Speaker 1: Hello, and welcome to the Credit Edge, a weekly markets podcast.
Speaker 1: My name is James Crombie. I'm a senior editor at Bloomberg.
Speaker 1: This week, we're very pleased to welcome Kay Her, chief
Speaker 1: investment officer for US fixed income at JP Morgan Asset Management.
Speaker 2: How are you, Kay, I'm doing great, James, thank you
Speaker 2: for having me.
Speaker 1: Thanks so much for joining us, so we're very excited
Speaker 1: to dig into your credit market views. Also delighted to
Speaker 1: welcome back Julie Hung with Bloomberg Intelligence. Great to see
Speaker 1: you again, Julie.
Speaker 3: Hi, I'm Julie Hung, Bloomberg Intelligence, Consumer Staples, Credit Analyst,
Speaker 3: part of Bloomberg's research department of five hundred analysts and strategists.
Speaker 1: Just to set the scene a little bit, credit markets
Speaker 1: are rallying. Debt spreads remain very tight. That means you're
Speaker 1: not getting very much compensation for the risk of default
Speaker 1: or downgrade on corporate debt, but the mood is bullish,
Speaker 1: especially in the US. Most investors are very excited about
Speaker 1: the high yields you can get on bonds that pay
Speaker 1: very low coupons for most of the last ten years.
Speaker 1: But if rates stay where they are or as many
Speaker 1: expect fall. Fixed income investors should benefit. A FED hike
Speaker 1: would probably cause some trouble, though. Meanwhile, issuance is ramping up.
Speaker 1: There's been a record volume of bond and loan sales
Speaker 1: as companies take advantage of the window to raise debt,
Speaker 1: front loading fundraising to avoid any potential election volatility later
Speaker 1: on this year, companies seem to have accepted that rates
Speaker 1: aren't coming down anytime soon. Credit bulls believe that the
Speaker 1: US economy will avoid recession, earnings will stay solid, and
Speaker 1: companies are fine paying higher borrowing costs, although there's a
Speaker 1: cohort of very low quality issuers that may still blow
Speaker 1: up if rates don't fall. We talked last week about
Speaker 1: two hundred billion dollars in junk bonds that look very
Speaker 1: vulnerable at current rate levels. And there's a lot of
Speaker 1: other stuff to worry about, commercial real estate, stress, war, geopolitics, elections. Overall,
Speaker 1: I'm sensing a bit of complacency in credit markets, given
Speaker 1: how tight spreads have become, even a bit of if
Speaker 1: you consider some of the deals that are getting done
Speaker 1: right now. But what do you think. Okay, we seem
Speaker 1: to be hearing a lot about the year of the
Speaker 1: bond a golden age for credit? What's your view?
Speaker 2: So, James, you've said so much in your intro that
Speaker 2: I've got to unpack a few of those things. First
Speaker 2: of all, fixed income investors always have something to worry about. Remember,
Speaker 2: there's always something that can go wrong, so we're always
Speaker 2: losing sleep about things. I think you made a lot
Speaker 2: of great points about spreads yields, but I think the
Speaker 2: important thing to remember is that there's income and fixed
Speaker 2: income again, and I think people shouldn't lose sight of that.
Speaker 2: I would submit that the era of financial repression is over.
Speaker 2: And yes, I absolutely agree that spreads compared to historical
Speaker 2: levels look tight. But there's income and fixed income, and
Speaker 2: there are attractive yields and various aspects of the investment
Speaker 2: grade markets, and I think people should focus on that
Speaker 2: instead of losing the plot on some of the macro
Speaker 2: issues like the FED for example.
Speaker 3: Okay, you know, I definitely agree with you that fixed
Speaker 3: income investors there's always something to worry about on our
Speaker 3: side compared to you know, the equity side, which you
Speaker 3: know they seem to always be very optimistic and you know,
Speaker 3: a little more bullish than we are. What do you
Speaker 3: expect from the FED in terms of rate cuts this year.
Speaker 2: Yeah, so, Jullie. First off, you may not know this
Speaker 2: about me, but I spent three years as a credit
Speaker 2: research channelist at JPMorgan Asset Management. Then I spent seventeen
Speaker 2: years in equities, and about five years ago I moved
Speaker 2: back to fixed income. I find that I actually prefer
Speaker 2: to worry about what can go wrong. I'm better at
Speaker 2: that thinking about what wonderful wings. Yeah, the worst case exactly.
Speaker 2: So you know, in answer to your question, our expectation
Speaker 2: is that the FED cuts probably two times this year
Speaker 2: in the back half of the year. We've got a
Speaker 2: FED focused on the dual mandate of inflation and employment,
Speaker 2: and our view is that inflation has been coming down steadily,
Speaker 2: arguably not as quickly as the FED would have Mutt liked.
Speaker 2: There were some what we call seasonal issue use in
Speaker 2: the first quarter, but we think inflation is moderating. Some
Speaker 2: of the unemployment data has started to tick back up.
Speaker 2: Admittedly it's four percent or under four percent. Longest period.
Speaker 2: I think it's twenty nine months the longest period sub
Speaker 2: four percent. But what we see is some underlying cracks
Speaker 2: and small businesses, and we think that high real rates
Speaker 2: are going to give the FED the opportunity to ease
Speaker 2: to ease this year.
Speaker 3: And what do you think the risk over recession this
Speaker 3: year is and how would credit markets react to that.
