Credit Markets: What's Next?

Panel Composition and Firm Overview

• Six credit experts from major asset management firms and rating agencies participated in the discussion.
• Steve Tannenbaum (GoldenTree): Manages $18+ billion across opportunistic credit, loans, bonds, structured products, and long-only/short funds.
• David Warren (DW/Brevin Howard): Manages $5 billion for Brevin Howard ($40 billion firm), focusing equally on mortgage/asset-backed securities and corporate credit.
• Tony Ressler (Ares): Runs $60 billion across four capital pools, including tradable corporate debt, private equity, and real estate.
• Josh Friedman (Canyon): Co-CEO of Canyon Partners ($22 billion), focusing on hedge fund credit, emerging markets, and real estate.
• Maria Boiasni (MB Global): CEO of MB Global Partners, utilizing a tactical dynamic asset allocation model since 2000.
• Richard Kantor (Moody's): Serves as Chief Credit Officer and Chief Risk Officer, overseeing rating methodologies and performance.

Current Market Cycle and Valuation Disagreements

• Tannenbaum notes the market is in a phase where investors feel "fairly compensated," contrasting with a likely correction in 18–24 months.
• Current bonds imply a 3% expected default rate versus 2% actuals, while loans imply 6% expected defaults, creating a perceived margin of safety.
• Tannenbaum warns that risk is increasing: Debt-to-EBITDA, acquisition financing, and CCC issuance are rising in 2013, suggesting realized defaults could hit 5–6%.
• Warren projects near-term default risk at less than 5% for the current year, with a rise to 5% likely within 18–24 months.
• Kantor remains sanguine about short-term non-financial corporate defaults, citing strong historical predictors and a 24% speculative grade default rate in the last cycle (vs. 32% in prior cycles).

Specific Investment Opportunities and Trends

• Mortgage-Backed Securities (RMBS): Friedman and Warren identify significant value in RMBS, noting loan-to-value ratios have improved due to higher home prices and the removal of worst-performing loans.
  • Friedman states incumbent RMBS portfolios could yield 20% returns after losses, compared to triple-C rates of 7%.
  • Warren notes many RMBS securities trade at 45–50 cents on the dollar but could return 70–80 cents if home prices stabilize.
• Structured Credit: Tannenbaum and Ressler highlight structured products (CLO debt, asset-backed securities) as undervalued relative to historical norms.
  • Tannenbaum identifies AAA CLO debt trading at call prices of 120–130 as a potential value play compared to riskier credit cards.
  • Ressler argues that while CDOs are leverage, the underlying collateral (AAA loans) has remained unimpaired in recent cycles.
• European Bank Debt: Friedman notes a shift from "really awful loans" to a steady flow of distressed European bank debt at attractive prices.
  • The market for this asset class is less competitive (3–5 buyers vs. 3,000–5,000 in general credit).
• Small Business Lending: Boiasni and Warren highlight a structural imbalance where liquidity remains trapped on large corporate balance sheets ($145 billion for Apple) while small business lending has contracted 20% since the crisis.
  • Ares (Ressler) predicts growth in non-bank shadow banking (BDCs, mortgage REITs) to fill the gap for SMEs in Europe, China, and Latin America.
• Country Credit: Tannenbaum points to Argentina (50% debt-to-GDP after adjustments) and Spanish regional bonds trading 300 basis points behind central government notes as opportunities.

Risk Factors and Structural Concerns

• Interest Rate Risk: Kantor believes the non-financial sector is prepared for rate hikes due to liquidity and interest rate floors; he warns of potential equity market fallout if rates rise sharply.
• Re-leveraging: Boiasni observes that leverage is re-emerging among distressed players, with funds taking 3–4x leverage on loans similar to pre-2008 levels.
• Liquidity Crunch: Boiasni advises that liquidity carries a high price; she suggests investors with a 3–5 year horizon should target illiquid assets to capture premiums.
• Securitization Debate: Warren and Kantor defend securitization as a necessary alternative to "too big to fail" banks, though Kantor notes European banks still rely heavily on a funding model rather than credit risk transfer.
• Fed Balance Sheet: Boiasni notes the Fed has tripled its balance sheet to over $3 trillion, purchasing 15–87% of treasury issuance, yet this liquidity has failed to reach the small business real economy.

Forward-Looking Statements and Strategies

• Asset Allocation: Boiasni advocates moving away from static models (e.g., fixed X% high yield) toward dynamic, tactical allocations across diverse credit sub-classes.
• Equity-Linked Debt: Friedman suggests that distressed debt trading at 50 cents often functions as equity, with high correlation to public equities but offering "endogenous liquidity."
• Return Expectations: Ressler argues that generating 6–12% returns in a low-rate environment requires flexible capital pools and dynamic allocation across private and public credit.
• Future Market Drivers:
  • Warren expects significant returns from illiquidity premiums (e.g., aviation finance) and structural complexity premiums.
  • Tannenbaum predicts that treasury yields will eventually rise, causing a "noise" period before higher rates are realized.
  • Kantor identifies two potential sleepers: a sharp rise in long-term rates affecting global equity valuations and the potential for European "mini-crises" to expand.
• Historical Validation: Panelists cite their past accuracy in 2011 regarding mortgage markets, where clients who stayed invested instead of selling gained over 20% in 2011–2012.

Unresolved Questions and Regulatory Context

• Warren questions whether the post-crisis banking system can adequately handle the full load of lending through securitization this time.
• The panel collectively argues that securitization allows for better risk distribution and monitoring compared to banks holding all assets on balance sheets.
• Kantor acknowledges past rating failures but asserts that the ability to pick winners in the non-financial corporate sector is currently higher than at any other time.