Shocks & Bonds: Credit Markets with Michael Buchanan (March 13, 2020)

Robert Abad: Welcome to the second part of our special edition webcast. I'm Robert Abad, Product Specialist at Western Asset, and with me is Deputy Chief Investment Officer Mike Buchanan, Head of Investment Grade Credit Ryan Brist, and Head of High Yield Credit Walter Kilcullen. Yesterday, our Chief Investment Officer, Ken Leech, provided a comprehensive commentary on the coronavirus outbreak and its impact on global macro conditions. Today, Mike, Ryan and Walter will hone in on the current state of the corporate credit market and share their latest thoughts on fundamentals,technicals and valuations. There will be time for a brief question and answer session at the end. If you'd like to participate, please submit your question by typing it into the Q&A box on the left-hand side of your screen. And with that, over to Mike.

Michael Buchanan: Ok, thank you, Robert. And thanks for taking the time to join us today. As you can see by the charts below, the credit markets haven't been spared over the past three weeks of market turmoil. The impact of the coronavirus and what we're sure is going to be the resulting hit to the global economy, global GDP, compounded by the sudden and surprise price war of crude oil, has placed the continued global and U.S. economy and recovery in serious jeopardy. To be clear, the outbreak of the virus comes with a very real, very tragic human toll. And, you know, we obviously want to be very sensitive to that. Ultimately, it's going to be something that in some way, shape or form affects us all. But we do need to recognize that the economic impact of this is very likely to be transitory. Our CIO Ken Leech in his call yesterday, emphasized that point. I won't belabor it, but I think it's a very, very important oversight as we talk about these very serious issues. In addition, we do think that extreme valuations in the energy space leave some room for optimism. Both Ryan and Walter will elaborate on that in more detail. We also think that the combination of coordinated global monetary policy as well as fiscal policy should provide a very powerful economic stimulus, as these dark clouds begin to recede. So to be clear, I want to make sure we really emphasize the point that with respect to corporate credit today and credit in general, we do see real opportunity at today's prices. We can't predict the longevity of the current crisis, but we do believe that both corporations as well as consumers have the balance sheet, the financial flexibility to endure through what is likely to be a very difficult time if we flip to the next page. Now, both Walter myself did a webcast on February 25th, so about three weeks ago, even a little less than that, and the title of this page at that time was called Stretched Valuations Leave Little Room for Error and the blue dot represented where current trading levels were in each of these asset classes or sub asset classes. At that point in time, the point of our webcast was, we were one, finding it challenging to find opportunity, but we did say that there was opportunity out there. But we did comment also on, again, the unique nature of how tight spreads were. And you really had to do your disciplined, fundamental work to find the opportunity. Here we are again only a few weeks later. And if you look at that red dot, you'll just see the dramatic move that we've witnessed really, really staggering. Not that we haven't been at these levels before. But what I think is really important to note here is that it's the abrupt change in narrative, how we've gone from what we thought was a reasonably positive investment psychology to now clearly an extreme negative and also the trajectory and the pace, how quickly we've gotten to these valuations. Truly, truly unique and truly something that harkens back to at least a decade ago in some of the more concerning times that we were going through in the markets. Finally, just a review of some of the bigger macro themes as it pertains to the impact of the coronavirus. Before I turn it over to both Ryan and Walter, who again are going to get a little more detailed into both global investment-grade credit as well as high-yield credit. We do know that the impact of the coronavirus, it's both a supply and a demand shock. We do know supply chains will eventually repair themselves. And we do believe that the spread of the virus is likely to get worse before it gets better. Clearly, the markets are in front of that risk. But it's important to note that we do not think there's going to be permanent demand destruction. Near-term impact's going to be painful. But ultimately, we should recover. You should start to see demand pick back up. Secondly, we think the resumption of economic activity should come swiftly. I talked earlier just about the coordinated fiscal policy, coordinated monetary policy. I don't think we can underestimate the power of these globally. And, you know, these should be a very forceful tailwind as these current risks recede. Clearly right now, there's lots of focus on the left side tail, the downward risk events. But we also need to remind ourselves there's also a right tail, which not a lot of people are talking about. And to the extent that you start to get some stabilization in the spread of the virus and some of these policies start to kick in again, economic growth can come back swiftly. Finally, we have to remember that we didn't come into the year 2020 with a weak economy or a weak consumer. We actually had a pretty nice tailwind at our back as we saw some improvement on the trade war front. Brexit was behind us and generally central banks globally, even the Fed, where we're becoming more and more accommodative. So I think it's important to remember these bigger factors and how they ultimately will affect the recovery as again, we get through this this period of, you know, very serious risks that we're dealing with. So with that, I was going to turn it over to Ryan Brist, again, Global Head of Investment Grade Credit. Have him talk a little more in detail about IG. And then from there, we'll turn it over to Walter.

