Opportunistic Credit: Attractive Strategy For Insurers To Take Advantage Of Idiosyncratic Risk

Kohlberg Kravis Roberts & Co (KKR) has engaged in a number of discussions among insurers around leveraged credit. These discussions highlight the macroeconomic and political uncertainty taking place across markets and dislocations around the globe. KKR believes these dislocations will likely continue, resulting in heightened volatility and incremental buying opportunities. Moreover, we believe that being nimble, having conviction and dynamically allocating across asset classes by identifying the strongest relative value opportunities can generate alpha in these periods. Thus, we expect performance strategy and manager selection to be even more important in the coming years as the combination of greater volatility and lower liquidity take hold.

WE BELIEVE THE KEY PHRASE THAT YOU WILL HEAR MORE OF IN 2019 IS THAT OF ‘DISPERSION’.

In 1852, Charles MacKay published “Memoirs of Extraordinary Popular Delusions and the Madness of Crowds”. In the book he discusses, among other things, three examples of economic bubbles – The Mississippi Company, Tulip Mania and The South Sea Company. One quote in the book regarding these examples came to mind at the end of last year.

“But it was a long time before public credit was thoroughly restored. Enterprise, like Icarus, had soared too high, and melted the wax of her wings; like Icarus, she had fallen into a sea, and learned, while floundering in its waves, that her proper element was the solid ground.”

Since the end of last year, we have seen a significant uptick in investors seeking to change how they are allocating capital in the leveraged credit market. We believe many investors – that have seen strong market driven returns over the last 10 years – are now seeking to mitigate beta risk and focus more on idiosyncratic risk.

The market returns in Q4 2018 acted as a jolt to many. The credit markets, and specifically the leveraged loan and high yield bond markets, witnessed the dangers of daily liquidity funds. Strong outflows in December created significant volatility, represented a tipping point, and most investors retreated. Many market participants who were drawn in by attractive market driven returns found themselves flying too close to the sun. The returns in sub-investment grade credit in Q4 2018 were not just remarkable for their sharply negative trend but also for their correlation across asset classes (bonds, loans and equities). We now look at the drivers of this trend:

1) FUNDAMENTALS – SCRATCH BENEATH THE SURFACE
The charts below show the broad strength in Revenue and Earnings growth across KKR’s Global Credit portfolio.

Exhibit 1: Sector Momentum (KKR Global Credit)

Source: KKR Credit Analysis as of December 31, 2018

Exhibit 2: Sector Momentum (KKR Global Credit)

Source: KKR Credit Analysis as of December 31, 2018

If we look at a sector analysis of EBITDA growth, we can see broadly positive momentum here. Exhibit 3 below shows last 3 month growth on the vertical axis and last 12 month growth on the horizontal. The size of the circles represents our exposure:

Exhibit 3: Sector Momentum (KKR Global Credit)

Source: KKR Credit Analysis as of December 31, 2018

However, look at how dispersion increases as we move from broad industry groups to sub-sectors:

Exhibit 4: Sub-Sector Momentum (KKR Global Credit)

Source: KKR Credit Analysis as of December 31, 2018

The chart highlights the dangers than can lurk in areas such as Household Products and Marine.

In truth, wider markets are already showing dispersion in performance. For example, Exhibit 5 shows EBITDA year- on-year growth in selected S&P 500 sectors and shows remarkably different earnings growth in IT and Materials versus Consumer and Utilities sectors:

Exhibit 5: S&P Sector EBITDA Y-o-Y Growth

Source: KKR GMAA, Federal Reserve, European Central Bank as of December 31, 2018

An index-linked portfolio will – by its nature – focus on all these sectors and generate index-like returns.

To put this in context in terms of Sub-Investment Grade credit, we have summarized the forecast from most of the investment banks below of what they believe the different indices will return in 2019:

Overall, these forecast returns are lower than historic norms and are relatively uncertain (as demonstrated by a wide dispersion of forecasts).

