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JULY 13, 2022
Wayne Hosang, Managing Director and Portfolio Manager of Crescent Capital Group LP, discusses leveraged loan markets, including how floating rate debt is holding up in the current market environment as well as investor considerations when allocating to leveraged loans or debt within CLOs.
Steve Peacher: Hi again everybody it's Steve Peacher, President of SLC Management and thanks for dialing in for this episode of Three in Five. Today I’m with Wayne Hosang from Crescent Capital, he’s a managing director and portfolio manager in the capital markets group and focuses especially on leverage loans. Wayne, thanks for taking a moment.
Wayne Hosang: Yeah, sure happy to be here Steve.
Steve Peacher: So we want to talk about a different aspect of the leveraged loan market, and that's typically a floating rate market, so that's the Feds aggressively raising rates. That's a good thing. People I think are more concerned about recession, you've got a lot going on in this market, you’ve got risk markets trading down, at least equities. You've got spreads of high yield bonds widening, so how has floating rate debt held up so far in 22, in this environment?
Wayne Hosang: As you mentioned Steve there's a lot going on, you know record inflation prints, you know talk, as you said, of stagflation or recession, depending on what, you know angle, you want to take on it. One of the things out there that's a constant and, you know, really hard to read is the whole idea of the military conflict in the markets right now, or in the globe and globally right now. And then, you know, distinct from that is the supply chain disruption. Although in North America we have kind of forgotten a little bit. Covid it is actually still a big deal in other parts of the world, in particular China if you've been reading the headlines. So having said that, in this environment, I would say that you know floating rate in general, leverage loans, in particular, and even CLO debt have held up relatively well compared to you know other asset classes. Nobody likes to see a negative print, but I was just checking the data, loans have performed pretty well, year-to-date returns, they're both negative 1.5% and for CLOs it’s about negative 2.3%. And while nobody likes to see a negative number, if you compare that to other asset classes, you know for example, high yield, that's done negative 8.2%. And investment grade negative 12+ percent. So relatively speaking I think those asset classes have held up pretty well and I think the main driver of that, clearly is not credit, but it's really duration management and having the floating rate aspect to securities.
Steve Peacher: You know you make a good point in that if you're a long only investor there's almost been nowhere to hide, because even if you're in cash you've got high inflation rates and that's going to erode the value of cash holdings. So it's you know, sometimes you can hide out in bonds, probably not this not this time around. So as investors think about potentially allocating to floating rate products, leveraged loans or debt within collateralized loan obligations or CLOs, what should they be considering, how should they think about that today?
Wayne Hosang: Yeah, good question you know, I just wanted to throw one other observation I made this morning, as this looking down the various rating stacks within CLOs and leverage loans and again just to circle back to just how powerful floating rate instruments can be in a portfolio. You know the lowest risk class within the loan market, which will be the triple c's, the return year to date is somewhere like negative 6%. And for CLOs, which would be the single or double bs, it's more like negative three and a half percent. Again when you compare that to you, again investment grade or even emerging markets, which are down double digits, again, it shows the power of floating rates. So the way I would think about applying or allocating floating rate to portfolios would be, you know, let's take investment grade portfolios for example. CLOs that can provide a very good diversity makes for a portfolio, plus it will have the floating rate aspect to it to help in the duration management. Just for those who are less familiar with the duration of floating rate, we tend to use the duration of about .25 of a year. And the reason for that is that the LIBOR or SOFR contracts sent to reprice every three months. If you compare the duration of a loan or a piece of CLO debt compared to say high yield, which has an average duration probably close to four years and longer even investment grade, it can be a really powerful tool to manage duration within a portfolio. The other side of it is that you know CLO tranches and investment grade tranches provided pretty good relative value. So, for example, single A's in CLO debt these days are yielding almost 6%, so I’m sure that stacks up well against any single A investment grade piece of paper out there. So the to real drivers, I would say, including CLO debt, investment grade, in an investment grade portfolio would be to really manage duration, to have a hedge against interest rates and also to get some relative value benefits through this a higher coupons related to CLO debt. If I were to do that below investment grade, focusing on leverage loans for a minute, clearly, I think that any below investment grade portfolio credit portfolio should have an allocation to leverage loans. Again, number one – duration management, especially if you're pairing it with high yield. And then credit risk management, because once you go below investment grade credit risk becomes you know, a bigger, let’s say topic to focus. Why would you go into loans versus staying in bonds? Well, you know, loans are higher up the capital structure, and they're secure. So while the yield on a single B seen in unsecured loan might be less a single B high yield issuance, you're certainly up the capital structure any case the markets do turn and there are defaults, the recoveries on those loans tend to be higher. So it depends on the portfolio managers view, but if there's a heightened sensitivity to credit risk in the market that certainly levered loans would be a good alternative to high yield.
