it depends what parts of private credit are we
talking about, I mean, to your point, you know, people
generally think of relative value comparisons in turn a direct
lending versus broadlystnigated loan market or the high yelt bond market,
if you take you know, proxies for private credit like
BDCs or mental market clos They will tell you that
that excess premium that you're getting by shifting from public
(11:14):
to private is at the very tight end of the
historical range. And yet if you look at capital formation
on the private side, I think twenty twenty four is
actually going to end very close to the record that
we had in twenty twenty one. So how do you
reconcile the two? You know, how come more capital is
being deployed into you know, private credit even though that
(11:36):
excess premium has actually compressed. I think part of the
reason is that most you know, investors don't look at
the excess premium only there's something else there's, you know,
and that is really the ability of private credit to
deliver better risk adjusted returns or better sharp ratios relative
to public credit. And I think that's the biggest driver
(11:57):
of investor demand because and the REA and I think
that is that if you look at the ownership structure
of private credit, like who owns you know, who's the
the ultimate user of private credit? It's generally liquidity agnostic investors,
insurance companies, endowments, family offices, pension plans. Investors that don't
(12:18):
necessarily need the liquidity that you know, public markets you
know give them. And so we can debate on the
calculation of sharp rations public versus private, the fact that
you know there's no more tomorrow or there's only quarterly
marks on the public on the private side relative to
the public side. Those are all, you know, legitimate arguments.
(12:38):
But at the end of the day, what those investors
are trying to solve for is, you know, the best
sharp and the fact is, you can go back ten
fifteen years, private credit delivers better sharp rations than than
than public credit. That's just the story. So that's number one.
I think the other insting shift is really the change
in the structure of private credit, where we're seeing continued
(13:00):
overlap between private and public credit. But you go back
only five years ago and the bread and butter of
direct lending was really middle market companies. I mean, the
birth of the asset class was primarily driven by the
fact that the banks actually can't do leverage lending anymore.
But that has changed quite a lot. Actually the last
five years. What we've seen is a toronative asset managers
(13:22):
increasingly I don't like the word competing, but providing the
type of capital solutions that actually the bloadly syndicated loan
market or the high bond market would provide that overlap.
I think will continue to grow in my view, not
least because capital is being concentrated among larger firms and
so the depth of financing of direct lending funds, you know,
(13:45):
has improved and it will remain that way.
Speaker 2 (13:48):
Does it feel like private credit could end up being
the first domino in a market falling down that it's
a little opaque, We're not really sure what's behind the curtain,
and you know, maybe there's some sort of like cre
exposure or even in the world I mentioned deepseek before.
You know, is there so much money out there that's
(14:08):
been propping up data centers that all of a sudden,
one shoe falls and then whoa lo and behold, it's
not as strong as we thought. Our private credit BDC
analyst Dave Havens talks about that space like I talk
about double A rated Amazon, Alphabet Apple, and it's just
(14:29):
not the same. So I just I'm just wondering, like,
are we is anyone missing anything here or is it
just really as good.
Speaker 3 (14:35):
As he looks? Great points, but I think it's important
to frame the risks, Like if we're talking about garden
variety default cycle type of risks, then absolutely, I think
private credit, just like broadly stigated loan market or the
high end bond market, will at some point experience a
(14:55):
full blown default cycle. And I think we'll test a
number of things, the ability of managers to kind of
you know, work through a wave of the faults, et cetera.
So that will happen at some point, and my best
guess is that it will happen when the business cycle
its self inflex the fact that you can go back
forty years, you know, the faults generally increase when the
(15:16):
economy goes into recession. There's a handful of exceptions. You know,
twenty fourteen fifteen is a good one. You had a
big sector story, But in general it takes a recession
to test that, and we will test it for private credit. Now,
private credit as a threat to financial stability, which is
a concern that you hear all the time. I have
been pushing back against that quite a lot, because if
(15:37):
you think about the two channels that can make losses
on any portfolio, whether it's a credit portfolio or something else,
make those losses painful to the system, it's leverage or
maturity mismatches. And if you look at direct lending, you
don't see any I mean, I'm sure you're calling your discoverage. Yeah,
who covers BDCs told you that there are legal limits
(15:59):
on leverage one and a half to two x, and
actually most BDCs never exceed that, and so it's not
a levered asset loss. The LPs or the investors are
not leveraged. So I do struggle a little bit to
see a channel that amplifies losses. And then and then
kind of, you know, make them a catalyst for you know,
some stress, and either in the financial system or in
(16:21):
the banking system, it's just not there to me. If anything,
it's as plain venolla as it can get. You got
the LP, you got the GP, and then the borrowers
in the middle, but none of them are levered other
than the borrower. And then the asset class itself is
also too small. We're going to have to put things
in context a little bit, because if you add up
all the subcategories of private credit, you get one point
(16:42):
seven trillion, maybe two trillion, of which a good thread
is actually dry powder. So the capital that is deployed
is actually much less than that. Okay, well, let's suppose
you have an annual loss rate of ten percent that
is non leveraged. Those are no you know, those losses
are not leverage, and so I don't think they will
trigger I mean the S and P five and it
loses that every day and it doesn't do anything to
(17:04):
the system, and so I think we have to keep
that in context. It would have been problematic if there
was a lot more leverage deployed behind it, which was
kind of the story in the run up to the
global financial crisis.
Speaker 1 (17:16):
Got you interested in what you were saying about the maturity,
You will love the You know, we have spent a
lot of time worrying about it on this show. Companies
did borrow a lot of money when rates were zero,
and you know, there is a there is a wall
of high yield and leverage loans coming up. Funding costs
is substantially higher than where they were triple in some cases.
(17:36):
So why why shouldn't we worry about it?
Speaker 3 (17:38):
I think there's a discussion about aggregate levels and a
discussion about idiosyncratic situation. There's no question that there's multiple
idiot psychotic syncratic situations particularly in Europe, by the way,
where the economics of refinancing isn't compelling. Basically, if you
refinance existing debt today, you'd have to point sometimes triple
the cost of that debt. But in agrig I think
(18:01):
we've made some pretty decent progress actually the last year
and a half. But I'll give you a couple of stats.
If you look at the share of the high bond
market that is maturing over the next two years, it's
eight percent of the total outstanding, and so there's no
issue in terms of the quantity for the lack of
the better word, the quantity of credit that needs to
be rolled over over the next two years. Now, the
(18:21):
second stat that I would give is your marginal cost
of refinancing. You know that that extra cost that you
pay to replace old debt that you issued back in
twenty twenty, twenty one, twenty two with new debt today,
that has also compressed dramatic. I mean, the flip side
of tight spreads is that it gives a lot of
flexibility to borrowers. But in aggregate that cost is around
(18:45):
a point and a half today, It's not nothing, But
if you were to refinance that ten percent, that is
coming due in the next two years. That means that
you pay in ten percent times a point and a half,
which is fifteen basis points of extra interest expense. When
you scale that by the average coupon, it's a couple
of points of increase in interest expense on a percentage basis,
(19:08):
And so you still have to pay more, but I
think you've reached a stage in which that marginal cost
of refinancing is now a lot more easily absorbable by
earnings growth, because there's assets, there's liabilities. Yes, you pay more,
but you're also growing your assets, you're growing your earning.
So in aggregate, I would say the transition to higher
funding costs, which is sort of a catchy sentence that
(19:29):
everyone is using, I think that transition has been completed,
except for maybe the lower end of the quality spectrum
in Europe, where refinancing costs is still way too high.
And I think that means that you need to address
basically refinancing needs via restructurings in the faults.
Speaker 1 (19:45):
And those companies not just in Europe but in the
US and elsewhere are also doing a so called liability
management exercises. You know you mentioned you got to add
sort of shale anden list to your list of skills
in twenty sixteen, But do you have to add legal
skills now because it's so complicated. It's you know that
the documents, the documents are so difficult to understand, and
everyone's getting, you know, in trouble with that.
