Macro Markets Podcast Episode 72: Credit Cycle Check-In
Tom Hauser, Head of Corporate Credit, and Dan Montegari, Head of Research for Corporate Credit, join Macro Markets to discuss credit quality and market technicals at this point in the credit cycle, as well as what is driving the divergence between the high yield and bank loan sectors. Find out how tariffs and A.I. factor into our bottom-up credit analysis, and where to find value in a time of market volatility and tight spreads.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody. And welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I’m Jay Diamond, Head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. Now, fixed income markets have calmed since April and spreads have returned to their pre–Liberation Day tights as economic growth and inflation gradually slow and the Fed is now back in play. Tariff policy is still unsettled and its effects have yet to filter through the economy. All of this leaves investors with a wide range of potential outcomes to think about, and expectations for more market volatility. So what does all this mean for corporate credit, which is one of our areas of expertise? Well here to help us make sense of where we are and how to approach investing with this heightened uncertainty are two of the leaders of the corporate credit team, Tom Hauser, the Head of Corporate Credit, and Dan Montegari, Head of Research for Corporate Credit. So welcome back, Tom and Dan, and thanks for taking the time to chat with us today.
Tom Hauser: Good to be back, Jay.
Dan Montegari: Thanks for having us.
Jay Diamond: So let's dive right in. Tom, if you could level set for us a little bit of the team you lead, as head of corporate credit, encompasses multiple sectors, can you give us a brief overview of the corporate credit landscape and sectors that you and your team focus on?
Tom Hauser: Sure. Corporate credit here at Guggenheim is really one unified platform. And what I mean by that is the same team is responsible for all of corporate credit AUM, and that includes investment-grade corporates all the way down to private illiquid credit and everything that falls in between.
Jay Diamond: What falls in between?
Tom Hauser: So high yield senior loans, syndicated senior loans. And when you put numbers to that AUM, you have about 105 billion in total AUM, of which about 75 billion is investment grade corporates. About 11 billion is traditional high yield. And then just under 20 billion is senior bank loans. And breaking that bank loan number down further, you have about 14 billion in syndicated bank loans and about 6 billion in private illiquid credit. The team responsible for that AUM numbers just over 90 investment professionals. And at our core we are a bottom-up credit research shop. And so the majority of the 90 person team is dedicated to investment research, doing the work on the individual opportunities and the relative value across all of those corporate credit sectors. And then away from research, we have dedicated individuals for trading, portfolio management, and private credit origination.
Jay Diamond: Now does your team focus on a particular sector or particular credits, and then wherever they issue within those sectors?
Tom Hauser: Sure. When you're talking about the research team, we are organized by industry or sector. And so we think the way we've organized our team, putting them in a position to analyze both the large and small credits within an industry, it puts them in the best position to determine relative value and pick their spots within capital structures.
Jay Diamond: So Tom, let us stick with you for one more question here. So where are we in the credit cycle, and what are some of the broad trends that you're seeing out there in the marketplace?
Tom Hauser: Yeah, it's an interesting question. I think when you're thinking about where we are in the cycle, it's always helpful to look at where we've come from. And over the course of the last 36 months, the last three years, we've seen really strong performance in below investment grade credit. And I'm going to concentrate on below investment grade credit for this. Both the high yield market and the senior loan market have had strong returns and have benefited from high all in yields, strong fundamentals or a benign credit environment where we've seen default rates below their historical average, and a technical backdrop that has benefited both asset classes. In terms of where we're going or where we are in the cycle on a go forward basis, we think that the technicals will remain strong for both markets, probably for the next 12 to 24 months. And in particular, we're going to see very limited net new supply to the market. And so we should see an environment where demand outpaces supply, providing that technical tailwind. And then from a fundamental perspective, I think the two markets diverge a little bit. We've seen the high yield market over the last number of years move up in quality, where today we have over 50 percent of the high yield market rated double B or better. Whereas the senior loan market, we've seen single B issuance grow as well as a market where the coupon is floating rate. And so we've seen continued pressure on senior loan issuers cash flow because they're paying a higher all in coupon than when those capital structures were first put into place. And so to sum it up, we think technicals will remain robust. There will be a tailwind. In terms of fundamentals, we're probably seeing a bit more of a headwind in the senior loan market than we are in the high yield market.
Jay Diamond: Well thank you for that high level overview. We're going to dive into some of it more later. But Dan you’re the head of corporate credit research one of the things that Tom mentioned was the fundamentals. So how would you characterize the credit quality of the issuers you're seeing in the markets right now? Where are you seeing strength and where are you seeing weakness?
