Hello, and welcome to The Credit Edge, a weekly markets podcast. My name is James Crumby. I'm a senior editor at Bloomberg. This week, we're very pleased to welcome Rob's Abel, global head of liquid credit Strategies at Blackstone.
How are you, Rob, I'm great, Thanks for having me.
Thanks so much for joining us today. And we're also delighted to welcome back on the show Lisa Lee, who covers credit markets from London. Great to see you, Lisa, thanks for having me. Also on the show, we're going to be talking to David Haven's who covers non bank lenders for Bloomberg Intelligence in New York. So do stay with us. But first Rob's Abel with Blackstone. Great to have you on the Credit Edge. You look at bonds, loans, clos all the exciting stuff. Let's start though with an
easy one. It was supposed to be the year of the bond, but most of the fixed income has been hammered by rapidly rising yields. Meanwhile, higher funding costs and an economic slowdown was supposed to cause a lot of trouble for the riskiest companies, especially those with a lot of debt, particularly if it was floating rate I leveraged loans, and yet if you look at the returns bonds from the worst rated companies and leverage loans have actually done
really well. What do you make of that, Rob? How surprised are you by this outcome?
Sure? Well, I think what you described was is accurate. The performance of the underlying fundamentals of the loans that we're lending to has generally been very very good. The performance going into this period of rising rates and the growth trajectory was really strong, and so it's not surprising that when you look at at most metrics, total return for the loan as the classes is up over ten percent, defaults are and continue to be pretty pretty minimal. So
the performance characteristics have been good. But the most important thing to us, I think is that the underlying fundamentals have been have been really strong and supportive of those those metrics.
Rob, Do you think those fundamentals will keep onmb being strong as we have a longer for higher for longer period.
Sure, I think it's a good It's a good question. And for sure, you know our team, and I'm sure most managers their teams are and continue to shock their portfolios for different rate scenarios. But in a period of rising rates, you know, in what we're seeing in our companies is that the performance has been strong, but performance
has been slowing. As a credit investor, that's not necessarily the worst thing in the world, but I think that we should continue to see that performance, you know, continue to moderate. And then the question is, oh case, so so what what does that mean as a credit investor?
And I think the backdrop and where you started off, is that the rate environment has made it such that the yield profile of of really first lean protected assets, whether it's in a COLO structure or just a broadly syndicated loan or even a direct lending loan is basically you know, a double digit a double digit yield. So I think that the backdrop as a credit investor is that performance has been slowing. On fundamentals, we don't necessarily
need double digit revenue growth for these companies. We just need, you know, stability, and the yield profile of of these companies given the rate and backdrop, has been really really attractive.
But are you not surprised there? Well, just going back to my original point that you know, rates did really jump very quickly and much further than anyone really expected that these borrowers can actually keep up with the interest payment.
We're not surprised because again, I think we look at it from a very mathematical perspective, and going into this rising rate environment, we were modeling. We're modeling this what's happened right now in terms of increasing base rates, and then you can model out, Okay, what does that mean for cash flow coverage for these companies? Going into this,
cash flow coverage was at all time highs. And so even with so for moving up to where it is right now, we're still steing very, very healthy cash flow coverage from these companies. And I think we always get to ask the question, well, are you worried that somehow as rates go up, we're going to see more default activity as a result. And my view is that for a company that's otherwise a performing business has a higher interest expense burden, I don't think that we ever see
those companies as being default candidates. I think that as long as the business is performing, there's sponsors supportive capital markets are supportive. I think for those businesses that already have their own idiosyncratic issues. For sure, a slow growth environment and a higher rate environment will be issues for those companies, and we have seen defaults pick up this year even though they're still basically in line with historical averages.
So the thought has been that there might be a soft landing. But what if the Federal Reserve can't maneuver that and we have a harder landing. How do you, as a credit investor brace for that?
Sure, I think that a couple of things. One is now more than ever. Credit selection is just absolutely critical. Making sure that we're staying in Blackstone. We'd like to talk about good neighborhoods, make sure that we're staying in good neighborhoods, and make sure that we're lending to larger companies that are more resilient and with good businesses and
good management teams. So I think, just like any other investor, if we think that you know, we're concerned about the fundamental backdop, making sure that we're positioned correctly, and I think that the yield environment is more than compensating you for that for that risk.
Rob, you're the global head and we're based right now. You're in London, So I would love to hear your take on the difference between what you see between us and European credit at the moment.
Sure, it's a good question, and we've been spending a lot of time looking at that as it relates to actually the COLO market, and so looking at the underlying positions in US clos VERSUS European clos, and both of those markets do have their own nuances. The US market tends to have greater diversity in the underlying collateral. The European market has relatively less diversity, but there are quality
differences and biases in each of those portfolios. I would say that in Europe what we've seen is also a very very benign default environment. We've also tended to see higher recoveries in the European market, which I think is interesting. And so if you're looking at both structures, the US market I think is benefits from greater trading liquidity. I think if you look at Europe, you know, the fundamentals from a default standpoint or even a triple C standpoint,
seem to be a bit better. Right now.