Speaker 3 (20:08):
Yeah, yeah, I mean, look, I mean you're right, lemies
or I call them distressing changes, because I think that's
a better way to describe it. But you know, that
has accounted for the bulk of the faults, and it's interesting,
it's been one of the reasons why people disagree with
respect to the actual level of the faults, because some
people include them on the don't and so. But the
bottom line, if you take the broadly saying you gated
(20:30):
loan market and include distress exchanges, we actually and you
look at things on a twelve month trailing basis, we're
above eight percent, which is a pretty elevated level. Is
that for high bones, that's for loans, for bonds, it's
been it's been a lot lower than that. And the
reason is quite simple. The liability are floating. If you're
you know, in the loan market, they're fixed rate on
(20:51):
the bond side, and so the transition to a higher
cost of funding environment has been a lot tougher. Uh,
you know, for those liabilities that are that are flowed.
The other dynamic I think that is very important for
those lmes is that they've been entirely concentrated amongst small
issuers too, so size mattered quite a lot. I mean,
it is true that this has been the most aggressive
(21:14):
or it was the most aggressive and the most front
loaded hiking cycle since pretty much the start of the
Great Moderation, but it weighed heavily on small companies. And
if you looked at the Dotter weighted the faught rate
versus the issue weighted the fault rate, you get a
dramatically different answer. Actually, the dotterweight of default rate has
been remarkably benign for the last two years. And so,
(21:35):
you know, I get people sometimes asking me like, how
come high yield spreads are at sixty or two seventy
and then the headline the fault rate is at six
or eight percent, And I'm like, there's a reason for
that is because those defaults didn't matter that much for
the index. You know, they weight in the indexes is
so small that they haven't really been a drag on performance.
Speaker 2 (21:56):
Where do you think we need all in yields to
be to see a significant an uptick in M and
A or leverage transactions? You would think that with so
much capital available, we would have already seen more.
Speaker 3 (22:10):
I think there's two dynamics up, So I would distinguish
IG from IG from high yield. Sorry, I think in
IG were there already. I think most CFOs and corporate
treasurers have sort of re anchored their long run expectations
for the level of tenure yields. But you know, a
year and a half ago, four and a half cent
on tenure would have been viewed as problematic. It's not anymore.
(22:32):
I think everyone has a much better understanding that, you
know what, it's actually that period from twenty ten to
twenty nineteen that was the anomaly. Were corrected that anomaly,
and we're kind of back to levels that are more
on line with the reality of the cycle. So I
think there's broader acceptance of funding costs. And then I
think the other big shift is CEO confidence. I mean,
if you look at confidence, it basically rebounded quite sharply,
(22:56):
and a lot of that is a reflection of just
a broader you know acknowledgment that this is a soft
landing and that you know, this is not sort of
your usual business cycle a little bit. So I think
you will see more of it, you know, in twenty
twenty five for sure. Now the question for US and
credit is what does that mean for bond holders? Does
(23:16):
that bring new risks? Because typically you know, if you
see you know, a reacceleration in M and A activities,
some of that is funded into credit markets. I think
for the high end of the quality spectrum in IG
where you have debt capacity, sure you know you'll see
more you know, M and A related debt this year,
certainly relative to last year, but also you know, you
(23:38):
know twenty twenty three, but only I think in the
high in the high end of the quality spectrum. I
think for the triple B space, which is still roughly
half of IGH, the incentives are to continue to act
a bit more conservatively.
Speaker 2 (23:52):
So if I could try to squeeze some details out
of you, which sectors do you think offer the best
value and the least value and are those calls more
of you know, near term we're playing off of tariffs,
or they do they have longer term sort of trends
to them.
Speaker 3 (24:11):
So before that, one big caveat which is we talked
a lot about valuations, We talked about dispersion. I think
the other challenge that a lot of people are facing
is that the left tail went from over sold about
a year and a half ago to overbought today. So
I'll give you two into three.
Speaker 1 (24:28):
Before you too, I just want you to explain to
our listeners what is left tail? What do you mean
by that?
Speaker 3 (24:32):
Yeah, it's basically the price or the premium that you
demand against a state of the world in which things
go horribly wrong. And so I'll give you two examples.
You know, the aftermath of the regional banking crisis in
March of twenty twenty three, the big concern was that
this would morph into a full blow financial crisis, and
that basically losses in the cre market would you know,
(24:55):
put bank's balance sheets under a lot of pressure. As
a result of that, banks traded at a pretty sick
discount relative to non financials. That discount has gone today,
and in fact, banks had a terrific twenty twenty four
and that left dai of risk premium is gone. One
other example, I would give you triple c's. You know,
up until October of twenty twenty four, the triple C
(25:18):
market was actually offering you a pretty decent premium. Why
because there was this widespread view among you know, a
lot of market participants that monetary policy would kind of
act with a lag a little bit, and that lag
is like a year to a year and a half. Actually,
we realized that that lag is a lot shorter, and
so you've had a big compression of premiums. So the
(25:38):
setup is a lot more challenging, not just at the
index level, but also you know, also thematically. So that
was a long intro, but I'll give you the answer.
So what do I like? Look, if you stick to
the high quality parts of the market, we like agency
mortgages more than IG. Now, it's what I find remarkable
(25:59):
with mortgages is that if you look at, you know,
the excess spread that you're getting in agency mortgage is
relative to IG, it's about forty to forty five basis points,
which is absolutely remarkable if you take into account the
fact that agency mortgages have no credit risk, and so
you have an asset class that has zero credit risk,
and yet it's paying you forty to forty five basis
(26:20):
points more on than IG. Now, of course, there are
reasons why that's the case. I think the biggest one
is that mortgages had benefited for many years from a
generous subsidy VIAQE and the fact that the FED was
deploying its bowel sheet. So essentially the market lost a large,
indiscriminate buyer and it's been having a tough time kind
of replacing that bit and attracting new sources of demand.
(26:42):
But as a value investor, you should look at that.
You're better off in my view, if you have like
a two year horizon or one year horizon investing in mortgages.
If you go down you know the quality spectrum. Yeah,
you mentioned loans versus bonds. We like loans because you know,
there's a bit of excess carry there and you know,
the supply dynamic or the supply demand dynamic, seems a
(27:03):
bit more compelling than in the bond market. In fact,
that's supply and the loan market is negative, so it's
a market that's shrinking, which is good actually if you're
trading this stuff on the secondary side. Europe versus US
we didn't talk about it, but that's also an interesting,
you know, relative value view. I think it's an understatement
to say that sentiment visa of Europe has been negative.
(27:27):
But we have been pushing back against the idea to
use credits as a proxy to express some kind of
a US exceptionalism view or US growth at performance view
for really two reasons. One, you know, European credit is
actually a lot less cyclical than most people think. It
doesn't media respond to sort of the EBBZEM flows in
(27:49):
the business cycle. Number two, the flip side of growth
weakness is that it gives the ECB more degrees of
freedom to actually ease and go a little faster than
the FED and so on, And that it's unclear to
me that the interaction between growth and policy is that
better in the US relative to Europe. And then I
think valuation constraints are also a lot more binding in
(28:10):
the ustern Europe. So I've always thought the growth divergent
theme was more of a rates effects story than a
credit story.
Speaker 1 (28:18):
On mortgages, Any May and Freddie mac could be privatized.
Does that note make spreads blow out?
Speaker 3 (28:24):
It depends how they are privatized. First of all, the
path that gets you there is uncertain and sort of
quite complicated. But let's assume, you know, we're having this
conversation with with with the gcs sort of standalone private entities,
if you turn them, you know, into sort of monoligne
companies that ensure and buy mortgages, and if they are
(28:47):
properly capitalized, so their cost of funding will probably go
up and go up by twenty thirty basis points. Some
of that will be passed on to mortgage investors, but
we estimate that pass through is probably all let's equal
emphasis is on all l SQL, uh, you know, is
around five to seven basis points, so not that much,
but there's obviously lots of moving parts in there. I
(29:09):
think the other shift that could happen is that obviously
even double A spreads move a lot over time, and
so that could introduce, you know, some some volatility and
agency mortgage spreads on a FOURD basis. But again there's
a lot of moving parts here, and I think it's
still very early. Okay.