Dan Montegari: I think maybe just to hit on the point that Tom raised, we definitely are seeing a bifurcation within the two markets. If I think about high yield skewing higher quality as Tom said, if we use the single B as the demarcation between below investment grade, higher quality, double B, lower quality, triple C, particularly within the leveraged loan space, about 70 percent of the issuers are single B or below. And I think the highest number of issuers that the index has ever seen are B3. So that rung right above both triple C. When you compare that to the high yield index, 42 percent of the indexes is single B are below. So definitely a big quality skew. We see that show up in some of the default numbers. Defaults, when we think about that and we include distressed exchanges, the high yield default rate is about 1.4 percent. The leveraged loan default rate, again inclusive of distressed exchanges, is about 3.8 percent. So you kind of see that differential in quality. And if we compare that to historical averages, the high yield historical default rate is about 3.4 percent. So today we're significantly below that within the leveraged loan space. It's about 3.1 percent. So around 3 percent. So leveraged loan defaults are creeping above, you know, where they've been historically. And then again you just go back to what we talked about from a bifurcation. Over time, the high yield market has definitely creeped up in quality. And historically the default differential was about 30 basis points of defaults were higher in high yield by about 30 basis points. Today based on those numbers, it's the inverse. Defaults are higher by about 240 basis points in loans. So that's just a broader overview of the market. What I would say is where we're seeing weakness today, it's particularly in markets or regions of the economy that are kind of exposed to excess capacity and that excess capacity in Asia being exported to other markets. So chemicals is an area where we've seen depressed demand for a long period of time. Steel. We are seeing depressed demand within the steel market. The consumer has been resilient, but the consumer has also been very deliberate in their spending. And an area of weakness that's been surprising or historically a sector that's been defensive is food and beverage. We've seen softness within the food and beverage market really for the past two years, volumes have been very challenged in that market. There's been some more recently at Del Monte, Tropicana, and The Hurt Side within the below investment grade market. And there's even challenges in the above investment grade market with Kraft, you know, Kraft potentially doing a spend of their assets to really separate the good and the bad, if you will. And so food has been a surprising area of softness over the last 12 to 18 months.
Jay Diamond: Now just to follow up, the big question of the day right now is how the tariff situation is going to play out. How do you and your team of analysts go about assessing the impact or potential impact of tariffs? And how do you think about this as a risk factor to tariffs?
Dan Montegari: So tariffs absolutely are a risk factor for every credit we evaluate. Going back to what Tom said, we are a bottom up fundamental credit job. What that means is we analyze each business, each credit. We look at their business model, the economics of their business model, and we try to really determine how this business generates its earnings and its cash flow. From there we try and understand the risks to that cash flow, the predictability and stability of that cash flow, which typically comes from either, you know, your input cost, the competitive set, or in market demand. The interesting thing about tariffs, when you kind of dig in and start to do our analysis, is the interconnectedness that tariffs really has across those three buckets. For the most part most issuers, the first impact will be in your input cost. And then those companies have to make a decision on how to offset those input costs. So they'll either absorb them, which will have an impact on profitability, they'll look to cut cost in other areas of their business, or they'll pass those higher costs on to the consumer. If they decide to pass those higher costs onto the consumer, they'll have to think about the elasticity of demand of that consumer, but they'll also have to think about the competitive set. How are my competitors positioned within their supply chain? Are they seeing the same level of inflation or cost increase. And if they're not, they have to be very thoughtful about pricing themselves at the market and losing share. And so it's very interconnected. We've done as a team a deep dive into all of our businesses to really understand who are most exposed and hopefully we were proactive in identifying those and trying to reduce exposure to those names over the last couple of months, too.
Jay Diamond: In general, where has this led to you in terms of industries or sectors or businesses that you either want to shy away from or move towards?
Dan Montegari: Yeah, I would say consumer product companies are kind of very in the bullseye of tariffs, as well as automotive businesses where we've actually seen a lot of insulation and strength is in services businesses, whether it be financial services, REAs, wealth managers, accounting services, you know, insurance brokers, the services space in general has been much more insulated from the tariffs overall.
Jay Diamond: So, Tom, how does the economic outlook play into your team's view of credit quality and risk in the marketplace as an overlay?