One of the hot topics this year has been private credit clos. I know you do both regular way clos and private credit clos. What's your thought on the growth of the private credit CLO market, and do you think there'll ever be one in Europe?
Well, starting with that last point, I think for sure, I think it's an interesting topic. It's just it's showing that the markets have continued to evolve. We've seen conversions of of financing from on the large side, from the BSL market they're probably syndicated loan market into the private
credit market. And now we're seeing that same convergence in the COO side as we're basically lending to larger companies and we're secured, we're using that same technology to secure ties and finance those companies, and so I don't see any reason why we wouldn't continue to see that evolution, both from an asset perspective, but also from an investor perspective and a geographical perspective as well.
What about the maturity will for leverage loans and junk bonds that needs to be refinanced, it's going to be much more expensive. Is that not going to be a big problem coming up?
I'll give the same answer as I gave previously on your question around interest expense. I think for companies that are otherwise healthy, in performing companies, there is a pretty active financing or refinancing market for those businesses, both in the broadly syndicated loan market as well as in the private or direct market. I think for businesses that are already having their own issues, whatever those are, I think
for sure they're going to have difficulty refinancing. And I think when you look at kind of default activity right now, it's basically those businesses. It's not a big part of the market, but I think that that's what basically characterizes
that that tawer risk of the market. But if you're talking about a company that's otherwise performing, interest expenses higher or the cost of capital is higher, those companies I think pretty easily get refinanced in either the BSL market or the direct lending market.
Do you think it's a problem that COLO issuance has been less than robust and you look at resets, Your forty percent of colos are going to go out of the reinvestment periods by the end of the year. What does that do to this ability for issue as to refinance.
Sure? So I think the answer, sure, unfortunately is a bit nuanced. And so you're pointing out a data point that by the end of this year, we think that forty percent of the market will go out of reinvestment period. I think that that number ebbs and flows with arbitrage. As the arbitrage looks more interesting, which is really a function of triple A levels, many of those transactions get refined and reset even though at this moment they're not.
And I think that for companies that are or for loans that are in those structures, many of those structures have the ability to actually extend or refinance in those within within the COLO, even if the CLO is out of the the reinvestment period. And I think it all just comes down to where we started this conversation, which is what's the view of the underlying company and the
underlying fundamentals of those companies. And for those companies that are performing, whether they're in a CLO that's in reinvestment or out of reinvestment, there'll be a capital markets or there is a capital market's takeout for them, both in the BSL side and the direct side.
When we look at the default risk, you know, we're talking a lot about the recession risk well than anything. You know, it has continued to be delayed economies. I think expects a recession starting later this year. In that case, defaults and spreads should be much much higher, shouldn't they.
I think when we look at the default environment right now, we're sort of mid two's in the US, and if you that's for the index, if you look at manager's default records, I think that's on average below one percent right now, depending on what bank estimate you look at. I think we think that the default rate in the US probably goes somewhere into the threes, which is again, I think, essentially align with long term averages, and Europe
is probably similar. So I think we are focused on the tail risk of the market and tail risk of portfolios, and making sure that we're positioned with the best companies and best borrowers and the best industries that we can be. I think that the direction of travel for default rate is probably north from here, but I also think that's still, you know, a low single digit type of number.
Are you worried about worried at all about the recovery levels? The recovery levels this year's haven't been great, but there's some argument that maybe they will pick up because the worst companies go first, or is it something that we're seeing a secular shift?
Well, I think that's definitely true, Lisa, and I'm glad that you said that, because I think so often there's a recovery rate at a trough period of time is then compared to a long term average and we say, okay, well, recovery rates are low this year in this period of stress, whatever the period of stress is, whether it's the GFC or COVID, and then they're compared to a twenty year long term average. And so I do think that you need to look at that point in time exactly is
the way that you you articulate it. But I would also say that particularly in the US, the LME liability management exercises that we have seen, even though the number of those situations has been relatively small, I think for sure that hasn't had an impact on recoveries. And as I said before, we haven't really seen that dynamic in Europe, which I think is pretty interesting.
So, just to wrap it up before we talk to David Haven's a Bloombak Intelligence, you seem very optimistic, you know, the outlook seems very benign, but again, rates do keep rising, the earnings are under pressure the recession. You know, maybe that doesn't happen immediately, but it is coming. Do we not really you know?
Is it?
Is it not to to rosy in this in this environment, I mean, surely we expect more bankruptcy and distress at some point.