Speaker 1 (29:25):
Also, the FED is scaling back to the banks step
in at this point to prop out that demand.
Speaker 3 (29:31):
Potentially, yes, and in fact, actually if you look at
bank demand, you know, for agency mortgages, over the last
three to four months. It's it's back into positive territory
on a net basis. But banks actually could be that
marginal source of demand that kind of flips the you know,
the balance a little bit in favor of mortgages relative to.
Speaker 1 (29:49):
Ig are they also less sensitive to the tariff and
trade war?
Speaker 3 (29:53):
And I mean it's it's sort of a low beta
you know, lassa class at least relative to growth.
Speaker 1 (29:58):
Absolutely.
Speaker 3 (29:59):
Yeah.
Speaker 1 (30:00):
Also one on Europe. I mean what do you mean
by Europe? Because it is, you know, a large continent,
many different countries, and is it not the one that's
you know, next most exposed to the trade will you know,
we're talking about tariffs and all sorts of things today
from the EU and the tit for tat and could
get a lot worse. Does that not change your assumptions
in terms of investing in European credit?
Speaker 3 (30:20):
I think that will weigh a lot more on the
equity market again, you know, you you sort of have
to take a capital structure of you and autos, by
the way, is a great example. You know, if you
look at the performance of the European auto sector last year, inequities,
it's been terrible Basically, if you look at the euro
ig auto sector, you see a little bit of widening,
but in the grand scheme of things, you know, it's
(30:42):
nothing right next to the underperformance of the equity market.
And so so that's one number two. We talked about
M and A earlier. I think Europe is a little
bit behind on the M and A cycle, But that's
actually a good thing if you're a bondholder. That just
means that most companies are still incentivized to manage capital concernedly.
And so I think there's to be less idiosyncratic noise
(31:02):
in Europe relative to the US too. And so the
bottom line is that, yes, there's no question that terraffs
would weigh more heavily on Europe. There's, by the way,
there's teriffs per se, and there's the uncertainty that the
terrifts created too, and that weighs more heavily on Europe
relative to the US. But I tend to think that,
you know, that's mostly an equity story.
Speaker 1 (31:21):
And the M and A in the US that you
are talking about potentially, you know, a large amount in
the single A tier. Does that push downgrades in in
I G for.
Speaker 3 (31:31):
Those companies that have a you know, a tolerance for
one or two notches of downgrade. Sure, yeah, I mean
that's sort of the typical playbook. And you know, in
the cycle now, it'll be interesting to see whether the
rating agencies will sort of have the tolerance that they had,
you know, back in fifteen, sixteen, seventeen, you know, by
alogue sort of these mega deals and you know, these
(31:54):
temporary deviations from you know, standard credit metrics. That will
be interesting to watch. But yeah, I mean you certainly
have det capacity in that similar space.
Speaker 2 (32:03):
So what are some of your red flags? I know
I can understand your comfort level, but is there a country,
a company, a sector, a segment that you really want
to stay away from?
Speaker 3 (32:18):
I think, look, if you asked me what's the biggest
risk basically to credit and to fix income more generally,
I would start with the following observation, which is, if
you go back to the start of the hiking cycle
in the US and look at how companies have responded
to that in terms of capital management, most companies have
been incredibly disciplined basically in terms of managing their capital.
(32:42):
You know, they issued a lot of debt in twenty
twenty and twenty twenty one materially strengthened their liquidity positions
that allowed them to be very patient in twenty twenty
two and twenty twenty three. I mean, look at you know,
how you'd issue volumes, and there's a reason why they
went down dramatically. It is because most companies didn't need
to issue they had that castional balance sheet. So the
reason I'm mentioning that is that I think unlike twenty
(33:04):
seventeen twenty eighteen, where credit was sort of viewed as
a as a as a pocket of vulnerability, you know,
in general, because of the growth of triple bs and
the floth and the late and the loan market, etcetera,
I think this feels very different, and so I think
the risk of an indulgenous shock in credit is substantially
lower today than it was, you know, seven eight years ago.
(33:26):
What I would worry about is really public balance sheets,
because you know, public balance sheets have not been managed conservative,
you know, the last you know, five to six years.
You know, concerns over debt sustainability would be my number
one risk, you know, but it's not something that is
indigenous to credit. It would be more of an exogenous shock.
(33:49):
But you know, deficits are large across the board and
at some point you need to sort of take care
of it.
Speaker 1 (33:55):
Is that more of the sovereign leveryly you're talking about
states and.
Speaker 3 (33:57):
Unis, that's more of a sovereign conversation. I mean, we
had a bit of a of a of a test
last year with France and by the way, you know,
FRENCHI A tea spreads are still sort of close to
that that that seventy seventy five percent, you know, a
seventy five basis point range, and so that excess premium
has has not gone away, it's still there.
Speaker 2 (34:17):
So what's the next group of mag seven? What's the
next in Nvidia? We're all missing this massive upside in
this lackluster sort of environment.
Speaker 3 (34:29):
Well, in credit, there's there's no convection basically most of
that unfortunately goes to goes to the equity market. So
you know, you can grow your market cap dramatically if
you grow your market cap and credit that's a problem.
By the way, and if we have a max seven
in credit, you know, with that level of concentration, I
would view that as as an issue. That just means
you have a group of seven companies that are over leverage,
(34:51):
and so that would that wouldn't be you know, that
wouldn't be a good thing. Look, I think if you know,
if there's innovation, if there's R and D, if there's
something like you know that that just creates a lot
of value, most of that value will go to equity investors.
Speaker 2 (35:05):
Yeah, the typical life of the credit person exactly, no
reward at all, risk exactly.
Speaker 1 (35:11):
Do you see anything on the horizon that might change
the supply demand imbalance I'm thinking of on the on
the supply side potentially M and A and on the
demand side, is there any hint that foreign demand might
slip off? Yeah, for US credit.
Speaker 3 (35:24):
So as you may remember, but soon of the consensus
going into twenty twenty four was that foreign demand will
weaken quite dramatic, and the narrative typically, you know, was
along the lines of funding and hedging in the dallar
market is too expensive and that will sort of destroy
you know, for you know, some some foreign demand. In hindsight,
it hasn't happened. And so I think what a lot
(35:47):
of folks missed is that there's a big chunk of
that foreign demand that is unhudged. But if you look
at the Treasury take data for example, tells you that
twenty twenty four is on track for being the strongest
year ever for foreign demand. I don't think that will change.
I think a portunistic foreign demand out of Europe, for example,
could weaken a little bit, just because the euromarket offers
(36:08):
domestic investors with a pretty decent level of yield support.
But when you think about Asia, when you think about Japan,
you know, these like big jurisdictions that are you know,
big bars of credit and fixed income. More generally, I
think foreign demand will likely remain there.
Speaker 1 (36:25):
When you're talking to these foreign clients, you don't have
to name them obviously, but what are the questions they're
asking you about US credit right now? What are the
things that really, you know, they want to know.
Speaker 3 (36:34):
I think in general that sustainability is a topic that
comes out all the time. It's media a rate story,
not not so much of a of a credit story.
And then I guess you have a topic of conversation
that we talk about all the time. Is really the
growth of private credit and how to deploy capital there.
That's sort of the next you know, growth engine of portfolios.
But most clients are laser focused on private credit, not
(36:57):
just direct lending, by the way, but even I you
know i G product credit, whether it's asset back finance
or or some of the you know, direct lending deals
that we've seen in the i G mark.
Speaker 1 (37:06):
And in terms of one thing relative value anywhere in
the world, what would you put your finger on, what's
your edge right now? Where where's the where's the best
relative value?