Speaker 2: Yeah, it's a good question. When we think about our
Speaker 2: base case, we think that the US economy is in
Speaker 2: a soft landing, and when we think about what the
Speaker 2: market price is in over the next three to six months,
Speaker 2: we think it's the most likely scenario remains a soft landing,
Speaker 2: and to James's point, that is essentially what's priced into
Speaker 2: the credit markets. You do feel a certain amount of
Speaker 2: complacency when you look at spreads, and we can talk
Speaker 2: about the fundamentals in a second, seventy percent we stay
Speaker 2: in a soft landing, maybe the odds of a recession
Speaker 2: or let's call it ten percent recession, five percent of crisis,
Speaker 2: so maybe fifteen percent a scenario that could cause spreads
Speaker 2: to widen, but would actually cause rates to rally. You'd
Speaker 2: get a decline in treasury so the outlook for bonds
Speaker 2: overall would actually probably be constructive in that. So we
Speaker 2: think about that, you add seventy percent on a soft landing,
Speaker 2: fifteen percent on either a recession or some form of
Speaker 2: a crisis. That's eighty five percent that you can collect
Speaker 2: a coupon. You know, the egg is yielding north of
Speaker 2: five percent. Now you can buy core plus strategies or
Speaker 2: even short duration type strategies with yields north of six percent,
Speaker 2: even if you get you know, you're looking at the
Speaker 2: yield plus some total return in there. The tougher scenario
Speaker 2: for bonds would be the other side of the spectrum
Speaker 2: from recession, which would be a reacceleration in inflation and
Speaker 2: in growth, and that we think is a lower probability
Speaker 2: let's call it fifteen percent you've got. You know, if
Speaker 2: you think about that as a as a normal distribution,
Speaker 2: something like eighty five percent is a constructive environment for bonds.
Speaker 2: Fifteen percent is more problematic when you think about managing
Speaker 2: bond portfolios.
Speaker 1: So why do you need the extra headache k of
Speaker 1: corporate debt? I mean, you're not getting your eighty five
Speaker 1: basis points over treagies. Why not just T bills and chill?
Speaker 2: Huh? So you know, I'll confess I opened, I resurrected
Speaker 2: a Treasury direct account that I had many many years ago,
Speaker 2: and I resurrected it a couple of years ago, and
Speaker 2: I was absolutely rolling over treasury bills. The answer to
Speaker 2: your question now though, and I started last year moving
Speaker 2: those treasury bills into short duration core plus and into
Speaker 2: core plus strategies lengthening duration. And I've been doing something
Speaker 2: that I don't think a lot of people on the
Speaker 2: bond side do, which is dollar cost averaging. I feel
Speaker 2: like in the equity markets, everyone has accepted the fact
Speaker 2: that they shouldn't try to time the market exactly, and
Speaker 2: bond markets, we see so many people looking for the
Speaker 2: exact perfect entry point. And I think what people are
Speaker 2: forgetting And you see this in the data, James. We've
Speaker 2: got six trillion dollars of cash sitting on the sidelines
Speaker 2: in money market fund So there's an awful lot of
Speaker 2: people who are in fact t billing and chilling. And
Speaker 2: I think what they love is you sit there and
Speaker 2: you think, my goodness, this is so comfortable. I can
Speaker 2: get north of five percent yields with a duration of overnight.
Speaker 2: This is I can't lose money this way. But if
Speaker 2: you look, and you know, I think you all are
Speaker 2: familiar with doctor David Kelly. He's got this great periodical.
Speaker 2: You know, we call it the periodical elements of returns,
Speaker 2: and cash tends to underperform over longer periods of time.
Speaker 2: I think we've got a generation of investors who've seen
Speaker 2: a one way bond bowl market with rates having gone
Speaker 2: down to almost zero percent and then a very difficult
Speaker 2: repricing two years ago, and they've got a form of
Speaker 2: you know, forgive the term, but post traumatic stress disorder,
Speaker 2: and they're afraid of both credit risk and they're afraid
Speaker 2: of duration risk. I think we have a generation of
Speaker 2: investors who've forgotten or never knew bond math and don't
Speaker 2: fully understand that reinvestment risk is a real problem for people.
Speaker 2: So if the FED starts easing, which is our base case,
Speaker 2: later this year, then those bond yields that people those
Speaker 2: money market yields is overnight yields that people are going
Speaker 2: to get, are going to disappear. So they will have
Speaker 2: missed the opportunity to lock in longer yields.
Speaker 3: Okay, you had talked about soft landing, and I think
Speaker 3: that's a very key term that we've kind of been
Speaker 3: hearing the second half of last year, you know, through
Speaker 3: the beginning of this year, I mean, heading into twenty
Speaker 3: twenty four. You know, as a consumer staples analyst, you know,
Speaker 3: we're always just looking at consumer behavior and what are
Speaker 3: they doing? How are they driving the economy? And there
Speaker 3: was this fear that they're just going to stop buying,
Speaker 3: which we know, you know, consumers never stop buying. But
Speaker 3: there's always that, you know, that fear that you know,
Speaker 3: something's going to happen where unemployment is just out of
Speaker 3: this world and you know, wages are are down and
Speaker 3: it's just gonna like put the economy to a halt.
Speaker 3: But we have not seen that yet, you know, looking
Speaker 3: at the consumer and you know, we just had a
Speaker 3: you know, consumer conference a couple of weeks ago, and
Speaker 3: I do encourage our listeners to listen to the replay
Speaker 3: because it was a very insightful consumer conference. But we're seeing,
Speaker 3: you know, two different consumers. The lower income consumers are
Speaker 3: are a little are a little more you know, hurt
Speaker 3: by what's going on. The higher income consumers are still shopping.
Speaker 3: What is your view on consumer spending behavior? Like where
Speaker 3: do you see this going? Like, given everything's been going
Speaker 3: on in the economy, all the headlines, you know, we
Speaker 3: haven't seen rate cuts yet, Like, what is your view
Speaker 3: on consumer purchasing behavior.
Speaker 2: I think you've articulated it very very well, July. I
Speaker 2: think the US consumer is, first of all, very resilient
Speaker 2: in terms of as long as consumers are employed, they
Speaker 2: continue they adjust their buying patterns in the face of inflation,
Speaker 2: but they tend to continue to spend it spend. So
Speaker 2: what we've seen and we can we can talk about
Speaker 2: maybe some of the trends that we've seen in the
Speaker 2: investment grade universe and some of the trends we're seeing
Speaker 2: in the assetbacks in some terms of the securitized credit market.
