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Oaktree’s performing credit note for July had a hit-list of credit related potential opportunities. Here are some of the hits:

Yields have increased, but default risk remains low: In 2Q2022, yields rose in the U.S. and European high yield bond markets by 280 bps and 320 bps, respectively.²⁶ (See Figure 6.) While analysts anticipate that default rates in the U.S. and European high yield bond markets will increase in 2022, they expect these rates to remain well below their long-term historical averages.²⁷ Issuers’ fundamentals are fairly healthy despite the slowdown in economic growth, and near-term maturities are minimal following the 2020–21 wave of refinancings.

Broad market weakness may create compelling buying opportunities [in EM Debt]: Outflows from the asset class could cause the debt of companies with strong fundamentals to trade at dislocated prices. Extensive credit analysis may help investors identify securities that can offer favorable risk-adjusted returns. Companies that can generate consistent cash flow may be well positioned in an environment in which access to financing is limited.

Market weakness could create attractive buying opportunities [in convertibles]: Value-oriented investors may be able to identify bargains in this environment, as an increasing number of convertibles are trading below par. (See Figure 9).⁴⁹

BB-rated CLO debt tranches have many sources of potential value: These instruments have attractive structural and credit enhancements as well as low sensitivity to interest rates increases. Structured credit continues to offer higher average yields than traditional credit asset classes. (See Figure 10.)

Weakness in real-estate-backed securities may create compelling opportunities for disciplined investors:We believe the risk/return profile for SASB CMBS and conduit CMBS is improving, but we also think disciplined credit analysis is necessary in this challenging environment.

Non-sponsor-backed [direct lending] deals may offer more attractive opportunities than the crowded sponsor-backed market: Investing in the former often demands specialization, an extensive network, and robust sourcing capabilities.

Yields on investment grade corporate debt have risen to attractive levels: The asset class’s yield rose by around 110 bps during the quarter to reach 4.7% as of June 30.⁶⁴ (See Figure 12.)

One investment we have in a private debt fund has close tabs on SMB / consumer defaults, as the portfolio holds a substantial amount of its loans in unsecured consumer loans (albeit purchased at a discount), and SMB advance facilities. I view it more akin to equity than debt given its return profile.

One of the principals of the firm commented today:

Liquidity dried up very quickly. But, the economy is weakening at a much slower pace. We see it with the pace of rising consumer and SMB loan delinquencies. The speed of change points to a regular recession.

I think it’s important to note that consensus regarding a recession is near unanimous. The stock market already contracted as well. It seems to me at least, that the nature of this upcoming recession will be a real decline in the economy, but one everyone is prepared for.

This is distinct from unforeseen shocks to the system that catch participants off guard and result in dramatic volatility. Could an event happen? Absolutely. Perhaps China moves on Taiwan, or Russia makes another advance, etc. The point of shocks is most don’t anticipate the trigger event.

To that end it still appears to me to be a good environment to continue cautiously re-investing into, especially on the credit side.

Here is an excerpt from Edgepoint’s latest commentary:

Why is that the case? What is it about investing that makes people likely to sell at the first sign of a decline? When prices of everyday items fall, consumers generally rush to buy more. How many people feel uncomfortable when they see a sale sign on a new shirt or bike that they were hoping to buy? Sale signs usually do the opposite – they get us excited. When that shiny new bike was $1,000 last week and is now on sale for $900, it’s a better deal. We all love a good deal. But why doesn’t that apply to an investment? Why do we head for the exits instead of the register when an investment declines in price? 

I believe it’s because most investors don’t know the value of what they own. They know that saving $100 on a bike is good value, but many aren’t sure if watching a stock or bond fall in price is a better deal or another mistake. The only way to distinguish between the two is understanding what you own and having a skillset at valuing investments. While this is something we’re excited to do every day, it remains difficult for the average end client. Untangling the value of a business is much harder than for a bike, but it’s also more important.

Nothing is more uncomfortable than watching an investment’s price fall if you don’t have a sense of its value. The once-deafening roar of Bitcoin bulls sure sounds more like a whisper after its price declined significantly from its peak in the fall.ⁱ The same can be said of the unprofitable technology companies that had an insatiable bid until the price corrected and gapped downwards. Both are examples of investors fleeing an asset when its price declined because these assets were difficult to fundamentally evaluate.

Edgepoint

Often I see compelling investment write-ups only to end it with a valuation that slaps a 15x multiple on something with justification being the comp set trades higher or at that range. But what if the multiples aren’t correct right now? What if the market is exuberant? When that security is down 50% with the same fundamentals and it seems like there is no re-rating on the horizon, how does all the research figure into the picture?

