Credit Markets – What’s Priced In?

The headlines are still unnerving and volatility remains a worry. Many asset classes have yet to recover and countless investors fear additional losses. Fundamentals, investor positioning and sentiment are all conveying mixed signals. The pundits, journalists and “experts”, who are notoriously faulty at forecasting future outcomes, tell us of more hazards to come. Lower lows!?  A double dip!?  Another top!?  Will the economy experience a “V”, “L” “W” or “Nike Swoosh” recovery?  As Yogi Berra once said “It is tough to make predictions, especially about the future.” Emotion and opinion are running ubiquitously high and it is understandable how decision-making can be affected in this environment. Nonetheless, valuations need to be calculated, judgment applied and choices made. How should an investor proceed today?

Cycle of Investor Emotion

“Uncertainty is the only certainty there is…”
– John Allen Paulos

Perspective can be difficult to achieve in a world dominated by frenetic social media and polarizing narrative news. COVID-19 is an example. Virus related news flow is both constant and frequently contradictory. Should we be fearful or respectful? Panicked or composed? As with most things, the truth probably lies somewhere in between and is influenced by perceptions and viewpoints to which one is biased. The novel virus is certainly lethal to specific demographics however, others may be less affected.

U.S. Deaths by Age From COVID-19 & All Causes (Feb – May 2020)¹

Data and analysis are powerful counterbalances to emotion and opinion…

Risk

Many investors reasonably fear losing money. Risk – the possibility that a portion, or all, of your capital could be impaired – is the essence of investing and is the definitive metric for which investors are ultimately compensated. Investors are paid to take risk. Investors get paid to take risk in the equity market, the bond market and, yes, the credit market. The illogical belief that risk is bad misleads countless investors from the factual question they should contemplate: Am I being remunerated for the risk that I am taking?

Expected Default Rate * Expected Loss Rate = Expected Credit Costs

A helpful way to think about the risk / reward equation in credit is by applying the common measure of “Loss Given Default”. Default levels are multiplied by loss levels to calculate the “credit cost” an investor could expect to experience when investing in a portfolio of credit assets. Large banks and various financial institutions are all exposed to credit costs; even Jamie Dimon has exposure to these probable losses!

Historical Loss Rates Through Default¹

Where Are We Now?

With global economies locked down, the past months exhibited unprecedented asset price moves, both up and down. The credit market was not immune and suffered along with many other financial assets as the panic selling hit. Today, uncertainty levels have not waned, the worry list is long and there will be further intense rallies and selloffs in the coming months while investors recalibrate their economic and policy assumptions and search for winners and losers.

Leveraged Loan and High Yield Bond Historical Average Prices²

The credit market has experienced a sharp rebound since the depths of the crisis nonetheless, prices and spreads remain at levels that are predicting draconian defaults and losses. Default and loss prospects have increased however, they will most likely be concentrated in sectors and issues with direct virus and shutdown exposure including smaller, lower quality and over-indebted issuers. As a result, manager skill will play an increasingly larger role in performance over the coming months and years.

Leveraged Loan and High Yield Bond Historical Default Rates¹

What Is Priced In?

The table below summarizes the potential annual return opportunity being priced by the loan market at current levels. These various return outcomes assume an assortment of Constant Annual Default Rates (“CDR”) and Recovery Rates (the inverse of loss rates). An investor can assess return levels based on the bearishness or bullishness of their default and / or loss views. Most importantly, one can also better judge downside risk centered on an assessment of this analysis (the red highlights suggest levels of concern while the green highlights represent expected outcomes based on history). What returns do you expect?

Leveraged Loan Risk Reward Analysis³

An emotional approach to risk taking is flawed. A fact based, quantifiable examination of risk versus return is a more effective method for investing. At the end of the day the crucial question remains: Am I being paid for the risk I am taking?

1. Source: JP Morgan, data as of May 1, 2020.
2. Source: Credit Suisse, data as of May 29, 2020.
3. Source: S&P Global, Moody’s JPM Leveraged Loan Index, data as of May 31, 2020. All the scenarios were generated using the following assumptions: (1) prepay rate of 0%/year; (2) the default rates for the first and second quarters are 10% and 15% of the stated CDR respectively; (3) any amounts outstanding at the end of year 3 are liquidated at par; (4) LIBOR Floor-adjusted LIBOR Rate is 0.34%; (5) average coupon spread of 355bps: (6) the asset are fully ramped up stated weighted average purchase on day 1 at an all in cost of 89.03.