2022 was a landmark year in markets, driven in large part by the reversal of a decade-plus regime of low interest rates and low inflation.
As I look toward 2023, my general outlook is that there is no obvious positioning for success, given the wide band of potential actions and outcomes. This is especially true for a tax-sensitive investor, as tax-exempt investors can construct a credit portfolio that locks in a high single-digit return over the medium term.
The view I generally share is that inflation has likely peaked, but it will be a long and tough road to get from 4% to the target of 2%. Many structural forces are causing resistance, including but not limited to de-globalization, unfavorable demographic trends for labor, and ESG-driven misallocation of resources.
Below are thoughts across the asset spectrum specific to what I find interesting, not all possible assets.
High Grade Credit
(Note: I used blunt force to tax adjust pre-tax YTM at 63% of gross YTM.)
Near-term government credit continues to provide good returns relative to the risk taken. The 13-week Treasury bill yields 4.34% as I write this. At the top federal tax bracket, this gets reduced to 2.73%. While exciting compared to the near zero of years past, the inflation factor throws cold water on this post-tax return.
Structured products continue to provide a 150–200 bps yield boost to comparably rated credits. AAA-rated CLO products (e.g., JAAA or CLOI ETFs) are earning roughly 200 basis points over SOFR, which currently stands at 4.32%, resulting in an all-in yield of 6.25%+. Tax adjustments for the top tax bracket result in a roughly 4% yield.
Muni products are most often fixed rates, and as of this writing, they yield roughly 2.6% for short duration and 3.75% for long duration exposure (both tax-exempt). One may consider munis vs. floating-rate CLO debt if locking in a rate is interesting vs. being exposed to the Fed lowering rates in the future with floating-rate credit.
Low Investment Grade and High Yield
BBB-rated CLO securities (e.g., JBBB ETF) currently yield about 525 bps over SOFR, or 9.5% (6% post-tax at the highest bracket). Remember, BBB-rated CLOs have a cumulative loss rate of 0.3% from 1995 to 2019 and sit behind roughly 15% of the capital stack in the form of BB-rated debt and unrated equity.
In the high yield arena, high yield bonds yield roughly 8.5% on a hold to maturity basis or 6.5% on a current yield basis (at an average price of 87). If yields rise significantly, high-yield bonds will fall, but bankruptcy recovery value will act as a lower bound on pricing.Thus, high-yield bond spreads to treasuries may not gap out as wide as in the past given the low coupon at issuance and the dramatically higher rate environment today. It is notable that high-yield bonds tend to be BB-rated vs. B-rated in the past, whereas leveraged loans have migrated to being mostly B-rated vs. BB-rated in the past. High-yield bonds can be interesting because they offer duration, high yield exposure, and a higher average rating than leveraged loans.
Leveraged loans yield roughly 8.9% and trade for roughly 93. These loans’ interest rates continue to rise as the Fed raises rates, a double-edged sword.While near-term income is higher, it is to be determined how many companies default as a result of the higher interest costs. My personal view is that the current pace of the proliferation of stress is slow, and stress that is well telegraphed often doesn’t cause proverbial “heart attacks” in markets. Given the current rate of income and average price of leveraged loans, it will take an acute rise in defaults at 2-3x the average high yield default rate to start driving losses.
Add in roughly 150 to 200 basis points for an illiquidity premium in direct lending, and you can get to just over 10%. Furthermore, certain direct lenders have leveraged their balance sheets (via BDC structure) with a handful of fixed-rate debt during good times, driving leveraged yields to the mid-teens before fees.
While equity returns on leveraged loans can appear interesting, it is worthy to note that at the highest tax bracket, leveraged loans get cut down to roughly 5.7% or 8.8% in a BDC vehicle. a material deflation of yield for the risk taken.
Equities
As a dividend-focused investor, I continue to find alternative investment firms interesting, with many yielding around 7% with qualified tax treatment. The contractual nature of their private fund vehicles places some form of floor on revenue degradation in the current macro environment. Furthermore, top-tier credit-focused asset managers have benefited from funding lines being reduced to lower-quality lenders, and banks have effectively shut down the high-yield market. In short, a great environment despite the material decline in the equity prices of these companies
I also find financials in general across large-cap banks and non-bank financial institutions to be interesting. Post-GFC, most live in a permanent penalty box imposed by regulators or investors and dutifully return fistfuls of capital to investors while keeping excess capital versus prior cycles. Again, while this market continues to absorb a known sickness versus a sudden, unforeseen terminal event, these sorts of financials should be able to absorb material amounts of increased future losses.
Last, certain publicly traded private asset funds with modest yields (4-5%) sourced from infrastructure earnings are trading down to levels that appear interesting, given diversification, stickiness, inflation indexation of contracts, and very long duration debt structures.
Conclusion
In a world in which rates may need to stay elevated for the medium term, the key question is where unforseen potholes will emerge. It is a certainty that corporate defaults will rise. But in light of rates taking time to filter through to the economy, everyone has had fair warning across the constituent spectrum, and I don’t believe defaults get unhinged like many predict.
It is clear that unemployment will rise, but in light of extremely tight labor availability paired with depressed immigration and a boomer labor force that in part turned off post-Covid, I don’t believe the unemployment rate will spike as it did during the GFC given current rate path guidance.
Overall there is a general abundance of assets that trade at prices that are attractive absent the unexpected (a geopolitical event, a natural disaster, etc.).
Here’s to a good 2023.