Ryan Brist: Thanks, Buck. Good morning to all our clients and Western. My name is Ryan Brist. It's been a real trying last 15 trading days in the marketplace. Clearly an all-hands-on-deck environment in our offices. Really important just to remind our clients, these are the times about calmness in the middle of calamity. It's really easy to get excited. You try and remind your teams about "right now in these time frames," real high focus on portfolio liquidity and understanding positioning and especially the stressful spots. There's also a real delicate balance between playing defense, but at the same time, at these extreme prices, putting on your offensive jersey and and having your hunting goggles to find far more opportunities in the marketplace. I'm starting on page seven and I'm not going to talk about the past. This is the investment-grade credit outlook that we presented to our clients over the last two months. And it's the first half of the playbook. Underneath our opinion there--if you know anything about Western, we always talk about our Credit Team that there are three names next to every name in our portfolio. There's an analyst, a trader and a portfolio manager. We talk about our fundamental opinion, the technicals associated with the traders, the technicals associated with ideas, as well as portfolio managers.The risk aspect to investment ideas, fundamentals in the credit markets have been positive for the greater part of the last two years. S&P 500 earnings are up, not down. The simple metric [of] are companies selling more lemonade than they were at any time in the past?--has been positive. So we've characterized general fundamentals to be positive. Technicals have been positive. We've seen a number of foreign buyers in the marketplace, a number of participants in IG credit over the last couple of years. There was a slide yesterday that Ken mentioned that, hey, if you want to be involved in positive yields around the globe, the only game in town is U.S. credit, or U.S. yields for that matter. So technicals have been very positive. When I circled their valuations near-post-crisis tights, Western is about deep value, about diversified strategies. And we've been clear with clients that, hey, we're near post-crisis tights. We just came off a year where spreads are 53 tighter in the United States and we had a lower margin of safety fundamentals still OK. Technicals still pretty good price. Just okay. I'm going to mention banks. I circled there and we have a near-term challenge in our energy position. But I'd like to talk a little bit about that. Let's move on page eight, Mike. Mike talked about I'm sorry, page seven. I'm one page ahead of my presentation here, page seven, a severe repricing in investment-grade credit. It's funny, in the last 15 days, we've gone 105 wider on the Barclays U.S. Credit Index. These are levels we associate with much more dire periods in the marketplace. Recessionary periods. It's been fast and has been super deep. Page eight. Just think about the markets from a bigger picture. This says focus on the sectors of the industries that are de-leveraging. We acknowledge we're later in this credit cycle. In the back half of the credit cycle. But think about upgrade and downgrade ratio. It's a good indicator about direction of balance sheets. If you look over the last year, you see the overall credit upgrade downgrade index is about even. There's the same number of upgrades for the name, same number of downgrades. But if you look under the hood one layer deeper, it tells a really different story. We've seen dramatic balance sheet movement in US banks and energy. There's been a $123 billion of par debt that's been upgraded in U.S. banks and literally zero downgrades in the last year, overwhelmingly the same in energy. It's funny. U.S. credit investors, when they go for a flight to quality, they tend to go to what the textbook says as the traditional sectors of safety. We'd argue to some of our clients hey, right now, late in the credit cycle, some of those more traditional sectors don't look so appealing from a balance sheet perspective at the bottom of the page. Utilities and telecoms are more highly levered and balance sheets have gone in a different direction. Page nine. Let's just talk for just a second about banks. Banks have gotten really beaten up over the last five trading days, especially this is BNP Paribas 10-year senior debt. I just think of this as a simple proxy for senior 10-year paper in U.S. IG. The title of this graph coming into this year was what a difference a year makes. At the end of at the beginning of 2018 BNP 10-years went from 100 265. And in 2019 we went one 160 back to 105. Those same bonds traded yesterday at 290 over. And so we say again, deep and severe, these are sectors that are de-leveraging. These are sectors where mindsets of the management teams are in the right direction. Appears to be a really good opportunity for us. Single, single A 10-year down-the-middle-of-the-fairway-paper. Page 11, let's talk about a hot spot in the marketplace. We have an overweight on in our portfolios to energy, and that has proved to be, you know, in the very near term, super challenging area. We've seen this highlights the graph on the right page, highlights where pricing is in independent energy. And you can see that energy is trading just in the last couple of days, at greater spreads than the great financial crisis. The commodity crisis, as I come in here, 30-year triple-B energy trades at $64 price, down 35 to 40 points and 10-year paper in the mid 70s. It appears to us to be an outstanding potential for opportunity. We believe that that a lot of investors have conflated high-grade energy with the near-term experience in 2014 to 16 in down and credit quality areas of the marketplace. It's important to remember these management teams have just had a fire drill three years ago and have clear understanding of what that playbook looks like. They've acted much more conservatively, dramatically lowered cost structures, improved cash flows. Just in the last two days, we've seen seven triple-B companies cut, CapEx, several have cut dividends and we think more is on the way. In the financial textbooks those things are positive for the bondholder, maybe not near-term for equity holders, but they're going in the same direction. We'd argued our clients that, hey, valuations or extreme prices, we are expecting downgrades in the near term which will pose near-term difficulty and in executing trades and and dislocation prices. But when we look in the world, the corporate bonds of bendable and breakable, that's what we talk about in corporate bonds. We're bending these securities in a really strong fashion right here. But if you look at these balance sheets, they're in a way different place. And they were just three years ago and they're in a way different place than some of the lower parts or lower quality portions of credit. I'll end there. I'm going to pass over my colleague Walter Kilcullen.