Speaker 2: But as you correctly knowe Julie, the consumer represents roughly
Speaker 2: two thirds of US gross domestic product, and as a result,
Speaker 2: we focus a lot on the consumer, and we see
Speaker 2: exactly what you've noted, a bifurcation in the consumer and
Speaker 2: in the investment grade universe in particular. What you see
Speaker 2: is resilience, but bifurcation. So when you look at Walmart,
Speaker 2: Walmart's continuing to take market share from high income households,
Speaker 2: so that's income of over one hundred thousand dollars. More
Speaker 2: than ninety percent of Americans have shopped at Walmart. With
Speaker 2: the the last twelve months, either on their online platform
Speaker 2: or in an actual store. And then if you look
Speaker 2: at their revenues, Q one revenues grew at six percent
Speaker 2: versus I think estimates were more like four point eight percent,
Speaker 2: and IBADAD grew at almost thirteen percent versus estimates that
Speaker 2: were six percent. And what was driving that was higher
Speaker 2: volumes from grocery and from general merchandise. You see similar
Speaker 2: things in dollar stores. So if you look at a
Speaker 2: dollar Tree, for example, so an uplift in traffic coming
Speaker 2: from higher income households. So absolutely you see bifurcation, and
Speaker 2: you see some trade down. You know, you've seen continued
Speaker 2: pressure in the home improvement stores, so lows in home
Speaker 2: depot and we had been seeing some weakness and big
Speaker 2: ticket discretionary purchases, so signs that consumers are remaining very
Speaker 2: budget conscious. But just last week Costco reported earnings which
Speaker 2: indicated some here's the term we haven't used in a while.
Speaker 2: I'll go with green shoots. So some green shoots in
Speaker 2: the consumer and starting to express some interest in buying
Speaker 2: bigger ticket items, so durables and things like that. And
Speaker 2: I think what's driving these trends are a couple of things.
Speaker 2: Companies that are focused on the value proposition are leading
Speaker 2: and I think when you look at those Walmart's result,
Speaker 2: Walmart's had their price rollbacks were up something like forty
Speaker 2: five percent on a year over year basis. Targets had
Speaker 2: to come in and match that, cutting prices on something
Speaker 2: like fifteen hundred items in everyday categories, and that's a
Speaker 2: boon to consumers. Really lower prices. We know you we've
Speaker 2: talked about inflation, We've talked about higher prices. And what's
Speaker 2: interesting is where this is coming from. Walmart is self
Speaker 2: funding that, So they're using price to drive traffic that's
Speaker 2: driving earnings for them. And interestingly, what you ordinarily see
Speaker 2: is the retailers pressuring the consumer staples companies to give them,
Speaker 2: you know, give them more discounting, give them things like that.
Speaker 2: And what you're actually seeing is if you look at
Speaker 2: high qualities like Procter and Gamble, they've seen operating margin
Speaker 2: increases in the first quarter driven by pricing, volume, productivity games.
Speaker 2: And if you look at comparable companies, whether Kimberly, Clark,
Speaker 2: or Pepsi, they had all had similar similar results. So
Speaker 2: I think there have been some benefits of tapering inflation.
Speaker 2: What you've seen of the companies that are leading on
Speaker 2: price and rolling back prices or driving traffic, and that's
Speaker 2: a further boon to consumer. So if they stay employed,
Speaker 2: you've got this moderation in inflation. It's very constructive. I
Speaker 2: think some of the warning signs and maybe this is
Speaker 2: a segue to talk about it is on the Target
Speaker 2: management call after Force first quarter earnings, they noted that
Speaker 2: one in three Americans have maxed out or nearing credit
Speaker 2: limits on at least one credit card. So those are
Speaker 2: some of the warning signs that we're looking at, and
Speaker 2: I'm happy to dive into that, or you can tell
Speaker 2: me where you'd like to take this, Julia James.
Speaker 3: Yeah, that's that's actually my next question about auto loans
Speaker 3: and credit card loans and deficiencies. Again, like you know,
Speaker 3: we're seeing a lot of differing views on that.
Speaker 2: Some people are seeing.
Speaker 3: You know, when you're looking at default rates on these
Speaker 3: auto loans or credit card loans, they're higher than it
Speaker 3: was last year, but then they're pretty flat to pre pandemic.
Speaker 3: What have you been seeing in terms of like the
Speaker 3: underlying performance of these loans.
Speaker 2: Let's dig into this because I think it's actually really
Speaker 2: really interesting. So, first off, low income low FICO consumers
Speaker 2: continue to struggle. We've seen some stabilization in their level
Speaker 2: of stress, but that's actually at lower levels than we
Speaker 2: saw pre COVID, So some slowing wage growth, some slowing
Speaker 2: wage growth, some pockets of sticky inflation. What we've seen
Speaker 2: is excess savings have been depleted. On the other hand,
Speaker 2: and this really goes back to your original question, Julie,
Speaker 2: on the bifurcation of consumers. The other hand, middle income,
Speaker 2: upper income higher fight go score consumer performance that has
Speaker 2: been stronger. Interestingly right now, that's deteriorating at a faster rate,
Speaker 2: but from very historically low levels. So if you think
Speaker 2: about that, the upper end consumers, those tend to be
Speaker 2: homeowners who are benefiting from the lock in effect of
Speaker 2: low mortgage rates. They tend to be asset owners, so
Speaker 2: they own real estate, they own stocks, and that's actually
Speaker 2: performed very well. And higher income consumers also still have
Speaker 2: access to excess savings from pre COVID levels. Lower end consumers,
Speaker 2: back to that bifurcation concept, they're not benefiting from this.