2) LOWER LIQUIDITY AND HIGHER VOLATILITY
We believe the lack of a consensus on forecast returns can be partly attributed to the fact that the 10 year quantitative easing cycle is coming to an end.

To put this in context, central banks in developed countries have purchased ~$16 trillion in assets and this is now reversing rapidly. As shown in Exhibit 6, the overall money supply is shrinking. However, our concern extends beyond the economy in general and into the financial markets, especially Sub Investment Grade credit markets.

Exhibit 6: Monthly Changes in Balance Sheet ($bn)

Note: * We assume that 80% of TLTRO is extended for two years (before rolling off completely by early 2023. Source: KKR GMAA, Federal Reserve, European Central Bank

Overall broker-dealer inventories have reduced by ~75% since the financial crisis. We believe the growth in daily liquidity mutual funds alongside a shortage of overall market liquidity is likely to exacerbate market volatility. Since 2011, we have seen numerous periods of heightening price movements and we expect this trend to continue.

Exhibit 7: Trailing 90 Day Volatility

Source: Credit Suisse as of December 31, 2018

3) DISPERSION OF COMPANY PERFORMANCE AND INVESTMENT APPROACHES
With thanks to our KKR Global Macro & Asset Allocation team, they have highlighted some areas where we expect a slowdown in 2019. Most notably, they believe there is likely to be a weakening of US Fixed Income Investment.

This trend is partly due to normalizing inventories as businesses had been building stocks ahead of potential tariffs. We expect to see slowing housing starts and auto sales in the US, declining upstream energy investment and potentially some deferrals of business capex.

However, we believe consumption growth is likely to remain strong. Looking at real personal consumption expenditures (PCE), we expect this to remain solid given lower overall unemployment levels.

For readers who would like to read more about our thoughts on these trends, please see our KKR Global Macro & Asset Allocation Team’s 2019 Outlook called “The Game Has Changed” at the following link: http://www.KKR.com/global-perspectives/ publications/outlook-2019-game-has-changed

So we expect a diversion of business results depending on the primary drivers. Against this backdrop, one would expect divergence in the performance of managers depending on style. However, we would caution investors that we expect overall dispersion to be significantly higher than normal given more bouts of volatility.

For example, in Exhibit 8 we look at the dispersion of performance across ~250 managers on eVestment. Dispersion is measured as the absolute difference in return of 1st quartile and 4th quartile managers. For example, if the average 1st quartile manager returned 8% and the 4th quartile return was 1%, this ‘Manager Dispersion’ measures 7%. We have overlaid this with annualized volatility in High Yield returns since 2013 to show the strong correlation. The more volatile the period, the more likely there to be significant dispersion in performance.

Exhibit 8: Dispersion of Performance versus Return Vol.

Source: KKR Credit Analysis, eVestment as of as of December 31, 2018

In summary, we believe that investors will have vastly different experiences depending on the investment approach they take and credit risk they hold. For investors that heed risks and avoid flying to close to the sun in index-linked products, we believe there are attractive opportunities to select risk. For those that don’t, we suspect it will be a bumpy ride in the medium term. We can summarize our views as follows:

  1. At a high level, fundamental performance is good. This may continue to drive broad bouts of risk taking, but underneath the surface there are areas of weakness;
  2. These areas of weakness mean that an index-linked approach to investing is likely to yield lower returns than historical norms;
  3. The global shift from monetary stimulus to fiscal stimulus may result in lower overall market liquidity;
  4. Lower overall liquidity levels will exacerbate volatility when areas of weakness are recognized by the market;
  5. The move to fiscal stimulus may also result in dispersion of returns, especially as we suspect spending patterns will change;
  6. With dispersion of company performance and a new realization of market norms and volatility, we believe that manager performance will also be heavily dispersed and it will be difficult for many to beat the index; and
  7. Better performance has (and may continue to) come from those that know credits’ intrinsic value well, have the ability to be (and are incentivized to be nimble and can invest with conviction.