Robert Abad: All right, thanks for that. One quick question here. So you know Mike and Ryan touched on the extreme volatility out there in the different spaces in high-yield.You're looking at today's valuations. What does it tell you about market expectations and opportunities?

Walker Kilcullen: Yeah, thanks. I think any time we see this type of disruption, this type of risk-off environment spreads meaningfully-wider yields a lot higher. I think you have to start looking at valuations and the implied default rate that spreads are showing. So like slide earlier showed the OAS on U.S. high-yield as quickly widened out to plus 726. Keep in mind, that's from a tight in mid-January of about 315 over. So violent move wider with this move in equities clearly Covid 19, OPEC plus unraveling, playing a big role here. But I think just to put things in perspective, if you look at the past, call it 30 plus years, you could see that the five-year cumulative rate of historical defaults in high-yield fits and starts. I think we go back to 2001, 2002. You can see that bump during the telecom boom and bust. You can see even during the global financial crisis what transpired when the cure rate hit about 30 percent. But I think more importantly, just given where spreads are today, 726 over, that's calling for almost a 10 percent default rate currently and probably more meaningfully looking out five years on a cumulative basis, 40 percent of the market forecast to default. Now using a 30 percent recovery rate on the high-yield market, which is basically the midpoint of what we call for somewhere between 25 and 35 cents on the dollar. I think when you look at where we are today on a trailing 12-month basis, we have about a two and a half percent issuer-weighted default rate. So yes, without question, we think defaults will pick up over the near term. We think we will see a pickup in defaults. Clearly in the energy space and it could be talk to Gib Cooper that covers the energy sector for us downstairs. He thinks that number is close to about 10 percent of energy defaulting in 2020, likely evenly split between ENP. That's exploration and production and driller. So we think it's a bit overdone just given fundamentals. Again, we do think the faults will likely move towards the historical average of roughly four, four and a half percent this year. But clearly that 9.9 percent calls for 726 spread a cume of 40 and a half percent. Those are numbers that you have to go back to the telecom boom and bust when we were lending to business plans, not business models and well above the global financial crisis. So just a little perspective there. And I think it's worth noting when you look at the look of the makeup of the high yield market today, less than 11 percent Triple Cs. If you go back to 2007, Triple C and below is about 20 percent energy today is about 10 percent of the market. If you go back to the commodity crisis in 2014 was about 15 percent. So we'd like to say it's a higher quality, high-yield market, about 20 percent secured. I do think the wave of refinancings we've seen these last several years, I think that'll help take the defaults a bit lower than expectations. But all in all, we think it's overdone given fundamentals. We think that default rate and the impairment expectations well above our projections. So next slide, just to talk a little bit more granular, what we have here are the moves and select subsectors over the past several weeks. If you look at big moves, as you'd expect in energy, leisure, gaming, metals and mining, the overall market about 411 wider. You know, this is obviously a very big move in a short amount of time. And I think what we're trying to show people here is when you think about these types of repricings and you understand that a lot of this was technical selling, I think we always want to bring it back to the fundamentals and what we're doing down on the desk, stressing our proprietary models, running scenario analysis, obviously subsectors specific and having intensive conversations about opportunities we're seeing in the marketplace, just looking at relative value. So to Ryan's point, we did see some indiscriminate selling. I think when we see opportunities in first-lien high-yield bonds, I think you have to look at the term loan market bank that right now trades at an average dollar price of about 88. I think there are some oversold parts of the markets. Now we clearly have to keep a close eye on looming fallen angels, the energy patch. We will have some larger cap structures come our way. But I think all in all, we're doing the work. We're looking at some asset-heavy credits, obviously some non-cyclicals. And really no one has been insulated from this selloff. So again, looking at energy almost 1200 basis points wider, if you run that implied default scenario on energy, just giving levels, that's telling you that 72 percent of the energy market will default over the next five years. So we push back on that. I think again, it comes down to active management issue selection do in the work. But all in all, just an idea of how violent these moves have been spreads.

