Dear Valued Clients and Friends,
I want to start this week’s Dividend Cafe by thanking those of you who offered such useful feedback on last week’s special China edition Dividend Cafe. I am glad, so many of you found it so useful in breaking down the key issues, and I appreciated the various perspectives you offered. The process continues with vigor and with principle …
If I did not have a loving wife to tell me the truth, I would like to believe that all subjects I address in Dividend Cafe are fascinating, thrilling, and exciting to the average person. But not only do I now possess the awareness that there is more than a little wishful thinking in that, I particularly know that the topic I am addressing today may be a little less interesting than normal at first glance.
How’s that for click-bait? Unless I am a master of reverse psychology, I may not be making well the case for you to read further. But alas, I not only believe you will find this week’s topic to be interesting and informative, I believe this week’s topic is really about a lot more than, well, this week’s topic. In other words, the topic of Structured Credit actually tees up a far more important treatment about our entire portfolio thinking at The Bahnsen Group and your entire thinking about risk and reward.
I kid you not – this will be worth the read. Jump on into the Dividend Cafe …
This week’s Video and Podcast features a long-overdue discussion with the Investment Committee, transcending the solo act I normally do each week. Deiya, Brian, and I cover a multitude of topics, re-visiting last week’s China discussion but also broadly covering markets and our various allocation burdens in the months ahead! You won’t want to miss it…
Magnifying the Basic Vocabulary
One of the most significant initiatives in the history of the Bahnsen Group was our Operation Magnify, conducted in the second half of 2020 and implemented throughout October of 2020 through May of 2021 in client portfolios. I wrote extensively about this last year and devoted several podcasts, national calls, etc., to the subject. Clients can be forgiven for primarily seeing it as a merely organizational framework. Still, the reality is that I am entirely convinced we improved client portfolios and our ability to manage risk and reward on a highly customized basis, client by client, with the Magnify paradigm.
One of the key components to Magnify was eliminating “Fixed Income” as a category of our investing and instead of creating a “Boring Bonds” sleeve and a “Credit” sleeve. There are no “cutesy” descriptions in any of the Magnify portfolio nomenclatures besides “Boring” Bonds, but it had to happen. First of all, my choice of “Bonds that Act Like Bonds” (my first choice) was too long to fit in the portfolio review templates, but we also felt strongly that “boring” was an appropriate concept to convey.
There are trillions of dollars that investors around this country consider to be “Fixed Income” that are anything but “boring.” The inputs that affect performance and results and ultimately deliver returns and determine levels of volatility along the way are simply not boring when it comes to high yield bonds, to levered loans, to emerging markets debt, and to asset-backed markets (securitized assets, or what we will today call Structured Credit). These various asset classes are legitimate investment vehicles, offering a trade-off between risk and reward that warrants consideration and, in many cases, are appropriate for inclusion in a client portfolio.
But “boring” does not apply.
When we use the term “boring bonds,” we are referring to the conscious, aware, and even desirable element of reasonably un-exciting. We have a known return expectation (something in the range of the combined Yield-to-Maturity of the underlying bonds). We have a known risk of loss (none, at maturity). And we have a reasonable but not perfect known bandwidth of volatility (limited).
Very high-quality corporate bonds, high-quality municipal bonds, and various elements of sovereign debt fit our description of “boring bonds.” Because “agency bonds” (Fannie and Freddie mortgage bonds) are in the conservatorship of the United States Treasury Department, they are de facto obligations of the same federal government’s good faith and credit that backs the Treasury bond market. Effectively, the “boring bond” universe is more or less:
- Municipals (high grade)
- Corporates (high grade)
And with yields at unprecedented low levels, “boring” not only means low volatility but low income and low return as well.
Two Food Items that Do Not Mix
Some of you may remember the famous 1980’s commercial that highlighted the mix of chocolate and peanut butter (you must watch, either for the nostalgia or the new exposure).
Combining Credit and Boring Bonds into one asset class that is called “Fixed Income” (as virtually the entire world does) is NOT like chocolate and peanut butter for this simple reason: Chocolate and Peanut Butter are delicious together, obviously.