Speaker 2: They're struggling with a higher debt burden. They're struggling with
Speaker 2: reduced excess savings and other headwinds. Think about the fact
Speaker 2: that it looks like student loan repayments are going to
Speaker 2: come back, and I think it's important to actually take
Speaker 2: a couple of step backs and think about why we
Speaker 2: are where we are. And one of the things that
Speaker 2: we started talking about, gosh, I think it was in
Speaker 2: twenty nineteen, twenty twenty, or actually I guess it was
Speaker 2: two thousand and twenty twenty one we started talking about
Speaker 2: is what I call fycoscore inflation. This is everybody's talking
Speaker 2: about consumer price inflation, but fycoscore inflation is a really
Speaker 2: interesting driver in the dynamic on the consumer side. So
Speaker 2: if you go back and remember what happened in COVID,
Speaker 2: you had stimulus payments, transfer payments from the government, you
Speaker 2: had debt payment moratoriums, and different policies that actually created
Speaker 2: what we viewed at the time and continue to see
Speaker 2: as unsustainable positive credit performance, and that translated into pretty
Speaker 2: significant fycoscore inflation to the tune of like fifty points.
Speaker 2: So let's use some examples on this. Roughly half of
Speaker 2: Americans have a FCO score. Who have fycoscores have a
Speaker 2: fycoscore over seven hundred, and you know there's some fycoscore
Speaker 2: inflation there, but median's roughly neutral. But when you're looking
Speaker 2: at subprime borrowers, so four hundred to five hundred or
Speaker 2: five hundred to six hundred, they were seeing scores go
Speaker 2: up by fifty eighty one points, and that translated into
Speaker 2: credit creation. So your five hundred borrower becomes a five
Speaker 2: point fifty borrower, and then bank's credit card companies are
Speaker 2: are much more willing to lend to them. So we
Speaker 2: saw credit availability spike in twenty twenty one twenty two,
Speaker 2: and credit card lenders in particular were increasing credit limits
Speaker 2: very rapidly, so that drove down credit card utilization, which
Speaker 2: we've now seen normalize over the six months. But if
Speaker 2: you think about that, that at the time was a
Speaker 2: very virtuous cycle. You stop making payments, you stop spending
Speaker 2: on things because of the moratoriums, You get a transfer payment,
Speaker 2: you look like a better consumer, Your bank gives you,
Speaker 2: your credit card companies give you access to more credit.
Speaker 2: That makes you look even better. But unfortunately there's a
Speaker 2: reckoning on that, and we've started to see that reckoning.
Speaker 2: And as I said, the subprime consumers were the ones
Speaker 2: who saw the biggest benefit and credit scores, and that's
Speaker 2: now where we've seen the most acute stress in consumer
Speaker 2: performance data, and it's it's not surprising. I think it's
Speaker 2: also important to remember that when you're looking at the
Speaker 2: consumer and you're looking at the asset back market, the
Speaker 2: probability of default is not linear. So a true five
Speaker 2: hundred borrower, a true FYCO score borrower at five hundred,
Speaker 2: has a fifty percent higher probability of default than a
Speaker 2: true five point fifty borrower. So that inflation that I
Speaker 2: talked about in FCO scores of you know, five hundred
Speaker 2: borrowers going up in the eightieth percentile, up ninety three
Speaker 2: points on a FICO score, that had a pretty material effect.
Speaker 2: So I think it's important to understand some of the
Speaker 2: backdrop and that's what's driving a lot of the trends
Speaker 2: that we've seen. Let me pause there if you want
Speaker 2: to jump in.
Speaker 1: I wanted to ask, okay about the trade here, what's
Speaker 1: the what are you positioning around it? I mean, you
Speaker 1: talk about abs. We've seen huge issuance this year. It
Speaker 1: could be a record year, even if things slow down
Speaker 1: around the election. Is it offering better value than investment
Speaker 1: grade debt right now corporate debt.
Speaker 2: So the short answer to your question is we see
Speaker 2: value in both, but we see a lot of value
Speaker 2: in securitize credit and maybe so yes is the answer
Speaker 2: to your question. You referenced yields in investment grade in
Speaker 2: the low fives, and we talked about some of the
Speaker 2: consumer and retail sectors. Their particular narrow Those sectors are
Speaker 2: trading inside of the investment grade universe, so that's not
Speaker 2: necessarily where we see the most opportunities. Some other sectors
Speaker 2: have wider. When you look at asset BAC securities, you
Speaker 2: can get high quality investment grade asset back yields north
Speaker 2: of six percent, north of seven percent, depending on some
Speaker 2: of the things that you're looking at. Do you think
Speaker 2: about the trends that I just talked about. I think
Speaker 2: we were relatively early before some of the issues and
Speaker 2: sponsors understood this dynamic. We had calculated this credit score inflation,
Speaker 2: and we started demanding either better pricing, better yields for
Speaker 2: some of these things that we thought were more at risk,
Speaker 2: or better credit enhancements. And what we've seen, though, is
Speaker 2: this trend which we were I think thankfully early to
Speaker 2: catch on to is now better understood in the market.
Speaker 2: So what you've seen is the tightening of the credit boxes.
Speaker 2: So essentially credit companies are giving consumers less rope so
Speaker 2: they can do that. The damage has been done. A
Speaker 2: lot of the damage has been done, and so you
Speaker 2: saw weakness in some of the vintages of twenty one
Speaker 2: twenty two, which we've talked about. Now you see kind
Speaker 2: of twenty three twenty four with the tightening in the underwriting.
Speaker 2: We've actually seen much higher performance in terms of credit.
Speaker 2: In twenty twenty two, subprime defaults were kind of twenty
Speaker 2: to thirty percent higher than what we would have expected
Speaker 2: in a typical cycle, and that really is due to
Speaker 2: the factors that we talked about, sort of too much
Speaker 2: credit given to subprime borrowers in this FIICO credit score.
