why the Fed might not cut

Good morning. Ethan here; Rob is away for the next week. In his absence, we have a world-class line-up of Financial Times journos, including Katie Martin on the bull case for dividends. But not before a short break: Unhedged is off Monday for US presidents’ day. In the meantime, email me: ethan.wu@ft.com.

Friday interview: Armen Panossian

Credit markets are booming. Investor demand for public corporate credit seems insatiable and private credit is the asset class of the moment. So I thought it was a good time to catch up with Armen Panossian, who will become Oaktree’s co-chief executive by March and currently heads up its performing-credit business. In the interview below (conducted prior to Tuesday’s hot inflation numbers), Panossian discusses the case for high-yield bonds, the changing weather in private credit and why banks are increasingly lending to middlemen.

Unhedged: With the economy strong and rates set to fall, corporate credit — especially high-yield bonds, but also investment-grade and leveraged loans — feels like the trade du jour. Is it as good as it seems?

Armen Panossian: High-yield is really interesting. I think it’s very good value, even though credit spreads are near their 52-week tights, around 330-340 basis points over Treasuries. Historically, the spread range for high-yield has been 300-500bp, so we’re on the lower end of that range. But given the fact that base rates are so high — with high-yield yielding 7.7 per cent — that’s a really good absolute return. When you combine that with a low dollar price, there’s nice convexity [more upside risk to bond prices, relative to downside risk] and a “pull to par” [ie, bonds priced below 100 cents on the dollar converge to par value as they mature]. 

High-yield credit quality is the best it’s been in many, many years. Half that market is double-B now; a decade ago it was only a third of the market. Beyond that, the companies issuing high-yield bonds did a good job of extending their maturities right after Covid. So the volatility of Covid and inflation was a non-issue. Because they tend to be larger companies than you see in the leveraged loan market, high-yield bond issuers had the ability to grow nominal profits while inflation was elevated.

I’m not talking about real dollars, meaning dollars adjusted for inflation. But in nominal terms, if a company had, say, $1bn of debt and $400mn in ebitda in 2021, coming out of this inflationary period their nominal dollars of debt is still the same, but their nominal dollars of ebitda is likely higher. Their nominal revenues went up alongside inflation. If they can defend their profit margins, which diversified big businesses tend to be able to do, then their dollars of profit will go up. 

By the time more high-yield bonds start maturing, in 2026-28, I suspect that a good portion of the high-yield bond market will look pretty healthy. Compare that to IG. The IG market did a great job of extending maturities. IG is significantly longer duration than HY. But IG spreads have come in so much — also at their 52-week tights, around 100bp. Triple-B [the lowest rung of IG] spreads are at about 120bp, whereas double-B high-yield is at 200bp. So you pick up 80bp from going from triple-B to double-B. And I don’t think that the quality of the borrowers is that different. 

So relative to IG, high-yield looks really attractive. Overall, moving from IG to HY, you’re picking up 240bp of yield, you’re picking up a shorter duration dollar, and the bond prices are the same, both roughly in the low 90s [cents on the dollar]. You get a total return and a convexity pull-to-par that’s faster and more attractive than IG. IG is more of a play on rates falling, and the spread versus Treasuries is just not inspiring. 

I think the leveraged loan market is probably less attractive than high-yield, too. Loan spreads are also near their 52-week tights, with a 460bp spread. But much of the loan market is trading at or above par, which means a lot of those loans may get called [paid off in full] or refinanced or repriced tighter. Loans do offer higher yields than HY bonds, around 9.4 per cent, but I think a fair portion of that is probably compensation for loss provisioning. You should expect to see elevated defaults in loans, because floating-rate debt [which is common in the loan market] becomes a problem immediately. Most borrowers didn’t hedge. Generally speaking, they aren’t as large or as profitable businesses. And frankly, the leverage, measured by total debt to ebitda, in high-yield bonds is lower than leverage in first-lien loans [the highest quality]. In loan land, you really need to be up in quality to ride through defaults.

Unhedged: Some high-yield sceptics argue that “promised” yields aren’t the same as realised returns. And once accounting for higher expected defaults among lower-quality high-yield issuers, you might not end up getting the yields you see on the tin.

