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    Oaktree's Wayne Dahl on Credit Markets Right Now

    enSeptember 18, 2023

    Podcast Summary

    • Combining local insights and global expertise for real estate investing opportunitiesDespite rising interest rates, the expected widening of credit spreads hasn't materialized due to high demand and diminished supply caused by the low-interest-rate era and COVID-19 stimulus. Practicing empathy is crucial for creating healthier work environments and companies.

      Principal Asset Management, as a real estate manager, utilizes a 360-degree perspective, combining local insights and global expertise to identify compelling investing opportunities in public and private equity and debt markets. Meanwhile, in the financial world, the credit market has been a topic of confusion as interest rates have risen, but the expected widening of spreads hasn't materialized. Wayne Dahl, a managing director, portfolio manager, and investment risk officer at Oaktree, explains that the low-interest-rate era and COVID-induced stimulus set the stage for high demand and diminished supply, leading to inflation and the subsequent need for central banks to raise interest rates. At the same time, it's essential to recognize the invisible struggles people face and practice empathy to create healthier work environments and companies. This podcast episode from Odd Lots delves deeper into these topics, discussing the credit market's current state and Oaktree's perspective on risk.

    • Minimizing credit risk in a high yield marketOaktree prioritizes minimizing credit risk to preserve yields in a high yield market, learning from past recession experiences

      For Oaktree, managing risk means avoiding losses, and in the context of credit investing, this translates to minimizing defaults. The current market environment, with high yields, has shifted expectations around credit risk, and while there are concerns about potential recession and increased defaults, the experiences from the COVID-induced recession have already led to a cleansing event, preparing the market for the present. Oaktree's investment philosophy emphasizes earning yields and keeping them, making minimizing risk crucial for investors.

    • Changes in High Yield Bond Market and Emerging Maturity ProblemThe high yield bond market underwent significant changes leading to improved credit pool and historically low refinancing rates, but a maturity problem is emerging as companies start refinancing in larger numbers from 2024. Some sectors or borrowers may face challenges, particularly those in the loan market with significantly increased financing costs.

      The high yield bond market underwent significant changes between 2019 and 2021, leading to an improved pool of credit and historically low refinancing rates. However, as the duration of debt has shrunk, a maturity problem is emerging, with companies expected to start refinancing in larger numbers starting in 2024. This month, there has been a pickup in new issuance, with some companies moving their exposure from the floating rate debt market to the high yield market. Sectors or borrowers that may face challenges in the next 18 to 24 months include those in the loan market, particularly those that have seen their cost of financing significantly increase due to indexing to short rates. The loan market has become a popular financing source for leveraged buyouts.

    • Technology sector leads loan market, CLOs mask potential volatilityThe technology sector dominates loan issuance, with private equity driving investment. CLOs, major buyers, are less active traders, reducing market volatility. However, borrower power has led to covenant-lite deals, but this trend may reverse with rising interest rates.

      The software and technology sector is the largest issuer of loans in the market today, with private equity sponsors heavily investing in this area. The loan market has seen a significant increase in M&A activity in this sector. Principal Asset Management, as a leading real estate manager, leverages a 360-degree perspective to uncover opportunities in the market for their clients. Regarding the leveraged loan market, there has been concern about froth in the market, with some borrowers potentially overextending themselves. However, the majority of buyers in this market are from the CLO market, which are not active traders, masking some potential volatility. The power dynamic in the market has shifted from lenders to borrowers in the past, resulting in covenant-lite deals and potentially sketchy leveraged loans. However, this trend may be shifting as interest rates rise and demand for loans remains high.

    • Private credit market shift towards cautionDespite market cycles, private credit market grows; buyers demand stricter terms, potentially signaling preparation for potential reckoning; rise of private credit may impact publicly traded opportunities; Oaktree sees trend as growth opportunity

      The private credit market, which has seen significant growth and seems to be unaffected by market cycles, is experiencing a shift as buyers become more cautious and demand stricter terms. This trend may be a sign of preparation for potential reckoning in the private credit market, where marks have stayed at par and assets are perceived as having no volatility. The rise of private credit may also impact publicly traded opportunities as companies opt for private deals due to high demand. Oaktree, an investment firm, sees this trend as a potential opportunity for growth in their global opportunities business, as larger players step back from the market. Overall, the private credit market's resilience and recent shift towards caution are key takeaways from the discussion.

    • Fed's actions impact investor behaviorThe Fed's corporate bond buying program and positive interest rates have shifted investor risk appetite, leading to increased interest in high-quality floating rate securities and a shrinking high yield bond market.

      The current economic environment with positive short-term interest rates and the Federal Reserve's corporate bond buying program have shifted investors' risk appetite and investment behavior. With the possibility of earning a decent return without taking significant risk, investors are now considering various investments, including high-quality floating rate securities. The Fed's backstop has also impacted the market significantly, leading to a shrinking high yield bond market and a mismatch in supply and demand. Despite some uncertainty, the Fed's actions have provided a sense of security to investors, potentially influencing their investment decisions.

    • Market expectations for interest rates have shifted significantlyMarket expectations for interest rates have been volatile due to changes in the Fed's stance on inflation and economic conditions, leading to debates over the neutral rate of interest.

      The market's expectations for interest rate cuts have significantly shifted over the past year, and the Federal Reserve's stance on inflation and economic conditions has played a major role in these changes. In January 2023, the market rallied on the belief that the Fed would cut rates despite economic concerns and inflation fears. However, this expectation was reversed in March when the market reacted to the Silicon Valley Bank crisis, leading to expectations of rate hikes instead. The Fed's stance on inflation and economic conditions has been a key factor in these shifts, with Chairman Powell having to reassure the market of the Fed's commitment to fighting inflation last year, and more recently, acknowledging the resilience of the economy to higher interest rates. As a result, the neutral rate of interest, or r star, is a topic of debate, with some believing it may be higher than previously thought. Overall, the market's expectations for interest rates have been subject to significant volatility, highlighting the importance of staying informed about economic conditions and the Fed's stance on inflation.

    • Housing market's refinancing boom boosts consumer spendingHomeowners' ability to lock in long-term financing despite interest rate hikes has led to increased equity and financial stability, contributing to consumer spending and overall balance sheet health.

      The robustness of consumer spending in 2023 can be attributed to the housing market's refinancing boom. Despite significant interest rate hikes, homeowners were able to lock in financing for long periods, leading to increased equity in their homes and a sense of financial stability. This, in turn, has contributed to overall balance sheet health and consumer confidence. Unlike the 1970s, when high interest rates were associated with inflation and economic instability, the current environment has seen the emergence of the junk bond market for those who made fortunes in that era. However, the current housing market situation has been a major driver of consumer spending, offsetting the impact of higher interest rates on overall economic growth.

    • Impact of high interest rates on bonds and housing marketHigh interest rates could negatively impact the economy by increasing the cost of public debt and potentially limiting refinancing options in the housing market.

      The current environment of higher interest rates and potential volatility in bonds may not lead to the same opportunities as in the late 70s for a new market dynamic, given the significant difference in interest rates then versus now. However, the market has a history of finding new ways to solve old problems. The belief that rates will not fall significantly in the future could impact the housing market and refinancing options. The cost of public debt is a major concern, and persistent high rates could negatively impact the economy. The discussion around bonds and credit trading has continued, with exchange-traded funds (ETFs) increasing liquidity in certain markets.

    • Understanding the complexities of high yield markets and commercial real estateWhile high yield markets offer opportunities, liquidity and economic uncertainties can pose challenges. Commercial real estate, particularly offices in certain cities, faces challenges but may offer higher yields for high-quality assets. It's crucial to remain vigilant about risks and navigate each market's complexities.

      While high yield markets, particularly in non-investment grade credit, offer potential opportunities, liquidity can vary greatly depending on the specific bonds being traded. Commercial real estate, specifically offices in some cities, is experiencing challenges, but extensions and other options can delay the impact of defaults. Defining "normal" in today's economic environment is difficult, and interpreting data like the jobs market can lead to conflicting views on the economy's health. Despite these uncertainties, it's crucial to remain vigilant about risks. Oaktree Capital's Howard Marks emphasizes that office real estate's challenges are far from over, but there's still debate about whether high-quality commercial real estate assets will offer significantly higher yields. Overall, navigating the current economic landscape requires a nuanced understanding of various markets and their unique complexities.

    • Challenges in interpreting economic signalsTraditional economic measures like inflation rates are less reliable indicators due to shelter prices and other factors. Market perception of recession risk has shifted dramatically.

      The current economic environment, specifically regarding inflation and the risk of recession, is uncertain and subject to significant changes in perspective. Traditional economic measures, such as inflation rates, have become less reliable indicators due to the impact of shelter prices and other factors. The market's perception of the risk of recession has shifted dramatically within the past year, highlighting the challenges in interpreting these economic signals. Wayne Dahl, a managing director, assistant portfolio manager, and investment risk officer at Oaktree, discussed these challenges during a live podcast at the Future Proof Conference. For more in-depth analysis, listeners can check out the Odd Lots podcast, follow Tracy Alloway and Joe Weisenthal, and subscribe to the Money Stuff podcast featuring Matt Levine and Katie Greifeld.

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