Well, I think Lisa, who knows me, knows that I'm not normally a rosy person. But I will say this backdrop in credit is, you know, we haven't seen anything like this from an opportunity set in in quite some time. From a yield perspective and return perspective, I agree. I think, you know, in a rising rate environment, that is going to translate to slower growth for the companies that we're
lending to. I think that favors credit selection and sector selection, as we talked about, and I think default rates tick up mildly. But I think that all of that is is you know, mitigated again by selection, and I think relative to the opportunity set, it's it's you know, it's
it's actually a pretty interesting time. And also, you know, and we look back at the history of volatility, I think some of that those periods have really been our best, our best moments for credit opportunity, and we expect that we'll continue to see those periods and we're you know, from a buying an investment perspective. Again, as long as you're making good credit selection, those are great opportunities.
Great stuff. Rob's Abel, Global head of Liquid credit Strategies at Blackstone. Thank you so much for joining us. Thanks for having me and Lisa Lee with Bloomberg News in London. Brilliant to see you again.
Cheers, great, Thank you so much for having me. Bye bye.
So, as I mentioned earlier, we're joined by David Havens with Bloomberg Intelligence in New York. Besides being highly knowledgeable about non bank lenders, he's a football fan who used to be a DJ. So this will be good. How's it going, David?
Very good? Thank you great.
So we're here to talk about middle market lending and private credit. It's a rapidly growing market, tons of excitement about it at the moment. All the big asset managers are in chasing fat returns. It's the golden age, or so they say. But break it down for us, David, Why all the hype right now?
Well, it's been one of the fastest growing areas of finance for a couple of years. We've seen this sector come out of about come from almost nothing not too long ago to over trillion dollars in total assets. We've also seen the sector perform quite well versus a number
of different investment sectors. Private credit so far has had relatively low volatility and above average return, So it's opened a lot of eyes and a lot of people have been drawn to it, particularly when rates were extremely low and yields are very hard to come by.
But just so everyone knows what we're talking about, because there is I think quite a lot of confusion what exactly do we mean by private credit? And also middle market lending? What are we talking about here?
Yeah, so middle market lending is lending to mid sized business is just like what it sounds like. It's not lending to the fortune five hundred. It's lending to the next echelon of companies below that. So you're talking about companies and might have five hundred million to a billion dollars of total revenues or earnings, however you want to measure that. And that area is an area that was as a result of some of the changing the bank regulations,
has sort of fallen between the cracks. Banks aren't really being are actually kind of being disincentivized from lending to those businesses, and into that vacuum you've gotten some private lenders come in, You've gotten business development companies. And it's kind of a wide array what private credit really means. A lot of it has to do with funding private equity deals, and other aspects of it have to do with funding regular standalone companies, family businesses, things like that, and.
The private nature of it. I mean, it sounds all a bit shady, but you're just going into a dog room somewhere and we're just negotiating why is it private? It sounds why the would so.
The differentiation is really, rather than going to a broad audience of public bondholders, the company that's borrowing the money is going directly to a lender or several lenders to get the financing in place. It's what you would have thought of as being traditional corporate bank lending twenty thirty years ago.
I mean, we've both been doing this a while. It sounds like old school just loans to me. But let's talk about BBC's business development corporations. Are they how are they structured? Why are they so hot?
Yeah?
So, business development companies, I think achieve a couple of things. First off, there's a degree of tax benefit associated with business development companies that aren't necessarily available to some other funds like Reeds. Business development companies, which actually came about at about the same time under US tax codes and investment regulations, don't pay income taxes. The income from these entities gets pass through directly to the investors, who then
pay the taxes on the earnings. And I think that what we've seen recently is business development companies have come out of the shadows a bit as private equity concerns and alter alternative asset managers like Blackstone, kkar Areas and others have found sort of a niche where they can operate with these business development companies that make sense for a group of new investors that they're courting a largely retail audience.
And the BBC is essentially they borrowing in let's say public markets they were shing bonds and they're lending to smaller companies, middle market companies privately directly bilaterally. Is that right?
That's right? And the basically what they're doing is they're doing some spread arbitrage. They're leveraging their business somewhat, so you generally have about two dollars of loans for every dollar of equity at a business development company. The business development company goes to a group of banks, it goes to public bondholders to borrow money. It borrows money at X,
and then it finds customers. Borrowers them elves come to the business development company for loans and rather than paying X, they play they generally pay X plus six hundred basis points six percent or so.
So the bonds of the BDC's how are they trading against similar debt? Is there some relative value the I.
Think there's definitely relative value, no question about that. If you look at where the investment grade business development companies trade, they're generally triple B issuers. Where they trade relative to triple B financials. Overall, there's several hundred basis points of excess spread at business development companies. I think that that probably reflects a couple of different things. One, I think that there's some trepidation in the market regarding private credit.
