Credit Market Outlook

Market Overview & Credit Cycle Assessment

• The global credit cycle is described as "getting long in the tooth," with defaults stabilizing around 2% despite worsening underwriting statistics.
• Panelists note that while low default rates currently exist, they anticipate a correction or correctionary environment in 2018 as the cycle matures.
• A significant trend identified is the shift from quantitative easing to fiscal policy, which panelists believe will create distinct winners and losers across sectors like retail, specialty pharma, and utilities.
• There is a consensus that passive investment vehicles (ETFs, large mutual funds) are disproportionately exposed to large, liquid high-yield issuers, creating a "disaster waiting to happen" if market dynamics shift.

Portfolio Structuring & Response to Rising Leverage

• Leverage Concerns: Panelists express concern over private equity firms raising over $500 billion to potentially originate over $1 trillion in new debt annually, often at 6x to 7x leverage with "covenant-lite" or no maintenance covenants.
• Active vs. Passive Strategy: Apollo (Jim) argues that active management is essential to navigate covenant-lite environments, noting that passive funds cannot properly analyze complex capital structures.
• Covenant Protection: Crescent Capital Group (Mark) maintains discipline by keeping average leverage in their mezzanine fund below 6x, allowing them to reject transactions with excessive leverage.
• Origination Focus: Apollo has pivoted to "origination front-end" businesses to avoid relying on "QSIP buyers" in a fairly valued world, with 85% of their direct origination product being led by them.
• Private Transaction Discipline: Crescent reviewed 1,300 transactions last year, selecting less than 5% to maintain strict underwriting standards and avoid the "morass" of public high-yield markets.

Specific Investment Strategies & Opportunities

• GoldenTree (Joe) – Structured Products & CLOs:
  • GoldenTree is leveraging the Dodd-Frank risk retention rule (effective Dec 2016) to improve CLO models, issuing risk retention vehicles with tight pricing.
  • They identified value in trust-preferred CDOs (legacy pre-2007 assets) trading at deep discounts (e.g., bought at 53 cents on the dollar), offering double-digit returns with 8-year duration.
  • The firm expects lower recovery rates and higher volatility due to bank loans representing 75% of capital structures today, up from a historical average of 60%.
• Apollo (Jim) – Distressed & Special Situations:
  • Executed an $800 million DIP (debtor-in-possession) loan for Westinghouse in seven days, focusing on the operating nuclear services business rather than the troubled reactor construction arm.
  • Apollo's European strategy focuses on buying non-core assets and non-performing loans (NPLs) from banks, targeting $45 trillion in banking assets in the region.
• Crescent Capital Group (Mark):
  • Structures transactions with floating rates (50%+ in recent vintages) to mitigate interest rate risk.
  • Focuses on private mezzanine lending where they can set terms, coupon rates, and covenants directly with sponsors.
• Creston/GoldenTree – Emerging Markets:
  • Opportunities identified in Argentina where provincial debt (e.g., La Rioja) trades 400 basis points over the sovereign, with expectations of spread compression.
  • Historical success noted in Brazilian province debt (Minas Gerais) and Spanish distressed assets in 2012.

Risk Management & Interest Rate Sensitivity

• Interest Rate Risk Mitigation:
  • Apollo holds less than $1 billion of fixed-rate high yield on a $130 billion platform, prioritizing 100% floating-rate paper in direct lending.
  • Crescent manages duration in liquid portfolios to approximately 2.6 years to hedge against rising rates.
  • GoldenTree and Creston Capital maintain short-duration, event-driven strategies to minimize exposure to macro rate shifts.
• Geopolitical & Macroeconomic Factors:
  • Panelists emphasize that geopolitical risks (e.g., Brexit, Russian involvement in Eastern Europe, potential Red Sea instability) are often "time bombs" that require active analysis and are frequently underpriced by the market.
  • Michael Milken notes that imagination is required to interpret complex global trends, as knowledge is now a commodity accessible to machines and algorithms.
• China & Energy:
  • Contrary to market pessimism, Michael Milken's firm bet against a Chinese economic meltdown and a collapse in oil prices (below $10/barrel) earlier in the year, generating significant returns.
  • Panelists agree that understanding commodity prices is critical, as energy constitutes 15% of the high-yield market.

Forward-Looking Statements & Future Outlook

• 2017-2018 Outlook: The consensus is that while the current environment allows for "grinding out" returns via active management, a shift in credit cycles is imminent, requiring disciplined sourcing and complex structuring.
• Private Equity Impact: With private equity firms targeting higher leverage and lower covenants, active credit managers anticipate a future market correction that will favor those with the ability to structure deals and perform deep fundamental analysis.
• Regulatory Tailwinds: GoldenTree views the Dodd-Frank risk retention rule as a "silver lining" that will allow them to improve capital structure and control costs in the CLO market.
• Global Opportunities: There is a continued belief that the "vintage" of distressed and non-core assets in Europe and emerging markets remains a key source of alpha, with panelists noting that active management allows for the exploitation of distortions created by index followers and regulations.