Robert Abad: Walter, that's awesome. That's a big question people are asking. Liquidity. What are your thoughts on that?

Walker Kilcullen: Yeah, I think high-yield liquidity is something that needs to be early in this discussion, you know beginning a lot of client calls on the matter. And in this slide here, it does show you that one thing that is is really important to convey is that the market did not break down on average high-yield trades about seven and a half billion notional a day. And I think if you look at trace volumes, that's basically the Bloomberg inventory system that shows every trade that trades within 15 minutes on average, 7 1/2 billion a day. We've ticked up to north of 10 million a day over these last few weeks. Now, I think it's important that I mentioned that from my hit ratio standpoint. So percent of actual transactions versus inquiry that's likely down just given the volatility would risk has been clearing redemptions have been solved for. And I think there has been some bargain shopping done by active managers. I think when you look at HYG, the biggest high yield ETF, that market value is down about 32 percent since mid January. They've often lost about six billion dollars in AUM between flows and performance. I think that just tells you that, again, it's not broken. We are able to maintain the integrity, the portfolio. And I think, you know, when we look at volumes, the last handful of days in particular north of 10 billion and yes, some of the price action drops were meaningful. I think it's important that despite what the media says, what pundits say, the market continues to work in clear.

Robert Abad: Perfect. Thanks, Walter, appreciate that. So we're gonna go to the fun part of this discussion. We're going to open it up to questions from our listeners. Let's see if we have a bunch coming in. And I think what I'll do is I'll just build on the question I asked you earlier. There's a question. It came in about liquidity in the IG market. Ryan. What do you think?

Ryan Brist: It's interesting. I agree with all that Walter said. It's a tiny bit different in the high-grade market. It's funny we get asked all the time. Is high-grade corporate bond trading going away in the future? Because we've trade we've traded on trading systems and more electronic trading since the advent of electronic trading over the last three to five years. And it's funny, this is a great, you know, 10 to 15 days that have highlighted, you know, the need, the reason that Western has senior people in sitting in the trading desks and executing trades. A lot of our day to day maintenance trading in more lower volatility times. We really--those systems have really helped us. But in the last 15 days, we've seen a real breakdown in the assistance of those electronic trades. What risk managers on Wall Street do? There's there's an algorithm trading on every desk now in Wall Street. And it's just an electronic trading system. They walk up and they just turn that dial down in times of stress. And so in this stress, we saw algorithm trading turned way down. It's been dramatically harder to trade odd lots where we just put them on a system for our clients. And we just we get 10 bids and 10 offers and we operate day to day. So that component has really turned down. And it's really highlighted the value of where your brain comes into order and where you can attack the market and where some participants are forced sellers or their backs against the wall. We can really attack and add value in terms of forced sales and for people doing things that they don't want to do in the marketplace.