I think absolute value is important to hold conviction through different market cycles. As in, if it was a lemonade stand and there was no liquid market to exit to, is that a price you would want to pay for something? Sure, mistakes are sure to occur in paying the right price, but less has to go right if an arbitrary multiple is slapped on an earnings figure.

Dan R. / Verdad Cap is out with a new missive on what to buy in a market that is deteriorating. Verdad’s crisis investing playbook centers around credit spreads, specifically HY and IG spreads.

As we sit here today, the US HY index OAS spread is trading at about 553bps. Verdad’s note basically says as you cross the 600bps threshold, things tend to continue to deteriorate but it’s a good time to get long BB and higher credit with < 5 yrs of duration. Here is their snapshot of yields segmented by credit rating and duration:

Note the non-linear credit spread expansion as you head down to CCC and below.

As mentioned prior, we just allocated to a low BB / high B private debt fund (would be represented right on the line above), and are buying small amounts of a single B private debt sleeve (below the line). The thesis is the debt underwriters’ history of a below average default rate through cycles, along with private market covenants, upgrade the credit quality of each by a modest amount.

To remind, the following credit players have indicated the following:

• Oaktree on current pricing: “In roughly six months, the average yield spread in the [HY] asset class has widened by more than 200 basis points to reach nearly 550 bps. With yield spreads at this level, we think investors are well compensated for default risk.”
• Apollo on direction of travel: “But the process is not over: while the recent spread widening has been substantial, we expect it to continue, and believe high yield spreads could reach 600 to 700 basis points over the next several months as the credit markets catch up to the equity markets.We think investors who can provide liquidity during these moments of dislocation will have significant deployment opportunities in the months ahead, with the structured market in particular offering attractive opportunities.”
• KKR not saying much: “We continue to look at credit opportunities through a critical fundamental lens and feel well positioned to take advantage of continued volatility and spread dispersion as we still see dislocated situations that can offer strong risk adjusted return potential.”

Alas only time provides outcomes.

Disclosure: This is not investment advice, do your own work.

Housing prices nationally appear to be peaking, at least for now. This is no surprise as affordability has dropped and the economy starts to slow.

But it’s a long way off from a “correction” and a very long way off from any sort of price collapse. Hell, we are still up 12% from 2021 alone.

Ivy Zelman, a housing legend, did an interview in which she proposes that what the market is missing, is that this time the speculative buyer wasn’t the subprime buyer like in the 2000s, but the investors. Specifically single family and multi-family speculation by mega-cap investment firms down to small “passive income gurus.” Here’s a quote from her:

See Calculated Risk’s comments on the topic and to listen to the full conversation here.

In Apollo’s 2021 Investor Day, it outlined a goal for $150B in inorganic insurance transactions over the next five years. This week marks the first transaction since the event, rending the goal ~12% complete.

A few days ago Apollo’s European insurance affiliate, Athora, announced its first transaction of the year. It is roughly a €20B transaction that will push Athora’s assets north of €100B. Furthermore, my insurance guru indicated a key difference between US and EU insurance regimes as it comes to M&A:

Regulators want to retain oversight of the insurers holding the economic risk. But, reinsurers are trying to move that risk offshore (Bermuda, Cayman). As a result, regulators block reinsurance transactions and acquisitions are normally required to transfer risk.

— Brett Walden (@brett_walden) July 16, 2022

Athora / Apollo indicated details that are in-line with the above as part of the plan for the transaction:

Subject to closing, Athora Germany will have €24 billion of AuA and 1.1 million customers, helping it to achieve economies of scale in Europe’s second largest life insurance market.

Prior to closing of the transaction, AXA Germany will transfer the portfolio and its associated balance sheet to a well-capitalised company which will be acquired by Athora Germany and integrated under the Athora brand. Athora Germany and AXA Germany will also sign extensive service agreements for the five-year transition period during which the portfolio will gradually migrate to Athora. As part of the transaction, AXA IM will continue to provide certain asset management services to Athora Germany, notably investment grade debt, until 2028.

Athora Press Release

Going forward, one may reasonably expect that the European M&A cadence to continue with some measure of regularity. According to Rowan:

In terms of what’s going to happen in Europe this year, I believe it will be an incredibly active year. All indications tell me that there will be sizable blocks of business that change hands. The pickup in rates, in some ways, is actually helpful in reducing the embedded loss of a lot of these historic books of business to the legacy companies. So in short, I thought ’21 was very active, but I expect ’22 to be even more active on a go-forward basis.

APO Q4-2021 Earnings Call

And more recently, Jim Zelter indicated:

So for us, we’ve tended to focus on the larger, more complicated M&A opportunities. Those are out there. They’re going to happen in the second half of 2022, no doubt. So from our mind, while it’s been a while, while we’ve digested a few things, I think we’re — certainly feel like there’s a robust M&A pipeline.