Speaker 2: So we see attractive opportunities and asset backed securities we see,
Speaker 2: you know, when you look it's an interesting topic to
Speaker 2: go down this rabbit hole. When you look at the
Speaker 2: ag you know it's it's I'm not a big fan
Speaker 2: of passive. You can argue I'm talking my own book,
Speaker 2: but we see active ETFs, mutual funds, et cetera. There's
Speaker 2: tremendous flows going into passive ETF that go into the
Speaker 2: AG and that doesn't actually offer the opportunity to invest
Speaker 2: in sectors like asset backed securities. So there's a lot
Speaker 2: of fixed income which provides yields that are beyond the
Speaker 2: traditional AG type things that people are looking at. I
Speaker 2: would say there's absolutely an element of caveat MTUR in
Speaker 2: terms of uh looking at you need to do the
Speaker 2: underlying credit work, you need to understand the dynamics. But
Speaker 2: we've just talked about, but we absolutely see opportunities for
Speaker 2: yield pick up there.
Speaker 3: And going back to your comment about you know these
Speaker 3: like they're they're giving them less rope to borrowers overall,
Speaker 3: I realized that.
Speaker 2: Was probably a horrible analogy, and I stopped where I
Speaker 2: was going there.
Speaker 3: Do you think that overall that that's a good thing though,
Speaker 3: because you're absolutely kind of yeah, you know, avoiding the
Speaker 3: financial crisis from back years ago. And do you think
Speaker 3: that this will keep the ABS market attractive because your
Speaker 3: underlying loans are a little I guess I quote unquote
Speaker 3: better quality.
Speaker 2: Safer exactly, Julie. The damage that's been done was really
Speaker 2: done in the twenty twenty one twenty twenty two vintages
Speaker 2: when this wasn't fully understood. I mean, if you if
Speaker 2: you look at it in a in a in a
Speaker 2: single case, that makes sense. Look, this borrower is presuming
Speaker 2: that is performing better than we would have expected. Her
Speaker 2: balance sheet has improved, she's got excess savings, her credit
Speaker 2: utilization is lower. Let's increase her fight go score. That's logical.
Speaker 2: But when you do that over a whole pool, and
Speaker 2: so much of it was driven by pandemic type behaviors,
Speaker 2: the transfer payments, the moratoriums on student loans, et cetera,
Speaker 2: it becomes problematic. And that's what's driven the type of
Speaker 2: delinquencies that we've seen, and I think that scared people
Speaker 2: out of the asset back market, and I don't think
Speaker 2: that's necessarily the case. I think going forward, as I
Speaker 2: said that, there's been tightening of underwriting standards and I
Speaker 2: think the outlook is better, but you still have to
Speaker 2: do your work. In this sector. It's not as it's
Speaker 2: not as transparent as investment grade corporates. When companies are
Speaker 2: making regular quarterly announcements and there's a lot of transparency
Speaker 2: and visibility on what's going on underneath, I think is
Speaker 2: an important understanding what.
Speaker 1: Some actual sections are were talking about here, Ka. We've
Speaker 1: seen some big whole business securitizations where a company pledges
Speaker 1: most of its assets as collateral, including franchise piece. For example, Subway,
Speaker 1: the restaurant chain recently sold three point three five billion
Speaker 1: of asset back bonds to help fund it's by that's
Speaker 1: the biggest I think we've ever seen of it's kind,
Speaker 1: and it may come back. But do you do you
Speaker 1: are you talking about that kind of thing or is
Speaker 1: it sub prime auta or data centers? A movie that
Speaker 1: there are so many different things included in in abs,
Speaker 1: So what are you thinking of when you think about Juncy.
Speaker 2: It's an excellent question, James, and I must confess I
Speaker 2: was a little surprised by the security. So you make
Speaker 2: a great point, a great question. It feels like increasingly
Speaker 2: anything can be securitized. And you're referring to a deal
Speaker 2: that came last week that was hotly over subscribed. I
Speaker 2: think there was substantial tightening the Subway deal, and it's,
Speaker 2: as I understand it, the securitization of future franchisey payment
Speaker 2: to Subway. I was actually talking to my counterpart our
Speaker 2: colleagues in equities this morning to ask if they expected
Speaker 2: that to be a source of financing for additional restaurant companies.
Speaker 2: I think in the five year that came at one
Speaker 2: thirty eight. So when you're looking at retailers probably inside
Speaker 2: of eighty basis points over treasuries, it seems unlikely that
Speaker 2: that's going to be a source of funding for investment
Speaker 2: grade s and P five hundred type restaurant companies. But
Speaker 2: I think this trend of increasing focus on securitization is
Speaker 2: one we're going to see. The answer to your question
Speaker 2: is we'll look at all of it. I think I
Speaker 2: wouldn't categorically rule out any of those sectors. But you're right,
Speaker 2: securitizations can be everything from business jets to revenue franchises
Speaker 2: to old fashioned auto loans, consumer loans, credit card loans.
Speaker 2: We've got a strong research team and we're digging in
Speaker 2: the weeds on all of those things, and it really
Speaker 2: comes to where we see relative value and where we
Speaker 2: see where we see opportunities. But it's to your point,
Speaker 2: much more it's a much more diverse market than looking
Speaker 2: at retail investment grade issue or A or a consumer
Speaker 2: products company or something like that.
Speaker 1: But other sector is right now that you really like?
Speaker 2: We're we see opportunities across the board. I think it's
Speaker 2: less about a particular sector, I would say, and more
Speaker 2: about individual credits.
Speaker 1: And is there anywhere that you're particularly concerned maybe subprime
Speaker 1: auto or I mean, we're not getting back to the
Speaker 1: Bowie bonds of the you know, fifteen years ago, but
Speaker 1: are we getting to As you said, anything could be
Speaker 1: securitized and we've seen some art deals and that's the thing.
Speaker 1: Is it getting very fruthy?
Speaker 3: Now?
Speaker 1: Are you starting to worry?
Speaker 2: As I said at the outset, James, I always worry.
