The chief investment officer on credit where credit is due.
'Every day, our investment team gets a fairly large number of email solicitations, mostly about how great a time it is now to invest in highly leveraged structures.
The argument goes like this: default rates are low, therefore strategies such as CLOs (collateralised loan obligations) constitute attractive investments.
This is the kind of cyclical logic that has always puzzled us because we believe that the best time to invest in credit is when default rates are high, spreads are wide and yields elevated. Investing in highly leveraged structures today implies locking in some of the lowest yields ever recorded and effectively discounting an extremely low default rate, leaving very little room for further improvement. In other words, you end up with a potential return which is skewed to the downside.
This is particularly troubling considering the artificial environment created by quantitative easing (QE): we wonder how many leveraged businesses would still be around today had central banks not rigged the price discovery mechanism in interest rates? Our guess is that the current default rate cannot truly be relied upon in the current cycle.
European credit is a case in point: nowhere have central bank actions been felt more than in this asset class. The overall size of the European high yield market has grown by a factor of four in the last decade as companies rushed to make the most of the low yield environment to fund or refinance themselves. This has led to the absurd reality of the yield-to-worst on European high yield indices being lower today than the yield on US Treasury indices.
Much of this is also the result of the incredible growth of passive credit investments. Consider that the market capitalisation of the iShares Euro High Yield Corp ETF has gone from zero at launch in 2010 to €5.4 billion (£4.8 billion) today.
A quick look at the top positions of this ETF will show you that the largest allocation is to Altice Luxembourg SA, a subsidiary of the Dutch telecom giant Altice NV. The company’s recent disappointing results laid bare its rather adventurous capital structure: the company is expected to generate Ebtida of about €9 billion in 2017 while its net debt sits at €55 billion.
This highlights to us one of the most fundamental issues with passive investing in credit: investors are simply allocating to the companies with the largest quantum of debt regardless of their true creditworthiness. Considering the current elevated prices of European high yield bonds, we prefer to err on the side of caution and abstain from significant allocations to this sector.
One area of credit we find attractive, however, is lending to small businesses in the UK and Europe. The opportunity set for companies such as Funding Circle is growing fast, due to the retreat of traditional banks in providing loans for smaller companies. During the last quarter, Funding Circle outstripped the major high street banks for net new loans. We see the company essentially as a technology platform enabling the efficient issue of small loans to thousands of companies. It has a solid management team and is looking to expand its successful business model to other geographies.
We believe that the current credit cycle is stretched, and that in most cases, the yield on many of these assets does not compensate investors adequately for the risks involved. The next down-cycle in credit could make for an interesting period given the explosive growth in speculative credit courtesy of global central banks’ action. Now, more than ever, is the right time to focus on the return of your capital as opposed to the return on capital.'