Panossian: Fair enough. You should factor a loss expectation into your yield. But from our perspective at Oaktree, we generally avoid defaults and losses. In our high-yield business, we generally have experienced about a third of the market’s defaults, and we have outperformed the market in terms of recoveries given default. So credit selection matters. Our losses, our burn against the coupon, haven’t been that material through a cycle. But I hear the point that if you look at the whole market, losses create a reasonable amount of value leakage from the advertised yields. 

Unhedged: But is the flipside that in a risk-on or reach-for-yield environment, clients start calling you to ask, why is my other credit fund manager posting, say, 9-11 per cent returns and you guys are only getting 7 per cent? 

Panossian: We have gotten those sorts of calls in the past, though not in the recent past. I would say sometime between the GFC and 2018-2019 we were surprised about how resilient the market was. We were conservative relative to most of our peers. We did get calls from folks saying, why don’t you own more triple-C’s? And then there would be periods of time where volatility would spike and these triple-C-only managers would blow up. And then we would say, well, that’s why we don’t do it. 

Unhedged: Oaktree founder Howard Marks has said, “It’s one thing to have an opinion on the macro, but something very different to act as if it’s correct.” How do you do credit investing if you are agnostic on the macroeconomy, which is to say the default environment?

Panossian: I would say we’re macro-aware. You have to be aware of how macro conditions will affect bottom-up credit selection. What Howard is saying is that making a buy or sell decision based solely on a macro view would be an irresponsible use of client capital — a fool’s errand. Howard just disclaims any sort of macro prediction and says if we do a good job in the micro — the bottom-up credit analysis — then we’ll make better decisions through a cycle. 

Unhedged: Explain your scepticism of the consensus soft landing plus rate cuts scenario.

Panossian: The Fed doesn’t reduce rates for the sake of reducing rates. The Fed has a certain mission: full employment, inflation stability and moderate economic growth. If we do have some economic growth, inflation is under control and unemployment is stable, the Fed doesn’t really have a reason to act. In a “no landing” or moderate soft landing scenario, the Fed is likely to just watch and wait. 

Now, some people point to what [Fed chair Jay] Powell did in 2019. There was a global economic slowdown and trade issues with China. And the Powell Fed reduced rates three times in 2019, even though GDP growth was still positive, though slowing. Plus, the Fed won’t want to be accused by the market of having missed the inverted yield curve [a historically reliable a sign of a coming recession]. That’s the market sending a clear signal to reduce rates. If they ignore that and a recession happens, they’re going to look foolish. That’s the theory you hear around how rate cuts could happen even without a recession.

The disconnect is that I think the Fed was more embarrassed by the statement that inflation is “transitory”. At the end of the day, it really was transitory, it was just a question of the timeframe. But they looked like they let it get out of control. So I think the Fed, now having been burnt by that recent miscalculation, is going to favour keeping rates higher, to make sure the job is done. And if a recession were to occur, they have a lot of firepower, in the form of reducing rates, at the ready.

I think the Fed will only pivot when it’s very clear that there’s a problem, not in anticipation of one. The fact it’s an election year might also change behaviour. The Fed’s won’t want to do anything unless it’s absolutely necessary, so they don’t look like they’re impacting the election.

Unhedged: Let’s turn to private markets. You said in an interview last year that private credit deals are being underwritten for the most predicted recession in history. Are you seeing that change, now that the soft-landing-plus-rate-cuts consensus has taken hold?

Panossian: The story in private markets dovetails with what we’re seeing in the public markets. Think about what a high-yield bond investor was seeing at the end of October 2023: some good inflation news, falling Treasury yields, 9.5 per cent HY yields, dollar prices in the 80s [cents on the dollar]. It looked like a great buy, and was. So a ton of money flooded into markets. In the last two months of the year, the HY bond market returned over 8 per cent. We call it a “lift-a-thon” — everything was getting bought.

Through that demand pick-up for high-yield, leveraged loans also rallied in sympathy. The formation of CLOs [collateralised loan obligations, the main buyer of leveraged loans] started coming back in November, December and January. Now the syndicated loan market is quite open — and competitive against private credit. 

If you look at spreads on private direct loans, they’ve tightened 100-150bp in the past 12 months. For a typical non-software LBO [leveraged buyout, the main type of transaction against which private credit loans are made] this time last year, spreads were around 625-675bp. Today, for non-software deals, I would say the spread in the market is around 525-575bp or so. Easily 100bp of tightening. That’s a pretty big move.