MS US Financials Conference

As an investor, the main takeaway here is the company is executing on its plan and validating its competitive advantages in the global inorganic space within the life insurance.

Disclosure: We own shares of APO, this is not investment advice. Do your own work.

As markets continue to shake with daily U-turns on future rate expectations as each FOMC voting member makes a speech, Italy melts, Trump indicates a 2024 bid, etc. – I continue to invest in different parts of the capital structure.

We’re making a new private debt fund investment that checks a lot of the boxes for us. It’s diversified, has a flexible mandate across large cap, middle market, and liquid loans, and has a strong credit sponsor backing it. While the world is awash with private debt vehicles, few traffic in loans with $250m+ in EBITDA, few have a flexible mandate to dial up / down where value is, and few are pushing into larger and larger loans where the air is thin.

I expect this investment to materially bolster investment income and provide a ballast as markets may worsen in the coming months and years.

Asset Liability Management, an insurance industry term, can be loosely defined as:

The practice of mitigating financial risks resulting from a mismatch of assets and liabilities.

CFI

In one’s own life, ALM is mostly practiced with respect to cash in the bank as assets and monthly expenses as liabilities. Said simply, do I have enough cash to pay my bills and for a rainy day or unplanned expenses? When a W2 income is in the picture, ALM is easy. Paychecks are assets that can be immediately applied against liabilities. So long as you keep your job and your spending is slightly less than the paychecks, it’s all good.

However, depending on investments to fund one’s life complicates things. Stocks have a historical return of something like 7%. But ensure with a high degree of certainty that you capture that 7%, the investment horizon is long, perhaps even in decades. Investing in stocks hoping to achieve the long term historical return is a good idea, when the liability the stock investment will eventually pay is decades away. Namely, retirement is often one’s main liability that is potentially decades into the future.

But if you’re closer to that retirement phase, or the liability that you are investing for is a more near term liability, investing in stocks hoping to clip the long term return on a short term basis, is a massive asset / liability mismatch. Imagine taking one’s savings for a down-payment on a home and investing it in stocks despite planning to purchase a house in the next year or two. If you invested on January 1, you would be down near 20% and not have the desired down payment if the perfect house popped up.

As such, asset liability management is critical, and in my opinion undervalued. Are there people that hold mostly stocks even in retirement? Sure, but they are overcapitalized on the stock side of the house and can tolerate major downdrafts in their stock account and still fund their liabilities.

All is to say, considering all asset classes and their respective durations against potential liabilities is just as important if not more, than individual asset selection.

It seems so many are consumed by the Elon / Twitter merger drama. Specifically not only with their commentary but with their wallets.

Merger arbitrage is defined by Investopedia as:

Merger arbitrage, often considered a hedge fund strategy, involves simultaneously purchasing and selling the respective stock of two merging companies to create “riskless” profits. Because there is the uncertainty of the deal being completed, the stock price of the target company typically sells at a price below the acquisition price. A merger arbitrageur will review the probability of a merger not closing on time or at all and will then purchase the stock before the acquisition, expecting to make a profit when the merger or acquisition completes.

Investopedia

It’s a professional niche of the finance industry with many fund managers focusing exclusively on this practice, doing it dozens of times per year, and often accumulating a satisfactory return.

Hoards of people are piling into Twitter stock in the 30s as Elon’s signed merger agreement is for ~$54 / share. The premise is generally that the buyer believes contract law will prevail and Elon will be forced to buy the company.

I think this is because investors, generally speaking, retail investors have few constraints within the world of publicly traded equities. There are simply *too many* opportunities. And if one is not honest with one’s self on what they believe they understand, have a process around, and have schmuck insurance in case they are wrong about everything – everything looks like a nail.

If Twitter has a positive result for the merger arb tourists, in inevitably will ascribe more of the result to skill in security selection than blind luck. And that leads to more emboldened bets in the future, with no unbiased self reflection on whether the merger arb investing style fits their intellectual and psychological makeup.

Style drift, in my opinion, is fine. One just has to be super methodical on establishing a process and evaluation milestones.

Often easier is to just stay in one’s strike zone and wait for the right pitches.

RenMac put out a nice chart of the current fed futures curve, implying cuts next year, along with the quarter end expectations back to 2020.

In the 2nd Quarter, Fed Fund futures curve started to price in a policy mistake, or at least an expectation of easing policy into 2023. #Fed pic.twitter.com/DZPgwtJ1ML

— RenMac: Renaissance Macro Research (@RenMacLLC) July 12, 2022

It seems like there is some sort of market consensus (don’t look at the headlines to find this, ha), that inflation is actually peaking now and into the next few months, and will be under control within the next year.

Take it with a grain of salt as clearly the market did not expect today’s forward curve (see above for the 9/30/20 expectations, which were zero percent for the next three years).