Robert Abad: Thanks, Ryan. I've got a question here from Mike. It says here, since the start of the week, we've seen a number of central banks and governments taking aggressive steps to help restore market confidence. But all of these have yet to make a real dent to maybe with the exception of this morning on the fiscal stimulus news out of Germany. Gentlemen writes, A U.S. equity and corporate credit market volatility are way up. So do we think we're spiraling into a 2008 credit Armageddon scenario? Big words here.

Michael Buchanan: Quick answers, no. You know, I don't think we can expect immediate gratification from either monetary or the announcement of fiscal policy. I think that's something that takes time to work through the system. And I think it's even more of a challenge when you think about, you know, the unknowns that we still have the spread of of this virus. So if we're all looking for instant gratification, we may or may not get it. It's hard to say. The markets have priced a lot of this in already. But in terms of where do we end up, where where's the ultimate destination? It's certainly not 2008 for a number of reasons. One, you know, just the global economy in a much less vulnerable place. Ryan talked a little bit about the banks. I thought that was a really powerful metric. How many banks have been upgraded versus downgraded. But the financial system in just a much, much better place. The investment community much less levered. You know, you see that in hedge funds. You see that in total return swaps, just a lot less leverage embedded in investor, investor type products. 2008, obviously, we had a real estate bubble. We can go on and on. But I do think that, you know, when Walter talked about the market implied defaults, you are pricing in right now real extreme stress as measured by what the market is per you know, what the market's telling you about where defaults might go. We look at defaults both from a top down perspective as well as a bottom up perspective using our global research team. And in both cases, we think that, you know, although defaults will go higher, you know, Walter talked about going to maybe for four and a half percent in high yield. Clearly, clearly, they're going nowhere near what we witnessed in 2008 and into 2009. And also, I think we need to separate to the idea of deteriorating fundamentals, which we may be looking at over the next few quarters versus opportunity and credit. Go back to 2009. Defaults went materially higher from 08 to 09. Yet you look at the return in the market in 2009 for high yield, well over 50 percent. So I think it's important for us as investment managers, we have to really be able to look at relative value. We have to look at what's being priced into the market and we have to make sure that we position our clients portfolios in a way that gets the most of that. So sorry, long answer to your question, but but yeah, know we're not going into a two thousand eight type of situation.

Robert Abad: That's a great answer, Mike. Another question here. It says, How were your research analysts stressing their models? Given all the volatility across a number of sectors when we opened this up, Walter, when did you start first?

Walker Kilcullen: Yeah, for sure. I think in this environment a little bit different than what we saw in 2014 and 15 with energy commodity prices, where this is more rampant selling and repricing of risk really across the board, all subsectors. So I think each analyst is taking a lot of time stressing their models. I think that slide that I showed that showed how much wider various subsectors are energy, leisure, gaming, metals and mining. The analysts are all putting different inputs in. And I think what we have to focus on as credit investors is downside protection. So we want to make sure when we're running our models and we're running scenario analysis out a year, 18 months, we do input the most dire potential outcomes possible. So $25 crude and $1.50 natural gas; Cel Sibley that covers the leisure space for us. When she's looking at cruise lines, theater operators, she's really stressing these numbers, making sure our positions are covered. And I think different than an equity manager where the valuations can change and you can really get a repricing. Equities can go to zero. We're looking at stressing our models to the downside, making sure the positions that we're in are covered. And ultimately, I think if we if we're locking in the downside, looking at our models, it gives us an ability in this type of environment to reposition things. There's often times where you look at a capital structure that has secured bonds and unsecured bonds and the price on the secure bond has come down as dramatically as the unsecured bond. Yet on top of the capital structure, security, nature, these are some of the swaps that we're looking at in the portfolio right now. I think it's providing opportunities for our high yield portfolios as well as our broad market assignments sheets just given the volatility.

Robert Abad: That's great. What about you, Ryan? What do you think about this?