Speaker 2: I'm actually paid to worry. But yes, when I see
Speaker 2: securitization of franchisee payments on restaurants, that that feels later
Speaker 2: cycle to me. When I think about where we are
Speaker 2: in the economics cycle, that feels more challenged to me.
Speaker 2: But I would I would counter that and bring you
Speaker 2: back to the investment grade universe that we were talking about.
Speaker 2: And when you look at corporates, while we've seen a
Speaker 2: deceleration in revenue growth, you've seen actually from our bottom
Speaker 2: up perspective, our investment grade analysts are expecting estimates over
Speaker 2: the next four quarters for revenues to grow three to
Speaker 2: four percent. You've actually seen some acceleration in EBITDAG growth.
Speaker 2: So we saw Q one EBITDA and this is quoting
Speaker 2: statistics on the US investment grade industrial companies for median performance.
Speaker 2: You saw cash flow or EBITDAHN in the first quarter
Speaker 2: trailing twelve twelve trailing twelve month basis up three point
Speaker 2: nine percent. That's an acceleration from last quarter. You see
Speaker 2: you know, you ask me about particular sectors. You see
Speaker 2: strong cash flow momentum growth in tech, in healthcare, and energy.
Speaker 2: And then I think kind of the third aspect of that,
Speaker 2: what do we see happening in leverage in the investment
Speaker 2: grade market. See, leverage is actually flat, so you see
Speaker 2: improving cash flow, stable leverage. And if you look at
Speaker 2: upgrade down grade ratios in the investment grade universe and
Speaker 2: you look at the first quarter data, those have been
Speaker 2: really strong. So something like two hundred billion dollars worth
Speaker 2: of investment grade credits upgraded in the first quarter. It's
Speaker 2: almost three percent of the index, which is meaningful. And
Speaker 2: you've seen strong upgrades of exceeded downgrades every quarter for
Speaker 2: the last two years, and I think a lot of
Speaker 2: those upgrades really interestingly, James, are happening in the triple
Speaker 2: B rated bucket. You've seen a decline in the share
Speaker 2: of triple B minus debt and the index falling to
Speaker 2: the lowest level since twenty eleven. You know, and triple
Speaker 2: B rated buckets now almost half the IG It's about
Speaker 2: forty six percent of the IG index. It's down more
Speaker 2: than five percent from the peak. So I know you've
Speaker 2: talked about at the outset, and I agreed with your
Speaker 2: point that spreads are tight, but triple B is the
Speaker 2: lowest percentage of the IG market. Single A is the
Speaker 2: highest percentage of the IG market in more than a decade.
Speaker 2: So there's some some real strength in in in the
Speaker 2: fundamentals that we see, and I think some of that
Speaker 2: actually does justify some tighter spreads.
Speaker 1: But the one thing I do look at, and I'm
Speaker 1: a real credit geek, I have to admit, okay, but
Speaker 1: the spreads between spreads are just getting crushed. Everything's just converging.
Speaker 1: So you're telling me that a triple B rated bond
Speaker 1: is similar risks for single A across the board. It's just,
Speaker 1: you know, I mean, that doesn't make sense to me.
Speaker 2: So I think a couple of points. I respect your point, James,
Speaker 2: and I can relate to your credit geekiness. I consider
Speaker 2: myself one as well. But let's go back to a
Speaker 2: couple of things. There are a lot of people yourself included,
Speaker 2: it sounds like, who are focused on the tightness of
Speaker 2: the IG market. Absolutely, you're right the old heuristic. And
Speaker 2: I celebrated my twenty fifth anniversary at JP Morgan Asset
Speaker 2: Management last week, so you can't see me on a podcast,
Speaker 2: but I got plenty of gray hair that I've earned
Speaker 2: in the fixed income markets, But the old heuristic was
Speaker 2: you would want to buy investment grade credit at spreads
Speaker 2: of you know, one hundred and seventy hundred and eighty
Speaker 2: over to compensate for a risk of recession. And we
Speaker 2: are or soft landing, but arguably late cycle. And when
Speaker 2: you see spreads inside of one hundred basis points, it
Speaker 2: absolutely causes pause to people. The two things that I
Speaker 2: would remind people of are number one, we're in a
Speaker 2: soft landing. In a soft landing, well, the first point
Speaker 2: would be the fundamentals that I just just articulated. You've
Speaker 2: got an investment grade universe. That is higher credit quality
Speaker 2: than we've seen in about a decade. The same is
Speaker 2: actually true in the high yield index, but it sounds
Speaker 2: like you talked about that last week, so we won't
Speaker 2: go down that tangent right now. But you've got higher
Speaker 2: quality fundamentals. The other thing is you've got a soft landing.
Speaker 2: In prior soft landings, you've actually seen so a couple
Speaker 2: of things. Number one, IG spreads actually trade inside of
Speaker 2: one hundred basis points something like a third of the time,
Speaker 2: So this is not a completely frothy, never exists type environment.
Speaker 2: This is roughly a third of the time. I think
Speaker 2: what's unusual is it's highly unusual for the FED to
Speaker 2: be able to achieve a soft landing. It's having pilot'slicense.
Speaker 2: A nice soft landing is difficult to accomplish. You've got
Speaker 2: all these tailwinds, all these turbulence, and all these different
Speaker 2: things going on, and the FED, it appears for now,
Speaker 2: has absolutely stuck a soft landing, which is terrific. And
Speaker 2: that's an environment where high quality yield performs exceptionally well.