It does sound a little bit scary, I think, as you mentioned before, and then the second thing is that we've seen this over the years, is that some investors view business development companies and their alternative asset manager advisors as de facto competitors, and there's a reluctance to fund some of those competitors. And then finally, the economy is a little bit soft. Interest rates have been going up, You're beginning to see coverage ratios at the borrower level decline.
So there's concern that there's going to be an increased level of default rate activity from very low levels within the portfolios.
So yeah, let's talk about the scary parts of it. I mean, high yield lending in the shadows. We don't really know what the risks are. We can't see them, you know, the transparency issues. I mean, how worried do you think we should be. Let's say we are heading into sorry, a recession, how worried should we be about a big increase in defaults?
I think it's definitely going to be coming down the pike, and you can look at you know, and you don't have to depend on me. Moody's came out with a report back in May where they estimate that the default rate activity on single B rated credits the sort of things that you'd find at a business development company. Expect that to go up to about five point six percent
from three percent over the next year. Our own my own equity colleagues here estimate that you're going to see BDC portfolio default rates non accrural rates go from a less than two percent to three point four percent in the next year. So there's definitely going to be or there's definitely the expectation that there's going to be deterioration. However, it's important to put all of this into context. Like I said earlier, there's two dollars of loans for every
dollar of equity at these business development companies. So if you see let's say a four percent default rate, and you have a fifty percent loss on each one of those loans that defaults, you're only talking a couple of percentage points of the business development company's equity capital cushion. So these companies have the ability to actually manage these losses and probably quite a few more losses. And then
you can compare that to other lenders. Banks, for example, probably have I don't know eight or ten dollars of investments or assets for every dollar of equity, so there are more highly leveraged business You see that at life insurance companies as well, So these are not highly leveraged entities of business development companies. They do lend to leverage borrowers, but the BDCs themselves are not highly leveraged.
So is the risk? Then you mentioned that the triple B right, which is the lowest tier of investment grade, is the risk? Then more like that they would be cut to junk at some point.
Yeah, I think that you'd probably have to have a very severe recession in order to see the business development companies see their ratings get reduced into the double B category. When the rating agencies assign ratings to these entities, they don't assign them on the basis that there's going to be rainbows and unicorns in the economy forever. They assign ratings based on a reasonable worst case scenario that would factor in a fairly significant economic downturn.
So I just step back from the investors side, though, I mean, you know, private credit, BBC's all this stuff. They're obviously making a bit more return because they lend. You know, you lose the transparency, you lose liquidity, you get a bit more return. Is it really worth it for most investors given that you know they can get five percent now on a Treasury bond.
Well, that's that's actually a very good question.
Now.
Now, one of the reasons that you saw business development companies and private credit grows so much during period of zero interest rates is that rates certainly just weren't available. So business development companies private credit was sort of an oasis in the desert. You know, the desert has been filled with water now in the form of higher interest rates. But now you're contending with inflation. So if you want to get a real return again, you have to look
to higher yielding sectors. Yes, you can get five percent in a thirty you know, in a short term money market fund or something, but you're matching inflation. If you want to get a real return, then you have to take on a little bit of risk in some way or another.
So, just to wrap it up, David, give us your outlook for the next let's say twelve months or so. What are you most worried about and where do you see the opportunity.
Yeah, I think the real concern is simply in the economy. Now, the good news there is that we're beginning to see the expectation of a recession. At least the consensus expects a recession to be somewhat lower today than it was a few months ago, but the economy continues to be a little bit soft, the messages continue to be mixed. Interest rates are applying pressure to the borrowers at private credit lenders, and all of that is probably going to
result in an increased level of default rate activity. And then I think we also have to turn our eyes to the geopolitical situation, which is obviously getting interesting unfortunately, and that could begin to, you know, sort of weigh on overall market sentiment and things like that. Business development companies, in the eyes of investors are probably a higher beta asset, meaning that if the market moves by x basis points,
they might move a double that. So if there's some downward of volatility in the markets, I would expect business development companies to maybe get hurt. But you've got a lot of cushion in the form of excess rates or excess yields at the same time.
David Havens with Bloomberg Intelligence in New York, thank you so much for joining us pleasure. We look forward to having you back on the show very soon, and do check out David's great analysis on the Bloomberg terminal. Thanks again. Also to Rob Zabel, head of Liquid Credit and clos at Blackstone, and Lisa Lee from Bloomberg News. Read all of Lisa's great scoops on the Terminal and of course at Bloomberg dot com. And please do subscribe wherever you
get your podcasts. We're on Apple, Google and Spotify. Give us a review, tell your friends, or email me directly at jcrumb eight at Bloomberg dot net. That's J C R O M B I E. As in my surname and the number eight at Bloomberg dot net. I'm James Crombie. It's been a pleasure having you join us again next week on the Credit Edge