But sometimes, Credit and Boring Bonds simply do not mix at all. The characteristics of each are so different and sometimes contradictory that, at best, they have to be thought about as a Zig vs. a Zag – as diversifying asset classes inside a total asset allocation. They scratch different itches and need to be thought of that way, and lumping them all into one “bond” category is lazy, or at least unhelpful (at least that is what we concluded at The Bahnsen Group).
Credit is from Mars, Boring Bonds from Venus
Here is how we would summarize the key similarities and differences of “Credit” strategies and “Boring Bond” strategies …
Maturity Date – in both cases, there is generally a maturity date that offers investors the “par” value of the various bonds back at maturity.
Yield – in the current environment, with Boring Bonds, the yield is generally 1-2% or so (depending on maturity). With Credit, the yields are more in the 4-6% range depending on the specific sub-asset class.
Default Risk – basically none with Boring Bonds; plenty of such with Credit
Volatility – limited with Boring Bonds (around interest rate movements); much higher with Credit (around credit fundamentals and macroeconomic conditions)
Tail Risk Events – in extreme downside conditions, Boring Bonds should do quite well – but not as well as times past with rates so low. In extreme downside conditions, Credit should suffer proportionately with the downside pressures of the moment.
Risk/Reward – pretty simple here: With Boring Bonds, low risk, low reward. With Credit, higher risk, higher reward.
I trust you can see what we have separated the two in our client portfolio construction with all of these differences.
Boring Bonds have a place where a client objective has a need for liquidity, capital preservation, and “parking lot” money. It may be for dry powder should there be equity distress. It may just be that one wants out of the market. But those are the objectives that Boring Bonds meet – capital preservation.
Credit has a place where a client has a need for income. There may be price appreciation as well, but generally, Credit investors invite this exposure because they want the coupon the asset class offers and then take the “total return” add-on as gravy.
Why not exclusively use Equities for the income and total return objective described above? The answer is nothing more and nothing less than a potential desire for diversification – a potential need to limit or cap equity beta within a portfolio. Credit caps upside potential in a way Equities do not, but also offers par value at maturity in a way equities do not. They have similarities and differences that make them potentially complementary in a portfolio.
The “Credit” Sleeve
This Dividend Cafe just gets too long, too dry, and too much if I try to exhaustively unpack each component of Credit here.
High Yield Bonds – straight corporate bonds, but where the companies are “below investment grade.”
Senior Floating Rate Bank Loans – packages of bank loans where the interest rate floats (with a floor); generally the most senior debt in a company’s capital structure; usually smaller or more credit-limited companies access this market
Emerging Markets Debt – bond instruments of either sovereign countries or companies within the countries of the “emerging” part of the world economy (essentially, countries that are not considered developed and mature economically)
Structured Credit – a variety of debt instruments backed by various assets are “structured” into securitized vehicles and offer investors cash flows out of the structured pools of debt backed by these assets (more info below)
Asset classes within an asset class within an asset class
The basic definition of this space provided above still leaves a lot to be desired. Indeed, the differences in the various assets that can underlie credit structures can be wildly different. What connects them for our purposes is merely that the cash flows from these assets have been securitized and turned into structures that provide investors a legitimate medium for obtaining cash flow, price return, etc. The underlying assets can include:
Residential mortgages – but here, it is imperative that we specify, we are not talking about the “Fannie/Freddie” variety – what we call conforming loans or Agency Mortgage Bonds. Those are governmental – boring – more rate-sensitive than credit-sensitive. Where Structured Credit may dip into residential mortgage-backed securities (RMBS), we are generally talking about non-agency bonds. They may lack governmental guarantees and Fannie Mae underwriting but can clearly offer significant yield premiums with proper credit enhancements to give investors a compelling opportunity.
Commercial mortgages – this space (CMBS) is further divided by the underlying nature of the commercial real estate, with significant CMBS debt around retail and hospitality, and to a lesser extent, industrial. Before the financial crisis, the CMBS market made up 40% of commercial real estate debt; it is now merely 15% of total commercial debt.
Asset-Backed Securities – and this space (ABS) is also further divided by the underlying assets, covering everything from credit cards to automobile loans to student loans to aviation loans!