Speaker 3 (37:15):
Yeah, so we started the conversation with Terraffs. Actually the
one place where you know, there's been evidence of a
tariffspreium is actually lat time credit where you could you
could we we at some point we had the lattime
IG index trading wider than the WUS and excess. So
that's a good example of some convexity that kind of
built up. These are really you know, good quality companies
(37:37):
in general that have you know, daughter denominated doinal sheets
for the most part. So I would look at that
a bit more, you know, as a as a pocket
of upside potentially talked about mortgages, you know, I like that,
you know, among high quality products and then within sort
of you know, some of the more niche asset classes.
We still see value in CMBs. Obviously, we loved it
(37:59):
eighteen months ago, when you know new issue triple B
minus CMBs staunchers were coming in at nine hundred basis points.
The easy money has been made, so to speak, and
so it's more labor intensive, but in relative terms, there's
still value in CMBs.
Speaker 1 (38:15):
And that gap on the mortgage side. Do you think
that closes this year the forty basis point at least slow?
Speaker 3 (38:21):
I think, you know, maybe half of it closes this year,
but it's it's a slow one. I mean. The other
drag on performance, by the way, is rates volatility. You know,
and there's lots of reasons to think that that that
speed of mean reversion in rates volatility is going to
be a little slower than most people thought.
Speaker 1 (38:37):
And if rates go slightly high, let's say people talking
about five percent, now, does that make things.
Speaker 3 (38:40):
Cry they go higher? You know, the drivers of the
backup and rates always matter more than the backup itself.
And so if they go higher because growth is stronger,
or in general, because that interaction between growth and inflation
is still friendly, I don't think that's a problem. If
they go up, because you know, there's evidence of inflation reacceleration.
(39:01):
That's a bigger problem. I mean that creates you know,
all sorts of issues because you got a pressure margins
and so bad for fundamentals. And you also you know,
could bring back, you know, the correlation between rates and
spreads into positive territory. I mean, twenty twenty three was
a painful year because you had that double wheremie of
higher spreads, wider spread, higher rates, wider spreads. And the
(39:23):
reason you had that is because the move higher and
rates wasn't entirely driven by you know, inflation premium. If
we go back to that sort of regime, I think
it would be problematic. I think the odds are low.
Speaker 1 (39:33):
Great stuff, Lot Fee Career, Chief Credit Strategists at Goldman Sex.
It's been a pleasure having you on the credit edge money.
Speaker 3 (39:39):
Thanks thanks for having me, and.
Speaker 1 (39:40):
Of course we're very grateful to rub Shiftman from Bloomberg Intelligence.
Thanks for joining us.
Speaker 2 (39:44):
Today Web Thanks so much, James for more.
Speaker 1 (39:46):
Credit analysis read all of rub Shiftman's great work on
the Bloomberg terminal. Bloomberg Intelligence is part of our research department,
with five hundred analysts and strategists working across all markets.
Coverage includes over two thousand equities and credits, and outlooks
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(40:07):
all other good podcast providers. Give us a review, tell
your friends, or email. Meet directly at jcrombieight at Bloomberg
dot net. I'm James Crombie. It's been a pleasure having
you join us again next week on the Credit Edge.
Hello, and welcome to The Credit Edge, a weekly markets podcast.
My name is James Crombie. I'm a senior editor at Bloomberg.
Speaker 2 (00:23):
And I'm Rob Schiffman, senior credit analyst covering global technology
for Bloomberg Intelligence, who also luckily gets to co leader
are US High Grade and High Yield research teams. This
week's we're very pleased to welcome Lotfeekuwe, chief credit strategist
at Goldman Sachs.
Speaker 3 (00:40):
How are you, Lotfe I'm doing all right, Thank you
for having me awesome.
Speaker 2 (00:43):
Great to see you.
Speaker 1 (00:44):
Likewise, thanks so much joining us today. We're very excited
to grill you on all things credit, mortgages and structure products.
But just before we do, to set the scene, markets
have been whip swored by trade wars that will probably
fuel inflation and could also dent US growth. Both would
be quite bad for credit. Yeah, corporate bonds and loans
remained priced for perfection after getting squeezed a lot last year.
(01:04):
Debt spreads are pretty close to where they were in
two thousand and seven, just before the global financial crisis
blew everything up. If you only looked at credit market pricing,
you'd think the world was a very peaceful, calm place
right now, But the news headlines would suggest otherwise. There's
a lot of complacency out there. But I also think
that the very strong investor demand for bonds and loans
and then not a lot of net new supply is
(01:26):
actually keeping things artificially tight at the moment. So let's
start there a lot for what's your take. Should we
worry more about the trade war? Is it just an
equity markets story and our credit market's right to be
so calm?
Speaker 3 (01:37):
Well, I would say a couple of things. Number one,
I think you know, the resilience has been a common
theme across all markets, not just credit, and so the
headlines have notably intensified the last two weeks. And yet
if you look across the board equities facts, maybe raids
is somewhat the exception, and certainly credit have been very
very resilient. There is a few reasons for that. Look
(01:58):
you know, ultimately, and I think you you've introduced it
very well. You know, terriffs have macro implications, they have
micro implications. But on the macro side, everyone agrees that
it's a short term booster inflation and a long term
or medium term drag to growth. Markets can price that
a little bit, unless you know, you kind of take
things to extreme levels. At the micro level, they are
(02:21):
hit to earnings, right, and this is why you've seen
a stronger response on the equity side relative to credit.
How much of a hit are you going to get.
Let's assume it's a couple points of a drag on
earnings growth. That actually shouldn't move your credit metrics that much.
You know, when you think about interest coverage ratios or
net or gross leverage all a sequel, they could deteriorate
(02:43):
a little bit, but the magnitude of the deterioration I
think is not big enough to move spreads at least
in aggregate. Now, where you could see an impact is
really in terms of dispersion, both between sectors and particularly
within sectors. There's a lot of companies that have greater
exposure to tear as you know, take Canada as a
great example of Mexico is another good one. And so
(03:05):
we would view it as if it persists, and that's
a big if, as a potential driver of dispersion rather
than a driver or the absolute direction of the market.
Speaker 2 (03:15):
Well, what do you think we need to break out
of this resilient range. I mean, in my world, we
saw a deep seek. It had a big impact for
the first couple of days, inequities and spreads didn't basically
move at all, and we've sort of poo pooed it
with a lot of other people as well. But I
do get weary with tariffs. It seems to have a
(03:36):
much larger, bigger macro drag. So what's that headline we
have to be looking out for? And maybe with this
Trump administration, you know, people just look through almost all
the headlines, But where do you see that resilience starting
to break down?
Speaker 3 (03:52):
A couple of things. Look Number one, I think in
and of itself, you know, as frustrating as it can be,
but expensive valuations isn't a reason to be negative on
the market. And in fact, if you've been trading valuations
for the last four to five quarters, it's been a
terrible strategy. And so if you go back forty years,
there's been plenty of examples where you can stay within
a very tight range for quite some time without having
(04:14):
any repricing of risk premium. And so ultimately, to answer
your question, something needs to break, either a supply demand
and balance where you're just bringing too much supply to
the market and demand cannot keep up with that, or
signs of a rapid deterioration in the cycle called outlook
i e. Evidence that recession risk has gone up. We're
not there right now, right And so back to tariffs again,
(04:38):
I think it would probably take lingering headlines and growing
concerns among market participants that these terroriorts are permanent and
they're essentially impairing the ability of CFOs corporate treasurers CEOs
investors to make capital allocation decisions. It can happen, but
it's a high bar at the moment.
Speaker 2 (05:00):
Dig more into tariffs and specific bottoms up analysis, But
you know, I've seen you use words like uninspiring spreads
or valuation conundrum. So this whole concept of resiliency looking
through not just tariffs but credit valuations, what has to
(05:22):
happen for that to break out? Like we're we're at
near historical tights. I know, yields in particular end up
making you know, high yield and left loons a little
bit more attractive. But like, what gets us out of
this Goldilock scenario?
Speaker 3 (05:37):
Well, I think one of the primary drivers of that
resilience and to your point is the strength of demand technicals.