Tom Hauser: When I think about the top down view and how that filters through, from a portfolio perspective, we are really building portfolios from a bottom up or on an individual name basis. So name by name. But certainly when you look at it from a top down, there's an organic view expressed by the credits we've picked or said differently, the credits we've avoided. I think Dan just walked you through a good example, the tariff situation and how that filtered through the bottom up analysis for individual names and how you see that filter through. And from a portfolio perspective is you start to see the portfolio organically turn over and sell some of its consumer products names, and you start to see an overweight being built in some of those services names, which are less exposed to the tariff situation. When I think about different economic cycles over the course of the last 20 years and how it's filtered through, again, it's not a top-down theme that we're trying to express, but more so it's organically expressed through the credits we're picking or the credits we're avoiding in that bottom up process.
Jay Diamond: The market is currently debating whether the Fed will move in at their July meeting, which is next week or maybe September, but how does monetary policy and Fed moves play into all this?
Tom Hauser: We've never really been too much of a team that focuses on rates from a perspective of trying to capitalize or predict where they're going. But when we think about our bank loan issuers or bank loan portfolios, that certainly impacts them directly because, as we mentioned, bank loan issuers issue a floating rate coupon. And so where the base rate is impacts what cash flow will be for those underlying businesses. And so rather than try and predict where the Fed's going, what we try and do is look at the forward rate curve and see what impact that has on cash flows, and then take it a step further and risk the model assuming rates stay higher for longer. Because what we're really trying to predict is which businesses can survive a higher rate environment or be able to service their debt costs, versus which businesses are going to continue to struggle and if we can avoid those businesses and overweight the ones that are in a much better position.
Jay Diamond: So, Dan, both of you mentioned historical context. You gave us a little bit of info on current default rates versus history. How does the broader credit profile today versus where we've been at different parts of cycles in the past?
Dan Montegari: From a broader credit perspective, high yield again, is better quality than it's been historically from a metrics perspective. Interest coverage historically about four times today it's a little over four times. So drawing on coverage from a leverage perspective, long term average within high yield has been a little under four times. And we're probably closer to maybe mid threes from a leverage perspective. So the metrics overall again healthy in the context of the historical environment. We talked about default rates. But the other area from a historical perspective that's maybe changed a little bit in the market is recovery rates. And so recovery rates are coming down particularly for leveraged loan issuers. If you think about historically, recovery rates is about 62.5 percent in 2023, they were about 30 percent, in 2024 about 44 percent, and in the LTM period closer to about 40 percent. And the driver of lower recovery rates are really weaker documentation and creditor protections within the market. And so that's really enabled issuers to prolong potential issues, prolong the realization of restructurings by adding priority debt to the capital structure or changing the collateral base, moving collateral and moving assets from existing creditors, which all has a detrimental impact on the existing lenders in that name. And so as a result of that, you have seen the recovery rates come down. And that just means that when you do have a default, the severity and the impact of that default is higher. I think on a go forward basis, we don't anticipate documentation ever reverting to what was the historical standard and so recovery rates will likely be structurally lower on a go forward basis. And ultimately, what that means is you need to have very strong credit selection and you need to constantly monitor names in the portfolio and as a result, avoid losses. And really that is kind of the fundamental aspect of our business model within the research team is bottoms up fundamental analysis, constant monitoring and communication again, to get ahead of and identify and be proactive when we see issues. Now that doesn't mean that we get it right all the time. We obviously do have defaults in the portfolio and that can impact performance in the near term. But over the cycle we believe our process and it's proven out that our process will ultimately avoid defaults, which will result in better performance. Given, again, our expectation that recoveries will be lower going forward.
Jay Diamond: So you also mentioned that there's an apparent divergence between, the high yield market and the bank loan market. Is this a typical late cycle divergence, or is there something else at play that may have led high yield to be in a better position than, bank loans at this point?
Tom Hauser: I think there's two things that are occurring that probably caused a divergence between the two markets. Over the last, call it 15 years, the senior loan market has effectively stolen share for the LBO model from the high yield market. Historically, LBOs were financed with first lien bank loans and then typically beneath the bank loan in the capital structure was an unsecured bond. And what we've seen over the course of again, the last 15 years, is more and more of the private equity sponsors and the banks issuing all bank capital structures. And so we lost that senior unsecured bond in that LBO capital structure. And that was through a combination of first lien bank that that stretched deeper into the enterprise value, so we saw more levered first lien as well as then a small second lien behind that first lien or no debt whatsoever instead of the unsecured bond. And the result was a growth in single B issuance and senior loans and a shrinking in the single B category within the high yield market, which is why today high yield is over 50 percent double B and senior loans today are roughly 70 percent single B.
