On the Money with Dynamic Funds

PARTICIPANTS

Tom Dicker
Vice President and Senior Portfolio Manager

Jeremy Lucas
Vice President and Portfolio Manager

Tom Dicker: Hello, and welcome to On the Money. I'm your host, Tom Dicker, Vice President and Senior Portfolio Manager at Dynamic Funds. I'm here to discuss the credit markets with Jeremy Lucas, who's Vice President and Portfolio Manager here on the Specialized Credit Team at Dynamic.

Mark Brisley: You're listening to On the Money with Dynamic Funds. The podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders.

Tom Dicker: Jeremy, welcome.

Jeremy Lucas: Thanks for having me, Tom.

Tom: Starting with the big picture, some folks were worried about a recession in the economy, and the labor market running cold. All of a sudden now, there's a worry about a return to accelerating inflation, and maybe the economy even running too hot. What environment do you think we're in? Are we in Goldilocks? What's your outlook for the North American credit market?

Jeremy: If you'd asked us a couple of years ago when the yield curve had inverted, and had violently inverted, our answer would have been to be cautious. It appears that Jerome Powell and the Fed have achieved the impossible, at least, for the near term, in the form of a soft landing. It's hard not to dispute the fact that recessionary risks are fading. The American consumer was simply less levered than the last time around.

For example, the global financial crisis when household balance sheets were in much worse shape. That's not the case this time around. The consumer has remained healthy, and I think Goldilocks is a great way to frame it. Not too hot, not too cold. Looking at corporates, another observation would be, corporate balance sheets are in great shape, better than we've seen in a long time.

Stakeholder alignment is also quite high, particularly, in the more levered markets. Our current outlook is, that this soft landing has largely been achieved. Here's the big thing. It's priced in. Credit markets in particular are at expensive valuations, and they are fully pricing in this Goldilocks or rosy period, if you will. I find them to be very vulnerable to exogenous shocks as a result.

Tom: How do you think about expensive valuations? Can you give us an example, or how do expensive valuations look now, and were valuations relative to historical?

Jeremy: Great question. Let's talk about how we think about credit valuations to start. I mean, we use credit spreads. Credit spread is the risk premium that investors receive for being exposed to a corporate issuer, rather than a government security. You'd rather have exposure to the US government than a corporation that has to compete for revenue, rather than a government entity which can tax you implicitly.

When we look at credit spreads, they are very tight, meaning that the risk premium is very low. You're not being compensated very much as a credit investor for taking credit risk to a corporate obligor. How we can measure it, is we can look at spreads over time. If we look in the high yield market, for example, double-B spreads and single-B spreads, these are the upper tier components of the high yield market. These have touched all time tights that we've seen before the global financial crisis. I mean, in generation, we have not seen spreads as tight as they are right now.

Tom: How do you get to this level of tightness?

Jeremy: An element is the fact that we have not had any defaults. Corporate fundamentals are very strong. The corporate balance sheets are in a very healthy state. There are other technical factors that are, perhaps, even more dominating in the valuations, like an all-in buyer, an all-in yield buyer. This is someone that says, "Well, I'm getting, 4.5% on my US Treasury, and I'm getting another 150 to 200 basis points of risk premium for owning a double-B corporate. I don't see default rates on the horizon. My all in yield is something like 6% to 6.5%, and that's good enough." In fact, that's great.

Also, you've got to think about all-in yields related to long term equity returns. If you go back a very significant period of time, you can find long term equity returns CAGRing around 9%. Now, you've got credit markets that are in the mid-single digit yields, a little bit lower in investment grade, a little bit higher in high yield. It's very competitive to that return profile offered by equity markets.

Investors are gobbling up these bonds, and these other things are happening. These all-in yields are attracting a more mature or more institutional investor base, so we're seeing more pension plan participation. They have large appetite to immunize their liabilities. We're getting this market that's got a strong demand picture.

The other side is supply, and supply is dwindling. Corporate balance sheets are improving. Equity holders and management teams are very focused on too high debt levels. Debt's expensive. It's no longer 1% or 2%, it's 6%, 7%. It's expensive to borrow to grow. Consequently, these corporations are managing their balance sheets a little bit tighter. That's less supply. Strong demand, less supply, equals a very tight valuation and credit spreads.

Tom: Can you explain a little bit about how the mechanics to the immunization actually work within a pension fund, or insurance company? Why are credit markets one of the places that they like to go?

Jeremy: it's an actuarial science, where they look at what they're going to have to pay out, and they look at what their assets are going to generate, in order to fund those future payouts. It was very hard to be a pension plan manager during a period of zero interest rates. You had a hard time immunizing your liabilities. You still had payouts you were forecasted to make, but you just couldn't generate any returns on the front side of that.

When you start putting into these 6%, 7% yields in performing companies where we're not looking at default risk, it creates a much better immunization profile for their liabilities, and consequently, equals a greater amount of demand.

Tom: They were just starved for something of these mid-single plus type of number for so long, that they have such a strong demand for it. There's a shortage of supply, so it's just driven these spreads to really, really tight levels, beyond the fact that corporate is actually fairly helpful.