    By Kohlberg Kravis Roberts
    Chris Sheldon, Member & Head of KKR Leveraged Credit
    Jeremiah Lane, Member, KKR Leveraged Credit
    Mitch Lee, Co-Head, KKR Insurance Relationship Management
    John Morrison, Co-Head, KKR Insurance Relationship Management

This material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, KKR does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and KKR assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements. This material is directed exclusively at investment professionals. Any investments to which this material relates are available only to or will be engaged in only with investment professionals.
About KKR: Established in 1976, KKR is a global asset manager with $195 billion in assets under management. KKR Credit manages $65.6 billion globally across leveraged and private credit strategies. Leveraged credit includes a range of senior loan, high yield bond, structured credit, and opportunistic credit based strategies. Private credit principally consists of senior direct lending, private opportunistic credit (e.g. mezzanine, asset based, and principal finance), and special situations / distressed credit. While our strategies differ by risk, return, and liquidity, all avail themselves of the resources and expertise embedded within KKR to better source and price risk in the pursuit of attractive risk ‐ adjusted returns for our investors including our insurance clients. In addition, KKR manages over $23 billion in non-affiliated capital across over 100 insurance companies globally. If you would like more information about our views on leveraged credit, please contact KKR’s Insurance Relationship Management Leaders (mitch.lee@kkr.com or john.morrison@kkr.com).
Senior Portfolio Managers – Leveraged Credit:
Chris Sheldon is a Member of KKR. Mr. Sheldon serves as the Head of Leveraged Credit. Mr. Sheldon is a portfolio manager for KKR’s leveraged credit and private credit funds and portfolios and a member of the US Leveraged Credit Investment Committee, Global Private Credit Investment Committee and KKR Credit Portfolio Management Committee. Prior to joining KKR, Mr. Sheldon was a vice president and senior investment analyst with Wells Fargo’s high yield securities group. Previously, Mr. Sheldon worked at Young & Rubicam Advertising and SFM Media Corporation in their media-planning departments. Mr. Sheldon holds a B.A. from Denison University. Mr. Sheldon serves as a member of the board of directors of SquashDrive, a member of the National Urban Squash and Education Association. Mr. Sheldon also serves as a member of the board of directors of the LSTA.
Jeremiah S. Lane is a Member of KKR. Mr. Lane is a portfolio manager for our leveraged credit funds and portfolios and member of the US Leveraged Credit Investment Committee and KKR Credit Portfolio Management Committee. Prior to joining, Mr. Lane worked as an Associate in the Investment Banking/Technology, Media and Telecom Group at J.P. Morgan Chase. Mr. Lane holds an A.B. with honors in History from Harvard University.
Co-Heads – KKR Insurance Relationship Management:
Mitch Lee is a member of the KKR Client and Partner Group. Mr. Lee co-leads KKR’s efforts in insurance company business development and helps provide solutions for KKR’s insurance company asset management clients. Prior to joining KKR, Mr. Lee spent six years at Goldman Sachs Asset Management (GSAM) where he was a senior relationship manager within GSAM’s insurance asset management business and prior to that was involved with institutional fundraising and investor relations for GSAM’s alternative investments platform. Previously, Mr. Lee worked at American Capital in internal strategy and investment capacities. Mr. Lee’s prior experience also includes practicing private equity and corporate securities law as an attorney. Mr. Lee holds an M.B.A. from Columbia Business School, and a J.D. and B.A. from Cornell University.
John Morrison is a member of the Client and Partner Group. Mr. Morrison co-leads KKR’s efforts in insurance company business development and helps provide solutions for KKR’s insurance company asset management clients. Prior to joining KKR, Mr. Morrison spent six years at Pacific Investment Management Company (PIMCO) where he was involved with insurance company asset raising and client coverage in both the U.S. domestic market and the Bermuda market. Previously, he worked at Sanford C. Bernstein and Citigroup Asset Management in research and portfolio management respectively. Mr. Morrison holds an M.B.A. from the University of Chicago Graduate School of Business, and he received an undergraduate degree in Economics from Georgetown University.