Steve Peacher: So let's extend that comment about credit risk, you know one concern on the part of an investor that may want to increase their allocation, make a new allocation to leveraged loans, is that threat of an economic downturn and the potential impact on credit quality and maybe increase in defaults. So, in light of maybe more economic uncertainty that's arisen today, given some of the challenges of the macroeconomic environment, what's your view of the outlook for loans and also CLO debt as it relates to the threat of an economic slowdown and potential credit issues?
Wayne Hosang: Yeah, that's a good question and you know it's funny, you're not the first person that asked me that question recently. For all the Superman fans out there, defaults are the kryptonite for private investing, in particular below investment grade. So really and truly the question is, you know what's the default outlook going forward in a recession and that will also depend on the type of recession that we go into. Currently the default rate on loans, believe it or not, is actually less than 50 basis points on an LTM basis, and that is compared to maybe a 30-year average or close to 30 or average of closer to 3%. So it's quite low relative to the average. If you speak to the strategist on the street, and we tend to poll the strategists every few months what their default outlook is, they think that based on the potential recession next year in 2023, default rates are going to go up to about anywhere between 1.75% and 2%. So if you think about that, that's actually still below the long term average and if you assume that the recovery rates on loans is 50 cents on the dollar, and it is actually higher than that just to make the math simple, you're really talking about the credit loss of 1% against the portfolio that would have an average default rate and if you think that spreads will actually widen going into recession, the yield on loans now is already above 7% and it spreads wide from there to say 8%, and you have a credit loss of 1%. You do have a 7% return on asset class that has historically had low volatility, which I think is good relative value. Now, nobody knows exactly how the recession is going to turn out and that's one of the big questions, but if you do believe that it's going to be a soft issue maybe with a few bumps in it landing next year. I think loans are going to be fine and, you know, where loans go, that's where CLO debt goes as well. Frankly, the depends on where you are in the stack, if you are all of the statistics, the AAA there's never been a default into AAA CLO piece of paper. And I think during the Great Recession there was a default in investment grade, it could be triple A corporate debt, so you know you could argue that there’s great safety in the higher trenches within CLO, I think where it gets a little bit more challenging is in the below investment grade tranches which will be the double Bs where the asset coverage cushion is only about 3% to 5%, and if there is a high level of defaults beyond what we just discussed, then those tranches could be affected, but I think that, ultimately though, if you're one to traffic in the CLO piece of it, mark to market sensitivity is something to consider because these tranches tend to be a little bit smaller and therefore they tend to move around price buys a little bit more than their their equivalents in the investment grade market.
Steve Peacher: Well, those who invest in triple A CLO debt hope you didn't just jinx it by noting that there had been no defaults in triple A CLO debt, so I got my fingers crossed for you, and I’m knocking on wood. As I mentioned before we record this, I want to end with, I’m going to want to throw a surprise question to you at the end, as somebody who's been involved in leverage loans and credit markets for a long time, anyone who's been involved in that market and I, and I consider myself in that category, having spent a lot of years in the high yield market. we've all we all, everyone makes miss you can't be investor in this market, you can’t be an investor in this market without making a mistake, so when you think, what is one of the worst mistakes you've ever made I say investor and leverage loans?
Wayne Hosang: In leveraged loans, I thought this was a personal question?
Steve Peacher: Well it's personal, I’m asking about your own, your worst mistake, I know how to answer personally but?
Wayne Hosang: Yeah my worst mistake was believing too much in the market on a particular investment versus my own instincts. And I followed, you know, I was very kind of young in my career as a credit investor, this was pre crisis, and it was a housing development in Las Vegas that was supposed to have a lake and it was supposed to be bulletproof, and despite what was going on in the housing market I falsely continued to believe in the project, and we lost some money there.
Steve Peacher: Well, I have the distinction of, we invested in the 90s, in a bond that I was strongly recommended, that end up going bankrupt twice, so.
Wayne Hosang: There you go. Nobody bats a thousand.
Steve Peacher: Well Wayne, thanks a lot for this, I appreciate you taking the time and thanks to everybody for listening to this episode of “Three in Five.”
Wayne Hosang: Thank you very much Steve.
Bloomberg, 2022. JP Morgan, 2022. S&P LCD Research, 2022.
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