Speaker 2: So the tights on investment grade that's a universe. So
Speaker 2: let's call them now let's say eighty five basis points
Speaker 2: eighty basis points. The tight on that all time is
Speaker 2: sixty two basis points. I'm not necessarily saying that that's
Speaker 2: where we're going. But if the FED does in fact
Speaker 2: pull off the soft landing and we get a gentle
Speaker 2: decline in UH and employment, gentle rise and unemployment, continued
Speaker 2: moderation and inflation, you get the FED easing, You get
Speaker 2: a distanversion of the yield curve. We are going to
Speaker 2: have an avalanche of money into fixed income, and that
Speaker 2: avalanche is going to flow into high quality UH fixed
Speaker 2: income at attractive yields that people aren't going to see
Speaker 2: again for a period of time. And I think that
Speaker 2: could well propel and investment grades spreads tighter. Yeah, you
Speaker 2: know that would be the book case. Not necessarily something
Speaker 2: I make a lot. As I said, I'm more likely
Speaker 2: to be worrying, but you know, I.
Speaker 3: Agree with you that, you know, the credit fundamentals have
Speaker 3: been better. And I think a lot of these companies
Speaker 3: when you're looking at corporates, and you know, specifically like
Speaker 3: for me, like Consumer Staples, they they got they got
Speaker 3: scared after the pandemic. And you know, I'm going to
Speaker 3: go back to you know, there's a big consumer conference
Speaker 3: every year that they have. February twenty twenty, I attended
Speaker 3: the last it's called Cagney, the Cagney Conference, and what
Speaker 3: the CEOs and CFOs were saying at these conferences were Okay,
Speaker 3: you know, everyone's asking them like, what's going on with China,
Speaker 3: And all they could say is, well, we're watching it.
Speaker 3: We're watching it. Then it's got to be less than
Speaker 3: a month later, you know, we're in full pandemic mode.
Speaker 3: Everything got shut down. Nobody expected it, and I think
Speaker 3: there there was this push recently, like the past couple
Speaker 3: of years, into let's focus on our balance sheet. Let's
Speaker 3: make sure we have cash on hand, let's make sure
Speaker 3: we're not overlevered, and you know, let's work towards our
Speaker 3: net leverage ratios to keep you know, good credit ratings
Speaker 3: in case we need to tap the bond markets. Because
Speaker 3: they didn't expect the speed of the pandemic, they didn't
Speaker 3: expect what was going to happen, and I think that
Speaker 3: in a way it was a good thing because it
Speaker 3: propelled them to focus a lot on the balance sheet
Speaker 3: and to focus on you know, very good credit quality.
Speaker 3: Just so they could avoid another situation. And like if
Speaker 3: ebadized down they have a lot of debt that they
Speaker 3: could avoid being downgraded. So I agree with you that
Speaker 3: you know, we're seeing a lot of corporates just you know,
Speaker 3: overall credit quality is just so much better than it
Speaker 3: was a few years ago.
Speaker 2: So Julie, I agree with everything you said, and I
Speaker 2: would add a couple points if I may, If we
Speaker 2: were to rewind the clock, and if you all had
Speaker 2: had me on here in the fourth quarter of twenty nineteen,
Speaker 2: or actually in January, so sort of late twenty nineteen
Speaker 2: or early twenty twenty, I would have cited credit statistics
Speaker 2: to you that were actually Alarming's too strong of a word,
Speaker 2: but concerning what we had seen was a material deterioration
Speaker 2: in credit metrics, whether you're looking at the IG universe
Speaker 2: or the high yield universe. So you saw both gross
Speaker 2: and net leverage had been achieved reached in twenty nineteen
Speaker 2: early twenty twenty, pre pandemic. I'm talking about December January.
Speaker 2: They reached levels that we hadn't seen really in a
Speaker 2: psych So it struck us from a credit perspective, and
Speaker 2: we agreed. I worry about things that I don't need
Speaker 2: to worry about, but it struck us as we're late
Speaker 2: cycle in an economy and companies have too much leverage.
Speaker 2: So we had been taking risk out of portfolios at
Speaker 2: that time, and I did not predict a pandemic that
Speaker 2: was not on my radar. Same thing that you said
Speaker 2: about what was going on at Cagney. But companies were
Speaker 2: horribly positioned for the pandemic. They had too high leverage.
Speaker 2: And then what you saw if we switched gears to
Speaker 2: the high yield market, you saw a six percent default
Speaker 2: rate in high yield in twenty twenty, which really demonstrates
Speaker 2: how poorly positioned companies were for any type of slow down.
Speaker 2: And I think what I would say is the entire
Speaker 2: corporate universe found religion and if you look at the data,
Speaker 2: extraordinary discipline. So what did you see? Dividends cut or curtailed,
Speaker 2: share buyback programs cut, and you saw a renewed focus
Speaker 2: on balance sheets. And what's really interesting to me given
Speaker 2: my background in that time period is you see an
Speaker 2: alignment of bondholders and equity holders of both looking for
Speaker 2: you know, companies rewarded in the equity market for focusing
Speaker 2: on their balance sheets. I mean that was the dawn
Speaker 2: of for the first time in history, the energy companies,
Speaker 2: exploration and production companies finally actually focusing on free cash flow,
Speaker 2: not just growth for the sake of growth, and equity
Speaker 2: markets doing that. So and you look at the underlying dynamics.
Speaker 2: The high yield market had way too much concentration in
Speaker 2: the energy market, so you have now a more diversified
Speaker 2: corporate bond market, a management team, a team of CFOs
Speaker 2: and CEOs who've been through a crisis. They all planned
Speaker 2: and I did too. We had an expectation that the
Speaker 2: recovery post COVID in terms of cash flow would have
Speaker 2: been much slower and much longer, and companies have benefited
Speaker 2: from that. But instead of immediately going wild with share
Speaker 2: buybacks and massive dividend increases, they've actually been quite measured. So,
Speaker 2: as we noted before, leverage remains remains flat. You know,
Speaker 2: whether on a net leverage basis in the IG universe
Speaker 2: it's something like one point nine times, So you know,
Speaker 2: we've seen a little bit of re leveraging in the
Speaker 2: single A space for some of the acquisitions like Conico
Speaker 2: acquiring Marathon, but we think those companies are going to
Speaker 2: continue to maintain single A and there remains a focus
Speaker 2: on balance sheets, so that will fade. You know, everything
Speaker 2: goes in cycles and people will get over the pandemic
Speaker 2: and they will tell themselves that was a one off,
Speaker 2: and we'll get excesses back into it. But we're we're
Speaker 2: not seeing that type of behavior in the corporate market.