The bad news
During COVID, much of the Structured Credit space got hammered during the month of March. There was a huge mismatch of sellers (a lot) to buyers (almost none), and the buyers in this time of distress are what we call “really smart” and “devilish fiends” – meaning, people that know how to smell blood. They held all the cards, the sellers were leveraged and forced sellers, and the buyers picked their price. On a mark-to-market basis, the space got hammered, and the size of the asset class, the relative illiquidity, and the general uncertainties packed a punch – especially for those with too much leverage.
The good news
The space has come roaring back, basically to pre-COVID levels in most spaces, and maybe 90%+ recovery in the more challenged areas. Issuance has come roaring back. There has obviously been the opposite of challenges to housing prices this time around. Plenty of bespoke deals seeking unique financing arrangements were to be found by skilled managers. Spreads have tightened substantially. Forbearance rates in RMBS have ground way, way lower. The Fed has splashed around liquidity as if it were Raging Waters.
Significant returns have been made since April 2020 in this space.
The current state of affairs
Two things are currently true at once for our Structured Credit positioning:
(1) The easy money has been made. The spread compression trade has happened. The dislocation has been cured. In this highly sophisticated but nevertheless crucially telling part of the U.S. economy, normalization has been found.
(2) While 10-25% recoveries are no longer in the investment thesis, the current yields, the pre-COVID pricing, the post-COVID pricing, the new new normal, whatever you want to call it – the basic “normal” investment return, apart from distressed and opportunistic, is back. And we like that just fine, too. We have to be (and are) very sensitive to weightings, to liquidity, to where we are being compensated for risk, but in a 1-2% Treasury world and a 26x S&P world, we still like structured credit yields on a risk-adjusted basis, and we believe in our manager’s skills in navigating these complex waters.
Why Honesty is in the Title
Structured Credit, like Real Estate, is an asset class where investors can very easily lie to themselves. Illiquidity or price transparency is not readily marketable all the time, and with limited mark-to-market comes the ability to tell yourself what you want to believe. We don’t just reject this because of its unhelpfulness or even immorality.
We reject it because it is unnecessary.
We want clients to know the truth, the whole truth, and nothing but the truth.
(Did you know our 2021 team motto and The Bahnsen Group is Simon Sinek’s line – “Trust is built on telling the truth, not telling people what they want to hear.”)
And in this case, there is nothing to be afraid of regarding the truth around Structured Credit. Is it an asset class where liquidity can and does freeze up when tremendous societal distress occurs? Yes, it is. Is it an asset class subject to periods of underlying asset class ambiguity, temporary confusion in mark-to-market, and a required patience for recovery? Yes, it is.
But is it also an asset class with varying degrees of selections available in terms of underlying credit quality, with various inefficiencies that skilled managers can exploit? Yes, it is. And is it an asset class with superlative cash flows that compensate investors for the corollary risk they are taking? Yes, it is.
And most importantly, is it an asset class that, when the really bad moments come, has tended to actually provide tremendous dislocation opportunities for savvy investors and not long-term losses? Yes, it is.
All of these things are true. We feel no reason to pretend that Structured Credit is a boring bond experience. It is not. Core Bond Funds that mixed non-agency mortgages with Treasuries pre-2008 got walloped, and I will never forget that experience. Honesty is the best policy.
Structured Credit is a risk asset class. And we like it.
Chart of the Week
The trajectory of home price appreciation has been steady and consistent since the post-crisis recovery, especially since negative price movement ceased and things began normalizing after excess inventory was worked through a few years after the worst of the bubble burst. But the RATE of appreciation since the Fed’s recent interventions has been, shall we say, noteworthy.
*Virtus Funds, Newfleet Asset Management, June 2021, p. 10
Quote of the Week
“A mania first carries out those who bet against it, and then those who bet with it.”
~ Jim Rogers
* * *
Today, my goal was not just to tout the Structured Credit asset class; it was to frame the entire thinking around “debt” asset classes that we have at The Bahnsen Group and provide practical separation in one’s thinking about Boring Bonds versus Credit. This is not a COVID distinction – it is pre, during, and post COVID distinction.
And Structured Credit is a subset of the conversation. All subsets are our job. We care about these asset classes to the extent we can exploit them to deliver returns for our clients that meet their real-life financial objectives.
To that end, we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet