• Alternative Investments
• Credit

Mitigating Volatility, Part 3: Opportunities in Credit

calendar_today May 11, 2020

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We expect volatility to remain in the system indefinitely as the world continues to cope with COVID-19 and the impact it has had on economies around the globe. April 2020 became one of the best returns month in history for the PPB Capital Partners platform and the managers that sit on it. This outcome was not surprising given the amount of dislocation that occurred in March 2020. The Fed continues to pump liquidity into the system and while that has been great for the equity markets, the tangible effects on Main Street will have to play out. While such aggressive monetary and fiscal stimulus can support stock prices, the sheer amount of the Fed’s balance sheet expansion is frightening in relation to GDP.

With this backdrop in mind, we believe the timing is ideal for a more dedicated allocation to alternative investments. Investors can benefit with more return streams, uncorrelated to the financial markets, to further mitigate expected volatility and add needed diversification into their portfolios. The credit markets remain of most interest. As we entered 2020, many were concerned about the prevalence of cheap debt and the amount of leverage on corporate balance sheets, but it was hard to predict what the catalyst would be that would shake the markets. What no one anticipated was how quickly COVID-19’s impact would be felt and the concurrent dislocation across the oil markets. The resulting valuations have created historical buying opportunities, especially in the structured credit markets. As such, the equities markets have rallied strongly, so what does that mean for credit?

In our discussions with fund sponsors, most agree that distressed cycles tend to have multiple stages. What we experienced in March 2020 was the first stage where indiscriminate forced selling took place as institutional investors scrambled to raise liquidity across their portfolios when margin calls came in and there were no buyers. Some of this has been alleviated as the highest quality paper has rebounded, but their spreads remain wider than historical norms to treasuries. As such, pricing remains in dislocation and it will likely remain this way for the next few months.

In addition, more pronounced opportunities remain present in the junior traches of the CLO market where price levels imply unlikely synonymous defaults across entire sectors of portfolios. With all the fiscal and monetary stimulus, we believe the Fed will do everything in its power to avoid such an outcome. The second phase of the opportunity set is already starting to play out in the mortgage market. With macroeconomic conditions deteriorating, mortgage lending standards have become increasingly stringent as banks get more cautious. Jumbo mortgages are harder to come by and higher down payments are required. This resulting illiquidity for both homebuyers and cash needy businesses could remain present in the near term until the global economy completely reopens and a COVID-19 vaccine is created.

As stated above, the Fed and the rest of the central banks will do everything in their power to create liquidity. Ultimately, however, short-term cash requirements for businesses will result in excellent yielding credit opportunities for savvy investors as banks and traditional lenders employ stricter borrowing standards. The final phase of a cycle is the rebuilding phase as companies recover from the added rescue debt burdens and make the necessary business changes.

In any event, the best opportunities for investors are in the early stages, as evident from the number of credit fund managers prepared to close funds as quickly as possible. Whether it is investing in publicly traded securities or through private investments, the opportunity is robust for investors with dry powder available to deploy into the credit market.

For more information on alternative investment strategies, please contact me.- Frank Burke, CFA, CAIA, Chief Investment Officer, PPB Capital Partners, 484.278.4017 Ext. 108
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