Base rates are still high, but part of the reason why spreads declined in direct lending was because deal volume was down, too. Private equity firms were looking at higher base rates and wider spreads and saying, no, I don’t want to do any deals right now, unless the company is growing really rapidly. The other factor is that fund flows into direct lending have been stable and growing, especially from high-net-worth investors putting money into semi-liquid BDCs [business development companies]. Those inflows have picked up since June 2023. 

All told: a lot of capital, not enough deals, public markets rallying and becoming competitive — all that has created a pretty material tightening in private credit over the last couple months.

Unhedged: In the coverage of private credit’s “golden moment” last year, we saw claims that the traditional big bank loan syndicators were increasingly irrelevant, opening the way for private credit lenders. But are we seeing the pendulum swinging back towards the investment banks? Are banks back?

Panossian: I think the binary statement that some private credit managers made last year — arguing banks are irrelevant — is an overstatement. We were saying that banks are suffering from losses, and it will take them time to come back. Frankly, they’re back a bit faster than we thought, but I don’t want to overstate how “back” they are. They’re willing to do deals for high-quality credits. You can get a deal done for a double-B senior loan at a 300-350bp spread all day long. That market’s wide open. But as you go down the credit quality spectrum, such as in single-B’s, deals are going to price higher, maybe at a 450-500bp spread. When you’re in that range, the syndicated loan market is improving, but it’s not fully open yet. 

The experience that private equity firms went through in 2022 and part of 2023 was going to banks and being told “I am closed”. That resulted in PE firms having to go to private credit, and they realised that working with a bank involved meaningfully higher execution risk than with a private credit manager. PE also realised that it’s in their best interest to support the survivability of both markets [bank loan syndication and private credit]. At some point, they’ll go back to mixing and matching. There used to be deals where the second lien was privately placed, but the first lien was syndicated. I think both markets will survive, and it’s not a binary outcome for either.

Unhedged: What do you make of the anxiety surrounding commercial real estate and regional banks? Does it make sense as an investment opportunity?

Panossian: On CRE, the maturity profile for loans isn’t out in the future; it’s here and now. There will be defaults and losses in certain types of CRE. Even in high-quality CRE, there will be assets that, once they have to restrike their loan, won’t be able to cover cash flow. I think there’s a great buying opportunity ahead of us, but it requires patience. So long as rates are high, high-quality assets will fall through the cracks as they have to refinance. 

On regional banks, I don’t think they’re back in the market lending right now. Instead, they are winding down their books a little bit. Many are also thinking about the Basel endgame regulatory framework coming. As a result, the shift that we’re seeing in business processes for regional banks is actually more pronounced outside of real estate than in real estate. Certain areas of lending where the regional banks used to be active — asset-backed finance, some types of small business financing, consumer lending — they’re no longer active in. They’re finding that these legacy businesses are no longer good from a required capital or risk-weighted-assets perspective. 

They’re not fully exiting, though. Instead they’re saying, I would rather lend to a lender that then lends to the end market. That way, I can reduce my loan-to-value against the end market, which helps from a capital ratio standpoint, rather than directly providing those loans to the end borrowers. The banks’ willingness to provide leverage to investment managers is also shifting. They’re favouring doing more with a smaller set of managers, rather than spreading business across a lot of managers. 

Unhedged: Should we see the fact that banks are increasingly lending to non-bank lenders as de-risking the financial system or adding risk to it?

Panossian: It’s a good question. It’s de-risking in one way, and risking up in another. 

Why is that? The de-risking is obvious: if the banking system, centred on too-big-to-fail money centre banks, is generally reducing their loan-to-value ratios, that’s a good thing. That’s de-risking. The investment managers that form the layer in between get their capital from insurance companies, sovereign wealth funds, pension funds and so forth. The risk in that mezzanine category of capital is no longer at the banks. It’s diffused in the market, which is good. 

If I wanted to be sceptical, some number of those investment managers are going to raise capital that they probably will not be as prudent in deploying. Problems could arise in moving away from a banking environment where regulatory oversight and risk management is really high towards a system based on investment managers that don’t have the same focus on risk. If you look at Howard Marks’s investment philosophy for Oaktree, the first item for us is the primacy of risk control. But some smaller investment managers don’t have sophisticated risk-management processes, and their incentives are just to grow and deploy capital.

But is that a systemic risk? I’d say probably not.

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