But you know, fixed income, not just credit has income again, right,
and the last time that happened was about twenty years ago,
And so yes, spreads are tight. Yes, valuation is uninspiring
(05:58):
if you're a spread investor, If you're a total turn
investor and care about the all in yield, it's not
that bad. You know how IG has an average yield
of five and a quarter to five and a half percent.
High yield is around seven and a quarter to seven
and a half percent. That's a pretty decent value proposition
in a world where actually, you know, the fault risk
(06:19):
will likely remain on the benign side. So that's number one.
Number two, expensive valuation isn't really a problem for just
credit as an assea class. I mean, on some estimates
you have thirty five percent of the SMP five hundred
that has a negative equity respirace. I mean that is
a valuation conundrum in and of itself. Now, the difference
(06:39):
I guess between credit and equities is that the equity
market can overshoot valuation constraints quite some time. In credit,
you have a natural lower bound, like you can't go
below a certain level, and in fact, that was very
surprised after the election by the number of conversations I
had with investors implying that you can overshoot basically historical valuations,
(07:01):
that you can have even IG spreads go negative on
some high quality parts of the market. I disagree with that,
but you know, it felt a little bit of evaluation frenzy.
I think back in November, we've corrected some of it,
and so the point is, you know, something has to break,
either in terms of fundamentals or technicals, and at the moment,
(07:22):
I would say strong demand technicals have the upper hand
in credit, There's no question about it. By the way,
you also see it in the flow data. That's probably
the most real time indicator you can look at. But
week after week, new money keeps going into the asset
class across the board, you know, leverage, loans, high yields
IG and then I guess the last shift that's been happening,
(07:42):
and I think it's one that's a little bit underappreciated
by people. If you take a step back and think
about this sort of transition to higher cost of funding environment.
You know, some people have been concerned about what that
means for credit quality. But the flip side of that
is that for credit portfolios, it's been increased the amount
of coupon payments over time, and that's capital that's on
(08:03):
autopilot mode, and it's capital that acts as a self
stabilizing mechanism. Basically, there's a reason why every time you
widen a little bit by three, four or five basis wants,
the market buys the dip immedity, and the reason is
that you have that embedded d eye power in portfolios
that is there ready to be deployed as soon as
you have these sort of temporary episodes of lightning.
Speaker 2 (08:24):
Got you? I'll let James jump into just one second.
But if you're basically arguing that we're in just a
carry environment with low volatility, it argues you move down
the credit curve. I guess that's your preference for left
loans over high yield. But where does everyone go wrong?
(08:44):
Like if it seems like that's obviously consensus, what has
to happen? Like what what are those those tails? What
are the black swans?
Speaker 3 (08:55):
Like?
Speaker 2 (08:55):
When?
Speaker 3 (08:56):
When? When? When? When?
Speaker 2 (08:57):
You when you go to bed at night and you're
where could I have messed this one up? That's what
I think we're all sort of looking for we see
these headlines, we see one or two days of all,
but then it sort of goes away like are we
just so strong? Are technicals and fundamentals so strong that
just really realistically doesn't happen.
Speaker 3 (09:14):
So I wouldn't get complacent, obviously, but I think those
headlines tell you something, which is the distribution of risks
is a lot more two sided that many have thought
going into the year. And so yes, we do have
faith in sort of a scary view and force cognizant
of the fact that valuations are a lot more expensive,
spreads are tighter. So whatever excess return to treasure is
(09:35):
you got to generate, it will feel mechanically lower than
twenty twenty four, and for sure twenty twenty three. But
we'll also be advocating to spend money on hedges. You know,
just take look at that left tail of the distribution,
the non unknowns, the unknown unknowns, the things that can
sort of take you off guard a little bit. But
you know, people can plain all the time about tight spreads,
(09:58):
but vall is very low. Actually, the cost of hedging
is the lowest it's been in probably a very fantastic point,
use that to your advanders, spend spend some money on
hedges and wait for better days, you know, wait for
that valuation reset and kind of revisit the pieces.
Speaker 2 (10:14):
What products are you using for those?
Speaker 3 (10:15):
Ce the xig cd X high yield, but macro products
in general very liquid, very liquid, I mean dogfs too,
although there's a rates component into that. But yeah, there's
a wide range of hedging solutions actually that are available
to investors.
Speaker 2 (10:31):
Gotcha.
Speaker 1 (10:32):
The low hanging fruit for a lot of our guests
at the moment is the private side of the market.
Everyone loves to talk about private debt and a lot
of people still see a lot of relative value there
versus public I know it's kind of hard to do
apples to apples comparisons between the two. But what's your
view right now of the value that you know people
are talking about in private and how does it compare.
Speaker 3 (10:52):
Well, it depends what parts of private credit are we
talking about, I mean, to your point, you know, people
generally think of relative value comparisons in turn a direct
lending versus broadlystnigated loan market or the high yelt bond market,
if you take you know, proxies for private credit like
BDCs or mental market clos They will tell you that
that excess premium that you're getting by shifting from public
(11:14):
to private is at the very tight end of the
historical range. And yet if you look at capital formation
on the private side, I think twenty twenty four is
actually going to end very close to the record that
we had in twenty twenty one. So how do you
reconcile the two? You know, how come more capital is
being deployed into you know, private credit even though that
(11:36):
excess premium has actually compressed. I think part of the
reason is that most you know, investors don't look at
the excess premium only there's something else there's, you know,
and that is really the ability of private credit to
deliver better risk adjusted returns or better sharp ratios relative
to public credit. And I think that's the biggest driver
(11:57):
of investor demand because and the REA and I think
that is that if you look at the ownership structure
of private credit, like who owns you know, who's the
the ultimate user of private credit? It's generally liquidity agnostic investors,
insurance companies, endowments, family offices, pension plans. Investors that don't
(12:18):
necessarily need the liquidity that you know, public markets you
know give them. And so we can debate on the
calculation of sharp rations public versus private, the fact that
you know there's no more tomorrow or there's only quarterly
marks on the public on the private side relative to
the public side. Those are all, you know, legitimate arguments.
(12:38):
But at the end of the day, what those investors
are trying to solve for is, you know, the best
sharp and the fact is, you can go back ten
fifteen years, private credit delivers better sharp rations than than
than public credit. That's just the story. So that's number one.
I think the other insting shift is really the change
in the structure of private credit, where we're seeing continued
(13:00):
overlap between private and public credit. But you go back
only five years ago and the bread and butter of
direct lending was really middle market companies. I mean, the
birth of the asset class was primarily driven by the
fact that the banks actually can't do leverage lending anymore.
But that has changed quite a lot. Actually the last
five years. What we've seen is a toronative asset managers
(13:22):
increasingly I don't like the word competing, but providing the
type of capital solutions that actually the bloadly syndicated loan
market or the high bond market would provide that overlap.
I think will continue to grow in my view, not
least because capital is being concentrated among larger firms and
so the depth of financing of direct lending funds, you know,
(13:45):
has improved and it will remain that way.
Speaker 2 (13:48):
Does it feel like private credit could end up being
the first domino in a market falling down that it's
a little opaque, We're not really sure what's behind the curtain,
and you know, maybe there's some sort of like cre
exposure or even in the world I mentioned deepseek before.
You know, is there so much money out there that's
(14:08):
been propping up data centers that all of a sudden,
one shoe falls and then whoa lo and behold, it's
not as strong as we thought. Our private credit BDC
analyst Dave Havens talks about that space like I talk
about double A rated Amazon, Alphabet Apple, and it's just
(14:29):
not the same. So I just I'm just wondering, like,
are we is anyone missing anything here or is it
just really as good.
Speaker 3 (14:35):
As he looks? Great points, but I think it's important
to frame the risks, Like if we're talking about garden
variety default cycle type of risks, then absolutely, I think
private credit, just like broadly stigated loan market or the
high end bond market, will at some point experience a
(14:55):
full blown default cycle. And I think we'll test a
number of things, the ability of managers to kind of
you know, work through a wave of the faults, et cetera.
So that will happen at some point, and my best
guess is that it will happen when the business cycle
its self inflex the fact that you can go back
forty years, you know, the faults generally increase when the
(15:16):
economy goes into recession. There's a handful of exceptions. You know,
twenty fourteen fifteen is a good one. You had a
big sector story, But in general it takes a recession
to test that, and we will test it for private credit. Now,
private credit as a threat to financial stability, which is
a concern that you hear all the time. I have
been pushing back against that quite a lot, because if
(15:37):
you think about the two channels that can make losses
on any portfolio, whether it's a credit portfolio or something else,
make those losses painful to the system, it's leverage or
maturity mismatches. And if you look at direct lending, you
don't see any I mean, I'm sure you're calling your discoverage. Yeah,
who covers BDCs told you that there are legal limits
(15:59):
on leverage one and a half to two x, and
actually most BDCs never exceed that, and so it's not
a levered asset loss. The LPs or the investors are
not leveraged. So I do struggle a little bit to
see a channel that amplifies losses. And then and then
kind of, you know, make them a catalyst for you know,
some stress, and either in the financial system or in
(16:21):
the banking system, it's just not there to me. If anything,
it's as plain venolla as it can get. You got
the LP, you got the GP, and then the borrowers
in the middle, but none of them are levered other
than the borrower. And then the asset class itself is
also too small. We're going to have to put things
in context a little bit, because if you add up
all the subcategories of private credit, you get one point
(16:42):
seven trillion, maybe two trillion, of which a good thread
is actually dry powder. So the capital that is deployed
is actually much less than that. Okay, well, let's suppose
you have an annual loss rate of ten percent that
is non leveraged. Those are no you know, those losses
are not leverage, and so I don't think they will
trigger I mean the S and P five and it
loses that every day and it doesn't do anything to
(17:04):
the system, and so I think we have to keep
that in context. It would have been problematic if there
was a lot more leverage deployed behind it, which was
kind of the story in the run up to the
global financial crisis.
Speaker 1 (17:16):
Got you interested in what you were saying about the maturity,
You will love the You know, we have spent a
lot of time worrying about it on this show. Companies
did borrow a lot of money when rates were zero,
and you know, there is a there is a wall
of high yield and leverage loans coming up. Funding costs
is substantially higher than where they were triple in some cases.
(17:36):
So why why shouldn't we worry about it?
Speaker 3 (17:38):
I think there's a discussion about aggregate levels and a
discussion about idiosyncratic situation. There's no question that there's multiple
idiot psychotic syncratic situations particularly in Europe, by the way,
where the economics of refinancing isn't compelling. Basically, if you
refinance existing debt today, you'd have to point sometimes triple
the cost of that debt. But in agrig I think
(18:01):
we've made some pretty decent progress actually the last year
and a half. But I'll give you a couple of stats.
If you look at the share of the high bond
market that is maturing over the next two years, it's
eight percent of the total outstanding, and so there's no
issue in terms of the quantity for the lack of
the better word, the quantity of credit that needs to
be rolled over over the next two years. Now, the
(18:21):
second stat that I would give is your marginal cost
of refinancing. You know that that extra cost that you
pay to replace old debt that you issued back in
twenty twenty, twenty one, twenty two with new debt today,
that has also compressed dramatic. I mean, the flip side
of tight spreads is that it gives a lot of
flexibility to borrowers. But in aggregate that cost is around
(18:45):
a point and a half today, It's not nothing, But
if you were to refinance that ten percent, that is
coming due in the next two years. That means that
you pay in ten percent times a point and a half,
which is fifteen basis points of extra interest expense. When
you scale that by the average coupon, it's a couple
of points of increase in interest expense on a percentage basis,
(19:08):
And so you still have to pay more, but I
think you've reached a stage in which that marginal cost
of refinancing is now a lot more easily absorbable by
earnings growth, because there's assets, there's liabilities. Yes, you pay more,
but you're also growing your assets, you're growing your earning.
So in aggregate, I would say the transition to higher
funding costs, which is sort of a catchy sentence that
(19:29):
everyone is using, I think that transition has been completed,
except for maybe the lower end of the quality spectrum
in Europe, where refinancing costs is still way too high.
And I think that means that you need to address
basically refinancing needs via restructurings in the faults.
Speaker 1 (19:45):
And those companies not just in Europe but in the
US and elsewhere are also doing a so called liability
management exercises. You know you mentioned you got to add
sort of shale anden list to your list of skills
in twenty sixteen, But do you have to add legal
skills now because it's so complicated. It's you know that
the documents, the documents are so difficult to understand, and
everyone's getting, you know, in trouble with that.
Speaker 3 (20:08):
Yeah, yeah, I mean, look, I mean you're right, lemies
or I call them distressing changes, because I think that's
a better way to describe it. But you know, that
has accounted for the bulk of the faults, and it's interesting,
it's been one of the reasons why people disagree with
respect to the actual level of the faults, because some
people include them on the don't and so. But the
bottom line, if you take the broadly saying you gated
(20:30):
loan market and include distress exchanges, we actually and you
look at things on a twelve month trailing basis, we're
above eight percent, which is a pretty elevated level. Is
that for high bones, that's for loans, for bonds, it's
been it's been a lot lower than that. And the
reason is quite simple. The liability are floating. If you're
you know, in the loan market, they're fixed rate on
(20:51):
the bond side, and so the transition to a higher
cost of funding environment has been a lot tougher. Uh,
you know, for those liabilities that are that are flowed.
The other dynamic I think that is very important for
those lmes is that they've been entirely concentrated amongst small
issuers too, so size mattered quite a lot. I mean,
it is true that this has been the most aggressive
(21:14):
or it was the most aggressive and the most front
loaded hiking cycle since pretty much the start of the
Great Moderation, but it weighed heavily on small companies. And
if you looked at the Dotter weighted the faught rate
versus the issue weighted the fault rate, you get a
dramatically different answer. Actually, the dotterweight of default rate has
been remarkably benign for the last two years. And so,
(21:35):
you know, I get people sometimes asking me like, how
come high yield spreads are at sixty or two seventy
and then the headline the fault rate is at six
or eight percent, And I'm like, there's a reason for
that is because those defaults didn't matter that much for
the index. You know, they weight in the indexes is
so small that they haven't really been a drag on performance.
Speaker 2 (21:56):
Where do you think we need all in yields to
be to see a significant an uptick in M and
A or leverage transactions? You would think that with so
much capital available, we would have already seen more.
Speaker 3 (22:10):
I think there's two dynamics up, So I would distinguish
IG from IG from high yield. Sorry, I think in
IG were there already. I think most CFOs and corporate
treasurers have sort of re anchored their long run expectations
for the level of tenure yields. But you know, a
year and a half ago, four and a half cent
on tenure would have been viewed as problematic. It's not anymore.
(22:32):
I think everyone has a much better understanding that, you
know what, it's actually that period from twenty ten to
twenty nineteen that was the anomaly. Were corrected that anomaly,
and we're kind of back to levels that are more
on line with the reality of the cycle. So I
think there's broader acceptance of funding costs. And then I
think the other big shift is CEO confidence. I mean,
if you look at confidence, it basically rebounded quite sharply,
(22:56):
and a lot of that is a reflection of just
a broader you know acknowledgment that this is a soft
landing and that you know, this is not sort of
your usual business cycle a little bit. So I think
you will see more of it, you know, in twenty
twenty five for sure. Now the question for US and
credit is what does that mean for bond holders? Does
(23:16):
that bring new risks? Because typically you know, if you
see you know, a reacceleration in M and A activities,
some of that is funded into credit markets. I think
for the high end of the quality spectrum in IG
where you have debt capacity, sure you know you'll see
more you know, M and A related debt this year,
certainly relative to last year, but also you know, you
(23:38):
know twenty twenty three, but only I think in the
high in the high end of the quality spectrum. I
think for the triple B space, which is still roughly
half of IGH, the incentives are to continue to act
a bit more conservatively.