Dan Montegari: And I think part of the divergence in credit quality, as Tom said it, leveraged loans are a floating rate asset. If you think about what's happened to base rates from 2020 and 2021, they've risen substantially and the capital structures that were put in place for 2020 and 2021 LBOs were not necessarily anticipating that massive rise in base rates, which is pressured cash flow for those businesses. So as a result of that, you've seen stress in the loan market really a function of the rise in base rates and capital structures that were not effectively put in place with cushion for that increase.
Jay Diamond: Tom, you mentioned technicals before, which is a big driver performance. Talk to us a little bit more about where the demand is coming from, with supplies coming from, how that's been driving returns or helping to drive returns up till now. And what do you see going forward?
Tom Hauser: On the supply side, I'll start there from the technical environment, with the rise in rates that we've seen since 2022, we've seen a slowdown, significant slowdown in LBO activity and most of the net new issuance, as we just talked about for the markets comes from that LBO activity. The LBO machine being turned on. And because we've seen rates rise, but we haven't necessarily seen a reduction in the enterprise value multiples, we've seen fewer trades between private equity sponsors as well as fewer public companies being taken private by private equity. They're really just dealing with the books that they put in place or the deals that they put in place, as Dan said in 2020 and 2021. And so very limited new supply, most of the supply that we've seen has been refinancing or repricing activity. So really just taking the existing paper and rolling it out or rolling it forward, as well as some opportunistic transactions, which adds a little bit of net new supply. On the demand side, the two markets sort of have different, demand dynamics. The bank loan market is dominated by CLO issuance and CLOs represent about 70 percent of the buyer base for senior loans. We have seen very strong CLO activity over the last three years. Last year was an all-time record with over 200 billion of net CLO issuance. And we are on pace this year to break that record. And so with that CLO supply being very strong, the demand for senior loans has outpaced the supply by a fairly wide margin when you look at it over the last three years. On the high yield side, you don't have that CLO dynamic, but what we have seen is fairly strong demand from both institutional investors as well as retail investors—money flowing into mutual funds and ETFs. And again, when you look at the supply and demand ledger, the demand side has outpaced that supply side in the high yield market as well. On top of that, high yield benefits from the coupon being recycled. The bank loan market, the coupon gets paid out to the CLO liabilities and so you don't necessarily see that recycling when on high yield market without the liability cost being borne by the coupon, you see that coupon being recycled by the funds every month. And so that's another dynamic that's creating, strong demand for high yield.
Jay Diamond: All of what we're talking about ends up in the price. Tom, how would you characterize pricing right now in corporate credit in terms of yields and spreads? And where are you finding value and what are you avoiding?
Tom Hauser: I think you have to look at the two components, yield and spread a bit differently. Right now, from a yield perspective, I would say both markets offer fairly attractive yields. High yield is just over 7 percent today right around 7.11 as we talk and the bank loan market is just inside 8 percent all in. And so when you think about those yields versus what you've earned historically in both markets, you're earning a decent coupon and decent yield for both of them. Especially when you consider the quality of high yield today versus its historical context. Spreads, however certainly are tight in that historical context. High yield spreads today are about 283 basis points, so inside 300 basis points. And on the loan side we see loan discount margins right around 444 basis points. Spread is what compensates you for expected losses. And when we think about the spreads for both high yield and bank loans and what they're saying about the expected losses going forward, we would say both markets from a spread perspective, appear to be priced for perfection. And putting numbers to that, we think the high yield market today is pricing in a roughly 1-1.5 percent default rate, which is right on top of where we are for the last 12 months and 444 basis points of discount margin in a bank loan market is pricing in a roughly 3.5 percent default rate, which is again, right about where we are on a trailing 12 month basis. As we talked about, there are signs that defaults and pressure on underlying corporate issuers ,while we don't expect a spike in defaults, we do expect pressure to continue to build a bit. And so from a spread perspective, you're not necessarily being compensated in our minds, for these asset classes. That's where our fundamental bottom up credit analysis comes in. As I said, you're getting a good yield in both high yield and bank loans. If you can avoid those defaults, the spread becomes a bit less relevant because by avoiding those defaults, you will guarantee that you will continue to clip the coupon just over 7 percent in high yield and just under 8 percent in bank loans.
Jay Diamond: So, Dan, I want to give you a shot at this question too. With spreads and yields where they are today, are investors getting compensated for the risks that they're taking?
