Nine years into a bull market for financial assets, we are seeing an increasing number of investors continuing to prioritize a return or income objective over the risk required to achieve that return.
For stock investors, that typically means chasing what is hot today. For fixed-income investors, that means venturing more heavily into more speculative issuers and instruments.
In our view, long-term investing is best done through the framework of prospective risk and potential return, while taking into consideration the role a particular investment or strategy plays in a more broadly diversified portfolio. We consider these things in relation to one another, along with the possible constraints an investment might have.
Over the last several years, as yields on high-quality issues have remained low, massive amounts of money have plowed into the more speculative areas of credit: high yield, bank loans and hybrid securities. There is more yield and less interest-rate risk in these areas, but more economic, credit and liquidity risk.
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Right now that is a trade investors seem willing to make, but do they truly appreciate the risk they are taking and the amount that risk has increased recently?
Investor interest has driven the spread that a high-yield instrument pays over a comparable term treasury to very low levels, a little more than 3.3 percent, which is bumping along a 10-year low. The ravenous appetite for bank-loan products has borrowers going back to banks and renegotiating the terms of their loans, lowering spreads and dropping interest rate floors. As a result, interest rates are finally rising and investors are coming to learn that there isn’t the pickup they’d expected because the issuer negotiated a better deal.
All this is happening at a time when protections for lenders to those issuers — the investors — are getting worse. Covenants are getting dropped and weakened significantly. Further, measures of profitability for purposes of the covenant compliance are getting more and more contrived.
As an example, last month a high-profile issuer invented a metric no one had even heard before — “Community Adjusted EBITDA” — which essentially added back almost all of their expenses. (EBITDA is earnings before interest, taxes, depreciation, and amortization, and is a metric for understanding a business's ability to generate cash flow for its owners and for judging a company's operating performance.)
Moody’s recently opined that covenant quality is the weakest it has ever seen, while pondering if anyone is actually reading the documents.
The investor interest is allowing companies to borrow more and more on a “secured” basis, fattening the capital stack. Increasing the size of the secured claims leaves less for holders of those claims when there is a problem, since you have to divide the pie among more of them. Another common thing that seems to be occurring is stripping or segregating assets that creditors can claim, meaning there’s less asset coverage when there’s a problem.
And then there’s the threat that a weakening of covenants will allow companies that should have been reorganized or restructured a long time ago the ability to keep going, potentially destroying value and recoveries when the day of reckoning comes.
When there is a slowdown and these investments go from income instruments to distressed instruments, recoveries could be much weaker than historically realized. Of course, these are not really problems for investors until the economy stalls or we enter a recession. Please note, we wrote until, not if. We will have a slowdown, and recessions are part of a normal economic cycle.
We think that most investor risk comes from not knowing what you’re doing. We are increasingly seeing “conservative” investors coming with “safe, income-oriented” portfolios. When we look under the hood, we tend to find large holdings comprised of high-yield bonds, bank loans and various hybrid securities.
Our experience is that investors have ... a hard time understanding that their income portfolio has so much sensitivity to capital markets.
These investments perform like bonds most of the time, when the environment is strong or benign. But when the economy stagnates or contracts, they will behave more like stocks. Our experience is that investors have little idea this is the case and have a hard time understanding that their income portfolio has so much sensitivity to capital markets and don’t truly understand what the risks really are.
We think they will be surprised when the economy slows one day — and most conservative fixed-income investors tend not to like surprises. To paraphrase Warren Buffett: It’s OK to have an opera, it’s OK to have a rock concert, but don’t sell rock concert tickets to people who think they’re going to an opera.
— By Gary Ribe, chief investment officer, and Mark Cortazzo, senior partner, at MACRO Consulting Group