Speaker 2 (23:52):
So if I could try to squeeze some details out
of you, which sectors do you think offer the best
value and the least value and are those calls more
of you know, near term we're playing off of tariffs,
or they do they have longer term sort of trends
to them.
Speaker 3 (24:11):
So before that, one big caveat which is we talked
a lot about valuations, We talked about dispersion. I think
the other challenge that a lot of people are facing
is that the left tail went from over sold about
a year and a half ago to overbought today. So
I'll give you two into three.
Speaker 1 (24:28):
Before you too, I just want you to explain to
our listeners what is left tail? What do you mean
by that?
Speaker 3 (24:32):
Yeah, it's basically the price or the premium that you
demand against a state of the world in which things
go horribly wrong. And so I'll give you two examples.
You know, the aftermath of the regional banking crisis in
March of twenty twenty three, the big concern was that
this would morph into a full blow financial crisis, and
that basically losses in the cre market would you know,
(24:55):
put bank's balance sheets under a lot of pressure. As
a result of that, banks traded at a pretty sick
discount relative to non financials. That discount has gone today,
and in fact, banks had a terrific twenty twenty four
and that left dai of risk premium is gone. One
other example, I would give you triple c's. You know,
up until October of twenty twenty four, the triple C
(25:18):
market was actually offering you a pretty decent premium. Why
because there was this widespread view among you know, a
lot of market participants that monetary policy would kind of
act with a lag a little bit, and that lag
is like a year to a year and a half. Actually,
we realized that that lag is a lot shorter, and
so you've had a big compression of premiums. So the
(25:38):
setup is a lot more challenging, not just at the
index level, but also you know, also thematically. So that
was a long intro, but I'll give you the answer.
So what do I like? Look, if you stick to
the high quality parts of the market, we like agency
mortgages more than IG. Now, it's what I find remarkable
(25:59):
with mortgages is that if you look at, you know,
the excess spread that you're getting in agency mortgage is
relative to IG, it's about forty to forty five basis points,
which is absolutely remarkable if you take into account the
fact that agency mortgages have no credit risk, and so
you have an asset class that has zero credit risk,
and yet it's paying you forty to forty five basis
(26:20):
points more on than IG. Now, of course, there are
reasons why that's the case. I think the biggest one
is that mortgages had benefited for many years from a
generous subsidy VIAQE and the fact that the FED was
deploying its bowel sheet. So essentially the market lost a large,
indiscriminate buyer and it's been having a tough time kind
of replacing that bit and attracting new sources of demand.
(26:42):
But as a value investor, you should look at that.
You're better off in my view, if you have like
a two year horizon or one year horizon investing in mortgages.
If you go down you know the quality spectrum. Yeah,
you mentioned loans versus bonds. We like loans because you know,
there's a bit of excess carry there and you know,
the supply dynamic or the supply demand dynamic, seems a
(27:03):
bit more compelling than in the bond market. In fact,
that's supply and the loan market is negative, so it's
a market that's shrinking, which is good actually if you're
trading this stuff on the secondary side. Europe versus US
we didn't talk about it, but that's also an interesting,
you know, relative value view. I think it's an understatement
to say that sentiment visa of Europe has been negative.
(27:27):
But we have been pushing back against the idea to
use credits as a proxy to express some kind of
a US exceptionalism view or US growth at performance view
for really two reasons. One, you know, European credit is
actually a lot less cyclical than most people think. It
doesn't media respond to sort of the EBBZEM flows in
(27:49):
the business cycle. Number two, the flip side of growth
weakness is that it gives the ECB more degrees of
freedom to actually ease and go a little faster than
the FED and so on, And that it's unclear to
me that the interaction between growth and policy is that
better in the US relative to Europe. And then I
think valuation constraints are also a lot more binding in
(28:10):
the ustern Europe. So I've always thought the growth divergent
theme was more of a rates effects story than a
credit story.
Speaker 1 (28:18):
On mortgages, Any May and Freddie mac could be privatized.
Does that note make spreads blow out?
Speaker 3 (28:24):
It depends how they are privatized. First of all, the
path that gets you there is uncertain and sort of
quite complicated. But let's assume, you know, we're having this
conversation with with with the gcs sort of standalone private entities,
if you turn them, you know, into sort of monoligne
companies that ensure and buy mortgages, and if they are
(28:47):
properly capitalized, so their cost of funding will probably go
up and go up by twenty thirty basis points. Some
of that will be passed on to mortgage investors, but
we estimate that pass through is probably all let's equal
emphasis is on all l SQL, uh, you know, is
around five to seven basis points, so not that much,
but there's obviously lots of moving parts in there. I
(29:09):
think the other shift that could happen is that obviously
even double A spreads move a lot over time, and
so that could introduce, you know, some some volatility and
agency mortgage spreads on a FOURD basis. But again there's
a lot of moving parts here, and I think it's
still very early. Okay.
Speaker 1 (29:25):
Also, the FED is scaling back to the banks step
in at this point to prop out that demand.
Speaker 3 (29:31):
Potentially, yes, and in fact, actually if you look at
bank demand, you know, for agency mortgages, over the last
three to four months. It's it's back into positive territory
on a net basis. But banks actually could be that
marginal source of demand that kind of flips the you know,
the balance a little bit in favor of mortgages relative to.
Speaker 1 (29:49):
Ig are they also less sensitive to the tariff and
trade war?
Speaker 3 (29:53):
And I mean it's it's sort of a low beta
you know, lassa class at least relative to growth.
Speaker 1 (29:58):
Absolutely.
Speaker 3 (29:59):
Yeah.
Speaker 1 (30:00):
Also one on Europe. I mean what do you mean
by Europe? Because it is, you know, a large continent,
many different countries, and is it not the one that's
you know, next most exposed to the trade will you know,
we're talking about tariffs and all sorts of things today
from the EU and the tit for tat and could
get a lot worse. Does that not change your assumptions
in terms of investing in European credit?
Speaker 3 (30:20):
I think that will weigh a lot more on the
equity market again, you know, you you sort of have
to take a capital structure of you and autos, by
the way, is a great example. You know, if you
look at the performance of the European auto sector last year, inequities,
it's been terrible Basically, if you look at the euro
ig auto sector, you see a little bit of widening,
but in the grand scheme of things, you know, it's
(30:42):
nothing right next to the underperformance of the equity market.
And so so that's one number two. We talked about
M and A earlier. I think Europe is a little
bit behind on the M and A cycle, But that's
actually a good thing if you're a bondholder. That just
means that most companies are still incentivized to manage capital concernedly.
And so I think there's to be less idiosyncratic noise
(31:02):
in Europe relative to the US too. And so the
bottom line is that, yes, there's no question that terraffs
would weigh more heavily on Europe. There's, by the way,
there's teriffs per se, and there's the uncertainty that the
terrifts created too, and that weighs more heavily on Europe
relative to the US. But I tend to think that,
you know, that's mostly an equity story.
Speaker 1 (31:21):
And the M and A in the US that you
are talking about potentially, you know, a large amount in
the single A tier. Does that push downgrades in in
I G for.
Speaker 3 (31:31):
Those companies that have a you know, a tolerance for
one or two notches of downgrade. Sure, yeah, I mean
that's sort of the typical playbook. And you know, in
the cycle now, it'll be interesting to see whether the
rating agencies will sort of have the tolerance that they had,
you know, back in fifteen, sixteen, seventeen, you know, by
alogue sort of these mega deals and you know, these
(31:54):
temporary deviations from you know, standard credit metrics. That will
be interesting to watch. But yeah, I mean you certainly
have det capacity in that similar space.
Speaker 2 (32:03):
So what are some of your red flags? I know
I can understand your comfort level, but is there a country,
a company, a sector, a segment that you really want
to stay away from?