Dan Montegari: Yeah. When we think about all in yields and where they are relative to history, as Tom said, they're at about average. And so I think from an investors perspective, what they want is return and return is yield. And so, yes, spreads are tight today. But going back to what we talked about from a quality perspective, particularly with high yield, you are very high quality over 50 percent double B. You are at a period in time where defaults have been very manageable. And again, where we've seen a lot of pressure and from a defaults is that rise in base rates. High yield assets are fixed in coupon and not floating. And so you've got much more visibility and less exposure to rates. So you kind of locked in your capital structure and you have more ability to predict or manage for your cash flows. And then the last piece is again just going back to the metrics again, specifically in high yield, the metrics are all better than historical averages. And so yes, spreads are tighter than we've seen at least are on the tighter end of the historical range. But given that all in yields are probably around the 50 percentile and the quality of, again, the high yield index is much higher, I think given those factors, we do believe that that you are being compensated and our job as credit managers is really to make sure that you earn, again that excess spread, because the spread is really just compensation for default risk. And so our job is to avoid defaults such that your spread and high yield isn't eroded on a go forth basis. And again, we fundamentally believe our process and the bottoms up analysis that we do should enable ourselves to do that on a go forward basis over the long term.
Jay Diamond: So Tom, you face off with clients all the time, meet with them, talk about portfolios. What kinds of questions are you hearing now from clients?
Tom Hauser: I think the biggest question my clients want to know is the run that we've seen and blown that's been great credit getting a little long in the tooth. And in particular, as we've just touched on, clients are concerned about where we are from a spread perspective. Are they being compensated for the expected losses in both high yield and bank loans? And as we just mentioned, we think that the all in compensation for both asset classes remains attractive. But where we are in the cycle, it is getting a little bit later and spreads remain extremely tight. And so that bottom up analysis, that avoidance of mistakes becomes much more important today than it was at the start of this run. And as you get later into the cycle, you start to see credits within similar ratings cohorts really priced very similar to each other. There's very little differentiation because the market is just sort of buying whatever comes out within the single B or double B landscape and pricing it on top of each other. They're not differentiating by credit for the most part. And so we think it's really important today to be selective, not go along with ride the tide of the returns that we've seen in below investment grade credit to date, and instead avoid those mistakes that we think may be coming down the pike over the next 12 to 24 months. And if you do that, you will book your yield and you will earn that yield.
Jay Diamond: Are there any other factors that you guys are looking at right now that we haven't discussed that you're factoring into your analysis?
Dan Montegari: I think the one area that we haven't discussed that is really permeating kind of everything that we do is, is AI, even here at Guggenheim, right, we are starting to develop that AI process and incorporate it into our daily activities. So, the ability of AI to change or impact every business that we're looking at, whether you're directly involved in AI today or indirectly in some form or fashion, I think that will be a key focus for the market on a go forward basis. And if we just think about there was a deal, a report out a couple of months ago that talked about the exceptionalism of American returns and that exceptionalism of the returns in the US market specifically, was related to the amount of growth capital that's been invested overall, but more importantly, the return on that growth capital that's been invested. What we're seeing is a handful of issuers or names in the market are becoming a bigger and bigger chunk of that growth capital investment. And what we need to really follow is make sure that the returns on that investment, amongst that handful of businesses continue to yield what the market is anticipating. If not, you could see definitely a change in investors sentiment and capital allocation as a result of that.
Jay Diamond: Well, great. Again, thank you so much for your time. But before I let you go, Tom, if you could summarize, what's the main takeaway that you would want listeners to walk away from this podcast thinking.
Tom Hauser: Yeah, look, I'm biased, but I think that it’s always a good time for credit no matter what the environment is, I think we do a good job of trying to react and predict where we're going. We think that bottom-up credit analysis serves our clients well over and through a cycle, because we believe we are going to avoid our fair share of defaults and credit losses in the market and outperform over the longer run. As we talked about, spreads certainly are tight in both high yield and loans when you look at them versus their historical numbers, as well as our expectation of where we are in the credit cycle. But all in yields do remain attractive. And so key to earning that yield is continued avoidance of mistakes. And doing so we think will serve our clients well through this cycle.
Jay Diamond: Dan, any final thoughts?
Dan Montegari: No, I think Tom summed it up very well. Thank you for having us on today.
Jay Diamond: Fantastic. Well, thanks again for your time and I hope you'll visit with us again soon. And thanks to all of you who have joined us for our podcast. If you like what you're hearing, please rate us five stars. That's how people find out about us. And if you have any questions for Tom, Dan or any of our other podcast guests, please send them to MacroMarkets@GuggenheimInvestments.com, and we will do our best to answer them on a future episode or offline. I'm Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, please visit GuggenheimInvestments.com/perspectives. So long.
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