Speaker 3: Yeah, yeah, I mean I definitely agree with that. You know,
Speaker 3: we are seeing a little more comfort in taking on
Speaker 3: more debt, but there is there also is this Okay,
Speaker 3: if we lever up to do it acquisition, we're going
Speaker 3: to pay that debt down as soon as possible. And
Speaker 3: again that goes back to the whole like, let's focus
Speaker 3: on credit quid.
Speaker 2: Yeah, I agree with that.
Speaker 1: It's okay when you look around at everything, you get
Speaker 1: to see and I know it's very case by case
Speaker 1: for you, but if you had to pick one thing
Speaker 1: for the next let's say twelve months, where's the best
Speaker 1: relative value for you? In credit?
Speaker 2: Oh, I would put money in securitize credit.
Speaker 1: And it's mostly around the consumer.
Speaker 2: Yeah, asset back consumer. Yep, that's what I would do.
Speaker 1: Okay.
Speaker 2: I think with good research discipline, I think you get
Speaker 2: very strong yield, strong carry, and I think the consumer
Speaker 2: is going to be okay, especially if you've got good,
Speaker 2: good credit research behind that.
Speaker 1: And in terms of the problem areas that downgrade the defaults,
Speaker 1: what are you most afraid of right now?
Speaker 2: You know the general rule and having done this for
Speaker 2: the last twenty five years is, and you touched on
Speaker 2: it earlier in this podcast, James, is when there are excesses,
Speaker 2: when too much money goes into a particular market, that
Speaker 2: tends to weaken discipline and investment. So if you look
Speaker 2: at the leverage load market, the high yield market, and
Speaker 2: the private credit market, those are all roughly the same size.
Speaker 2: So there's something like one point six trillion dollars that's
Speaker 2: flowed into the private credit market. And I think some
Speaker 2: of that will do just fine. I think there's been
Speaker 2: so much money that's flowed into that market, I have
Speaker 2: concerns about the credit quality in that and how that
Speaker 2: will all turn out.
Speaker 1: Is that particularly risky area right now? Private credit? I
Speaker 1: mean a lot of people have flagged it. Even Jamie
Speaker 1: Diamond has talked about it. But is it a big
Speaker 1: concern of yours? Private credit specifically?
Speaker 2: So fortunately for me, so two things. Yes, I agree
Speaker 2: with Jamie, and secondly, fortunately for me, I focus on
Speaker 2: the public market, so it's not something that I am
Speaker 2: worried about in terms of investing on a daily basis
Speaker 2: in our portfolios. But I worry about what delinquencies, what
Speaker 2: amend and extend will look like that market, and whether
Speaker 2: there will be consequences that will ripple through into the
Speaker 2: high yield and the lever blone market. Those are where
Speaker 2: where my concerns lie on that.
Speaker 1: And given what we've discussed over the last forty minutes
Speaker 1: or so, you don't seem that concerned about a serious,
Speaker 1: sort of big risk off move that could cause some
Speaker 1: big volatility a bit if there was. I mean, is
Speaker 1: there any way to hedge that in credit right now?
Speaker 2: That's a great question. You know traditional bond portfolio management.
Speaker 2: Is you hedge risk off with duration in portfolios? We've
Speaker 2: had what I would call wrong way correlation for a
Speaker 2: period of time, I think, and as you've noted, volatility
Speaker 2: has been pretty high in the broader bond markets. I
Speaker 2: think that's a function of uncertainty about the FED. So
Speaker 2: I think two things. Number one, when people gain confidence
Speaker 2: that the FED in fact will ease that they absolutely
Speaker 2: will not hike. They may stay on hold for longer
Speaker 2: than people had originally expected, but I think that will
Speaker 2: bring down volatility, and once the FED starts to ease,
Speaker 2: I think that helps. That helps with concerns around that.
Speaker 2: I think the other really interesting thing, and I hate
Speaker 2: to say this because it promotes poor behavior, is you know,
Speaker 2: you get some terrible risk off move some crisis. Look
Speaker 2: at Silicon Valley Bank last year. I think everyone knew
Speaker 2: there were some excesses and a lack of duration management
Speaker 2: and on the part of some of the banks, But
Speaker 2: the FED came in and essentially bailed them out. So
Speaker 2: is there still a FED put? Probably so, But I
Speaker 2: wouldn't say it's not fair to say that. I don't
Speaker 2: worry about a risk off environment. I think we have
Speaker 2: a particularly fraught geopolitical environment. We've got elections over the
Speaker 2: weekend and three different emerging markets. We've got US elections
Speaker 2: coming up. There's a fair amount of geopolitical conflict in
Speaker 2: the world. I don't think it's I don't think it's
Speaker 2: I wouldn't say there's zero percent chance of probability. I
Speaker 2: think I said at the outset, you could easily five
Speaker 2: percent chance of some sort of crisis that should be
Speaker 2: a good environment for duration for treasuries. In that environment,
Speaker 2: agency mortgages without perform as well.
Speaker 1: Great stuff. Okay, her chief investment officer for US fixed
Speaker 1: income at JP Morgan Asset Management. It's been a pleasure
Speaker 1: having you on the Credit Edge Money.
Speaker 2: Thanks, Thanks James, Thanks Julie, Thanks Gabe, and of.
Speaker 1: Course Julie hung with Bloomberg Intelligence, thank you very much
Speaker 1: for being on the show.
Speaker 2: Thank you for having me back.
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Speaker 1: I'm James Cromby. It's been a pleasure having you join
Speaker 1: US again next week on the credit edge.