Ryan Brist: Not not a bunch to add to that. I mean, this week, you know, you know it back to energy. Rene Ledis. Who leads our high grade energy research has been burning the midnight oil. And, you know, we've been here a couple late nights and and we've re stressed these companies and, you know, kind of pounded them down over the head and said, hey, what does this thing look like in these different scenarios? We've been on with Moody's, we've been on with S&P Energy this week. We haven't gotten in touch with Fitch this week as an example. We spoke with two global energy managements in the last two days to just try and get different opinions. You know, talks like these when when when OPEC and Russian talks break off like these, these are these are real hard things to get to get an edge on in the marketplace. But you can talk to management teams that have assets in these locations, and that's been helpful. Their perspective is it's going to be a long, medium or short sort of turn or could there be a turn. But but all those things that Walter mentioned, stressing portfolios, looking at different scenario analysis and trying to understand can we have permanent loss of capital for our clients and and protecting for the downside during this during this near-term bad storm.

Robert Abad: Thanks, Ryan. So a couple of questions here. I might try to combine them here, but they point to this whole like active versus passive debate, maybe a subquestion in that category. As you know, you see ETFs trading at deep discounts, their net asset value. How impactful has this dynamic been on managing portfolios? But, you know, we can open that up to something broader. When you take a stab at that and again, open it up to speak up.

Walker Kilcullen: Yeah, sure. On the high-yield side, I think again, breeds opportunity for a deep experienced manager that that's actively moving its positions around. I think the high-yield ETFs have taken the brunt of the outflows the last couple of weeks and it goes back to that indiscriminate selling that they're doing. They're not looking at valuations, they're not looking at relative value and that does provide opportunity for active managers like ourselves. I think, you know, the one thing that we try to do here is when when technicals are overriding what we think are sound fundamentals and you do get those outflow patterns, that's really when you can be that provider of capital commitment and buy bonds at very cheap prices vs. intrinsic. So, look, we while we admit that the ETF s are good vehicles for cash flow management, maybe some momentum index trading. I do think ultimately in this environment there's no time like the present where you need to be with an active manager who's rolling up their sleeves. He's been through multiple credit cycles and he's doing the work, right?

Michael Buchanan: Yeah. You know, and this is Mike Buchanan. I would just add that when I think of passive vs. active in especially corporate credit, you know, this isn't meant to be a commercial for active. But you know, what we're really trying to do as an active manager is identify those companies that are paying down their debt. And in other words, they're going to become a smaller and smaller component if we're successful of a passive ETF and the job of an ETF is to replicate the general performance of the market. So as companies become more indebted, obviously they become bigger representatives within that respective ETF. So, yeah, we kind of we sit around and we talk about this as a team. We always think about, you know, that that structural opportunity that we have, you know, we got to look for companies that generate generous free cash flow. They can pay down their debt. And I think that's, you know, one of the big competitive advantages in general that active managers and fixed-income have versus passive.

Robert Abad: Well, that's great. So we're almost approaching the 45 minute mark. I think I'll try to squeeze in one last question, maybe for for Ryan here, starting out there. It says, Do you anticipate material, broad downward earnings revisions by equity analysts? Is it plausible that we get continuous downward guidance in earnings?

Ryan Brist: How about this? Robert, I think it's anytime company managements can can get a crutch or a hook to revise downward or use an excuse. I think we're going to see it. And Ken and Mike. Ken yesterday, Mike, today we completely acknowledge that we're going to have a down trade, not only in broader economic activity and then timing that and the depth of that is really difficult. But I think we're gonna see the same thing near term. But I think that that doesn't thwart our longer term opinion. We've been in this this unconventional credit cycle where we've had if you've listened to Western and any time the last five years, we said positive but unimpressive growth. Another way to say that is boring growth coupled with non-existent inflation and a lot of help from not only the U.S. Central Bank, but central banks around the globe. And in that environment, it makes for a decent petri dish for credit spreads. Credit spreads can do OK in corporate's mortgages and high-yield. That's where our focus has been at Western.

Robert Abad: That's great. Well, that's all the time we have for questions. Thank you, gentlemen, for taking the time. Our crazy morning. I know, but we really appreciate your thoughts. And thank you to our listeners for tuning in. If you're interested in a replay of this webcast series, please go to WesternAsset.com dot com.