Speaker 3 (32:18):
I think, look, if you asked me what's the biggest
risk basically to credit and to fix income more generally,
I would start with the following observation, which is, if
you go back to the start of the hiking cycle
in the US and look at how companies have responded
to that in terms of capital management, most companies have
been incredibly disciplined basically in terms of managing their capital.
(32:42):
You know, they issued a lot of debt in twenty
twenty and twenty twenty one materially strengthened their liquidity positions
that allowed them to be very patient in twenty twenty
two and twenty twenty three. I mean, look at you know,
how you'd issue volumes, and there's a reason why they
went down dramatically. It is because most companies didn't need
to issue they had that castional balance sheet. So the
reason I'm mentioning that is that I think unlike twenty
(33:04):
seventeen twenty eighteen, where credit was sort of viewed as
a as a as a pocket of vulnerability, you know,
in general, because of the growth of triple bs and
the floth and the late and the loan market, etcetera,
I think this feels very different, and so I think
the risk of an indulgenous shock in credit is substantially
lower today than it was, you know, seven eight years ago.
(33:26):
What I would worry about is really public balance sheets,
because you know, public balance sheets have not been managed conservative,
you know, the last you know, five to six years.
You know, concerns over debt sustainability would be my number
one risk, you know, but it's not something that is
indigenous to credit. It would be more of an exogenous shock.
(33:49):
But you know, deficits are large across the board and
at some point you need to sort of take care
of it.
Speaker 1 (33:55):
Is that more of the sovereign leveryly you're talking about
states and.
Speaker 3 (33:57):
Unis, that's more of a sovereign conversation. I mean, we
had a bit of a of a of a test
last year with France and by the way, you know,
FRENCHI A tea spreads are still sort of close to
that that that seventy seventy five percent, you know, a
seventy five basis point range, and so that excess premium
has has not gone away, it's still there.
Speaker 2 (34:17):
So what's the next group of mag seven? What's the
next in Nvidia? We're all missing this massive upside in
this lackluster sort of environment.
Speaker 3 (34:29):
Well, in credit, there's there's no convection basically most of
that unfortunately goes to goes to the equity market. So
you know, you can grow your market cap dramatically if
you grow your market cap and credit that's a problem.
By the way, and if we have a max seven
in credit, you know, with that level of concentration, I
would view that as as an issue. That just means
you have a group of seven companies that are over leverage,
(34:51):
and so that would that wouldn't be you know, that
wouldn't be a good thing. Look, I think if you know,
if there's innovation, if there's R and D, if there's
something like you know that that just creates a lot
of value, most of that value will go to equity investors.
Speaker 2 (35:05):
Yeah, the typical life of the credit person exactly, no
reward at all, risk exactly.
Speaker 1 (35:11):
Do you see anything on the horizon that might change
the supply demand imbalance I'm thinking of on the on
the supply side potentially M and A and on the
demand side, is there any hint that foreign demand might
slip off? Yeah, for US credit.
Speaker 3 (35:24):
So as you may remember, but soon of the consensus
going into twenty twenty four was that foreign demand will
weaken quite dramatic, and the narrative typically, you know, was
along the lines of funding and hedging in the dallar
market is too expensive and that will sort of destroy
you know, for you know, some some foreign demand. In hindsight,
it hasn't happened. And so I think what a lot
(35:47):
of folks missed is that there's a big chunk of
that foreign demand that is unhudged. But if you look
at the Treasury take data for example, tells you that
twenty twenty four is on track for being the strongest
year ever for foreign demand. I don't think that will change.
I think a portunistic foreign demand out of Europe, for example,
could weaken a little bit, just because the euromarket offers
(36:08):
domestic investors with a pretty decent level of yield support.
But when you think about Asia, when you think about Japan,
you know, these like big jurisdictions that are you know,
big bars of credit and fixed income. More generally, I
think foreign demand will likely remain there.
Speaker 1 (36:25):
When you're talking to these foreign clients, you don't have
to name them obviously, but what are the questions they're
asking you about US credit right now? What are the
things that really, you know, they want to know.
Speaker 3 (36:34):
I think in general that sustainability is a topic that
comes out all the time. It's media a rate story,
not not so much of a of a credit story.
And then I guess you have a topic of conversation
that we talk about all the time. Is really the
growth of private credit and how to deploy capital there.
That's sort of the next you know, growth engine of portfolios.
But most clients are laser focused on private credit, not
(36:57):
just direct lending, by the way, but even I you
know i G product credit, whether it's asset back finance
or or some of the you know, direct lending deals
that we've seen in the i G mark.
Speaker 1 (37:06):
And in terms of one thing relative value anywhere in
the world, what would you put your finger on, what's
your edge right now? Where where's the where's the best
relative value?
Speaker 3 (37:15):
Yeah, so we started the conversation with Terraffs. Actually the
one place where you know, there's been evidence of a
tariffspreium is actually lat time credit where you could you
could we we at some point we had the lattime
IG index trading wider than the WUS and excess. So
that's a good example of some convexity that kind of
built up. These are really you know, good quality companies
(37:37):
in general that have you know, daughter denominated doinal sheets
for the most part. So I would look at that
a bit more, you know, as a as a pocket
of upside potentially talked about mortgages, you know, I like that,
you know, among high quality products and then within sort
of you know, some of the more niche asset classes.
We still see value in CMBs. Obviously, we loved it
(37:59):
eighteen months ago, when you know new issue triple B
minus CMBs staunchers were coming in at nine hundred basis points.
The easy money has been made, so to speak, and
so it's more labor intensive, but in relative terms, there's
still value in CMBs.
Speaker 1 (38:15):
And that gap on the mortgage side. Do you think
that closes this year the forty basis point at least slow?
Speaker 3 (38:21):
I think, you know, maybe half of it closes this year,
but it's it's a slow one. I mean. The other
drag on performance, by the way, is rates volatility. You know,
and there's lots of reasons to think that that that
speed of mean reversion in rates volatility is going to
be a little slower than most people thought.
Speaker 1 (38:37):
And if rates go slightly high, let's say people talking
about five percent, now, does that make things.
Speaker 3 (38:40):
Cry they go higher? You know, the drivers of the
backup and rates always matter more than the backup itself.
And so if they go higher because growth is stronger,
or in general, because that interaction between growth and inflation
is still friendly, I don't think that's a problem. If
they go up, because you know, there's evidence of inflation reacceleration.
(39:01):
That's a bigger problem. I mean that creates you know,
all sorts of issues because you got a pressure margins
and so bad for fundamentals. And you also you know,
could bring back, you know, the correlation between rates and
spreads into positive territory. I mean, twenty twenty three was
a painful year because you had that double wheremie of
higher spreads, wider spread, higher rates, wider spreads. And the
(39:23):
reason you had that is because the move higher and
rates wasn't entirely driven by you know, inflation premium. If
we go back to that sort of regime, I think
it would be problematic. I think the odds are low.
Speaker 1 (39:33):
Great stuff, Lot Fee Career, Chief Credit Strategists at Goldman Sex.
It's been a pleasure having you on the credit edge money.
Speaker 3 (39:39):
Thanks thanks for having me, and.
Speaker 1 (39:40):
Of course we're very grateful to rub Shiftman from Bloomberg Intelligence.
Thanks for joining us.
Speaker 2 (39:44):
Today Web Thanks so much, James for more.
Speaker 1 (39:46):
Credit analysis read all of rub Shiftman's great work on
the Bloomberg terminal. Bloomberg Intelligence is part of our research department,
with five hundred analysts and strategists working across all markets.
Coverage includes over two thousand equities and credits, and outlooks
on more than ninety industries and one hundred market indices,
currencies and commodities. Please do subscribe to the Credit Edge
wherever you get your podcasts. We're on Apple, Spotify and
(40:07):
all other good podcast providers. Give us a review, tell
your friends, or email. Meet directly at jcrombieight at Bloomberg
dot net. I'm James Crombie. It's been a pleasure having
you join us again next week on the Credit Edge.
Host
James Crombie
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The Bobby Bones Show
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