Jeremy: How many corporates did you look at, Tom, 5 to 10 years ago, where part of your analysis involved understanding how large the pension plan liability was? If you looked at Air Canada, that was a big component of the equity story, this huge overhang. Those types of stories are no longer in the market, right?

Tom: Oh, that makes sense. Credit fundamentals are strong, and valuations are supported by this technical tailwind. What could go wrong right now?

Jeremy: I guess this is the part where we start talking about Trump, right?

Tom: I guess.

Jeremy: Actually, before we do, let's talk about the Fed, because in our minds, the number one thing that could go wrong, would be an inflationary impulse. If you think about 2022, and what would markets hate? Markets would hate inflation. An inflationary impulse is probably the biggest risk, and that would force the Fed to take action.

In fact, this week we saw the Fed pause. Maybe that's given some people some room to think a little bit about this glide path of slowly reducing rates. If inflation rears its ugly head again, we should expect the Fed to take action. We're going to expect, and we should expect a lot of volatility surrounding President Trump's administration. The risk is, there is some sort of a US policy error, for example, being an overly aggressive tariff regime that hurts the US consumer, or something that results in tit for tat, government responses, sort of what Canada appears to be preparing from a tariff response.

This is not good for consumers, and this is not good for the economy. I've made a few points here about the impact of tariffs. I don't necessarily think that tariffs are the real issue. At the end of the day, I think the damage has been done. Capital investment in Canada, for example, or Mexico, if you're an automaker, you're probably really thinking hard about where you're going to put your next auto plant.

We'll see how this plays out. Then, I'd also point out Fed independence. Jerome Powell's term is up in just over a year. President Trump is not going to appreciate any hawkish rhetoric. He's going to want a very dovish Fed chair. I think this is a narrative that could emerge in the near term, let's say, one to two years, where President Trump contemplates replacing Jerome Powell with a more administration friendly Fed chair.

What could result from that? An overly dovish Fed chair could, in fact, incentivize increased inflation. These are some of the risks. Again, we're in a world where everyone's saying, "There's nothing wrong, it's Goldilocks, and valuations are expensive, and all of this is going to work out just fine."

Tom: In light of all that, what do you do with your portfolio? What's your investment process tell you to do when spreads get to all time tights?

Jeremy: In our long only mandates, we high grade, we focus on issuers where there's a good reason for spreads to be tight. These are high quality corporates with predictable cash flows, and very strategic and tangible balance sheets. Spread compression, where the lower quality tiers compress up into the higher quality tiers. The inverse of that is decompression, where the lower quality companies will consequently decompress away from a higher quality spread bucket.

I'd rather own a higher quality company at an equivalent spread, to a lower quality company. Why take that kind of corporate risk, and not getting compensated for it? That's the main thing in our long only mandates. Then, we're focusing on sectors where we see tailwinds. We still maintain a decent energy overweight in a lot of our mandates, and particularly, focused on the US, the rationale behind that is that the regulatory regime there is improving from the Biden administration, and we can see improving credit profiles.

In our liquid alternative mandates, where we have a little more flexibility, we'll be using shorting strategies to protect capital. We'll be shorting the exact opposite of what we're long. I would short a company, where spreads have compressed materially to a higher quality peer. We think that company is at risk in a recessionary environment, or an inflationary environment, and investors aren't getting compensated on the spread. Shorting that spread makes a ton of sense. It's shorting weaker companies.

This is something that's more levered. This is something that might have less tangible asset value, might question recovery value in a recessionary scenario. All of these kinds of factors that will drive spread widening, and consequently, capital gains from being short. In our liquid alternatives, we're looking to make money from those shorts, we're looking to make money in a sell off, reducing broader correlations to other asset classes, and protecting capital.

Tom: Just to get a little bit more granular on that. Are you hoping that some of the things that you're short, have things like credit downgrades that drive their spreads wider? How does winning look in that scenario for you?

Jeremy: It could involve that sort of a rating agency action. We're not a rating agency-focused investment manager. As an active manager, we read agency reports, but we also ignore them healthily, because the rating agencies tend to be laggards. That same feature of rating agencies, the fact that they are laggards, is a wonderful advantage to have as an active manager in a downturn, because they're going to be a little bit late to cut those ratings.

Consequently, you're going to be able to short those spreads at a tighter valuation, and front run what you think would be a rating agency action that you've identified for your in-house research process. Yes, it could involve a rating agency action. How about just earnings deterioration? If you cut EBITDA in half, and leverage climbs higher, that's going to become very obvious to market participants.

If you pick the right credit, maybe one that doesn't have a lot of tangible asset value, maybe more of a cash flow story in a good market, but then a non-cash flow story with not a lot of assets behind it in a bad market, all of a sudden, people will start questioning recovery value. You can really get some good spread decompression from that in recessionary scenarios. We're not there, though. These valuations haven't got there yet, but you want to be buying those insurance policies, and taking those shorts when spreads are expensive.

Tom: Maybe we'll just talk a little bit about duration. How do you manage duration, and how are you positioned right now across your funds?

Jeremy: Right. For listeners, we'll start off by what duration is. I often get that question. Duration is just simply the sensitivity of a bond to a change in its yield. Bonds with longer maturities, they're much more sensitive to changes in yields than a bond with a short maturity. An example would be, if you have a bond that's going to mature tomorrow, you can change the yield, you can change the spread all you want. It's going to mature tomorrow at par. The price will not change overnight.

It's a shorter duration bond, almost a zero-duration bond. That's the extreme example of low duration versus a bond that's due in 30 years, where if you change the yield just a little bit, you'll get a wild swing in the price, much more volatile. What's important for us as an active credit manager, is that we are hired by our investors to drive alpha through active credit selection. That's our main focus. That's our bread and butter.

We do think of duration, but we think of it more on the extremes. If we go back a few years to during COVID, and even before COVID, during a period of lower interest rate policies and rate suppression by central banks, we were very short duration across all of our mandates. In our liquid alternatives, we were short duration. The rationale behind that is, if you're getting paid 1% in your investment grade corporate bond mandate, but you're taking eight years of duration.

If rates change by 100 basis points, that's an 8% hit to your NAV. There's a lot of volatility, a lot of downside if rates go higher, and their starting point was 1%. Today, we've added a bit more duration in the portfolio through the second half of a '24, and into the early bits of 2025 as well. That's simply and primarily in the US, and that's simply because we've seen US Treasury yields go higher.

US Treasury yields go higher. US Treasury bond prices go down. It's a good time to buy duration. Why did that happen? Inflation crept back into the picture just a little bit. Investors became a bit concerned about fiscal spending policies of the Trump administration. That would result in increased supply of US Treasuries, which would put pressure on yields as well.

We're modestly overweight-to-neutral, I guess, is the best way to put it in duration. I don't think we're living in an extreme world just yet. If we do get rates backing up a little bit more and prices even lower, we'll start to push the portfolios to a healthier overweight in duration. Again, we think about duration on the extremes. In the middle, we tend to live around neutral and generate our alpha through our active credit selection process.

Tom: What about private credit? That's very topical. What impact is that having on the market overall, and on your portfolios?

Jeremy: Private credit is topical, and it is growing like mad. Investors are promised to this wonderful world of high returns offered by private credit managers. Here's the issue. Investors in private credit are exposing themselves to very risky issuers. What's happening is, private credit is mopping up the garbage in high yield, and it's underwriting risky issuers that would never even be able to issue a bond in a broadly syndicated market.

The triple C bucket of high yield is shrinking, because a lot of those issuers are saying, "I'm going to go fund myself through a private credit manager." I saw a stat last night that showed where all these leveraged buyouts are being funded. The share of private credit funding leveraged buyouts has been growing materially over the past five years. This is where all the risk is.

It's the asset class where you wake up one day in the morning, and your portfolio position that was previously marked at par, is all of a sudden defaulting. It's an area where investors really need to tread careful. We think you're not being adequately compensated for the types of risks you're taking. We think you can generate similar levels of returns through liquid alternatives where you can exploit these alternative strategies to generate a decent private credit like returns via public credit.

Tom: Maybe we'll just finish the discussion with an outlook on where you're seeing opportunities for 2025 in the credit markets right now.

Jeremy: We like exposure in the short end of the credit curve, and we see a merit in applying leverage on investment-grade securities. We think that's a very good structural strategy that can generate decent returns consistently without incurring significant, if any, default risk. We like discounted price bonds as well. There's still a few to go in the front end of the curve.

These are bonds that were issued during the GFC, and previous lower interest rate periods, where the coupons are very low, and the prices, as a result, are very low. Yet, the yields are still decent, and the return profile will be delivered via an increased proportion of capital gains. We like discounted price bonds still. There are parts of the Canadian preferred share market where shares are trading at a discount to their $25 par.

There's potential upside there as that market continues to shrink through redemptions, and the remaining investor base chases an ever-shrinking pool of assets. We think there's upside there in Canadian prefs. Energy, as I mentioned earlier in this podcast, is a sector that we like. We see strong alignment between stakeholders. We see the potential for credit spread compression.

Valuations there are still cheap. Balance sheets are as good as they've ever been. We like that sector. We think it's an area that generates decent returns for the risk that you're taking as a credit investor. Broadly speaking, when we look at 2025, Tom, the key here is to stay nimble. We've got to be mindful of portfolio liquidity, and we've got to preserve our ability to take advantage of volatility.

The Trump administration is likely going to deliver some volatility. The Fed may deliver some volatility if inflation creeps back up. We think it's important to stay on your toes and be ready to pounce on these opportunities that those volatile environments might deliver, as this market navigates its way through a sea of uncertainty.

Tom: For us as equity investors in the equity side of a balance fund, and having you and your team on the other side managing the fixed income, we're very grateful to have you folks looking after our credit investments. I want to thank you a lot for all the work that you do on that, and for joining us today and talking about the credit markets.

Jeremy: Great. Thanks for having me.

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