GLENN REYNOLDS: That inversion from, for example, overnight or three months down to one year, that is something that you don't see very often. That's a flight to quality. But then why is equities rising sharply? Why are credit spreads tightening in high yield? And what you're going to have is someone's going to be wrong. This is actually the highest quality origination cycle we've had, for example, in the high yield market. So, when you start throwing tariffs on, you are, by definition, squeezing margins. So, that leads to the concern about the correlation between equity and risky credit. And when you start talking about things like Section 232 Auto Tariffs, that's like a declaration of war on some companies.
VINCENT CATALANO: Hello, I'm Vincent Catalano, Chief Investment Officer with Redmount Capital Partners. And today, we're going to talk about things related to fixed income. So, this very broad, wide topic, going to cover lot of areas with Glenn Reynolds. He's co-founder and Chief Global Strategist with CreditSights here in New York. Glenn, welcome.
GLENN REYNOLDS: Thank you.
VINCENT CATALANO: Capitalist. Let's talk a bit about yield curve. A lot of talk about that going on, inverted yield curve, what does it mean, recession's coming, things of that sort. How do you see the yield curve right now, and the inverted aspect of it?
GLENN REYNOLDS: Well, the history is- and this is the way the economists typically view it as an inverted yield curve is the precursor to a cyclical downturn, it's the signal. It's coming. But you really haven't had that many credit cycle downturns. And you had plenty of times where you've had flat curves and inverted curves which didn't immediately lead to it. So, it becomes more of a warning sign.
But curves are more- just call it symptoms than causes. So, the way we look at this current inverted yield curve, when you're talking about rates that are below 2% from 1- Year almost out to 10-Year, we just bumped back above 2%, it's a very different backdrop in past inverted yield curves. And really, what you have to do is go behind the curve and look at what's going on in the fundamental stress points of the market. And every time you've looked at an inverted yield curve in the past that led to a downturn '89, 2000, '06, there was a raft of structural problems, fundamental problems, industry stress, asset class turmoil- there was a lot going on behind the scenes. And you we don't have that right now.
What it does say is that the market's afraid of something. When you have flight to quality or when you have a reversal of a tightening cycle for the Fed to cut, that leads to the next question, well, what does that fixed income markets see in the bond market that rallying equity markets and rallying credit markets don't see? And therein lies the debate.
VINCENT CATALANO: The UK, typically, whenever it inverts, it's where the short rises above the long. But we have a little bit of the ladder where the long is dropping below the short, the short has risen, granted. But in the past, that's the- I've looked at it with the data from the same that was Fed, in which they showed is like convergence with all- you got the short rising, and then it meets together, and then there might be a bit of an inversion going on. That's not really what's going on right now. It's not so much the short rising as it is, then the long declining and I know, you just touched on an aspect of that. Thoughts on that quality, that dimension of it does it mean anything to you?
GLENN REYNOLDS: Well, historically, you've had inflation periods late in credit cycles. The historical credit cycle was market blows up, Fed eases, market recovers, curve goes north, Fed tightens. You didn't have that, you had seven years of zero interest rate policy this cycle that's unprecedented. And since you had the strangest credit crisis in modern capital markets history in the last go-around, it probably shouldn't be surprising that this was a bit of a different type of transition to a late cycle.
Starting Monday, we'll be in the longest economic expansion in history. And we're already in the longest credit cycle in history. So, there's a lot of things that are unusual about this, but that inversion from, for example, overnight, or three months down to one year, that is something that you don't see very often when the long end's coming down. And what you really have is an inversion on the front end, and it steepened from 1-Year out to 10-Year. So, it's almost like you break it up into a combination of an inversion and what some people would call off, they want to overdo the lingo, it's actually a bull steepener.
You don't see that every day, because you had the front end coming down faster than the long end. And that gets tied up in the inflation story. And also, the question marks around what people who are rushing into Treasuries actually see, and a lot of what people put it back on is trade policy and global turmoil. So, that's a flight to quality. But then why is equities rising sharply? Why are credit spreads tightening in high yield? And what you're going to have is someone's going to be wrong, and someone's going to be wrong, and it will be painful.
It's just a matter of timing that, because you can have a lot of interment adjustments in the curve. We've had flash curves before in the '90s in particular, where the market kept doing very well, then it would steepen, then it would flatten again, but have flattened from what we would call a bear flattener with the front end coming up in an inflation market. This is a pretty unique animal this cycle, and it's making some pretty vigorous debates. But if you're a bear, and you traded just off the yield curve, you just would have gotten slotted this year. So, if you do have conviction in that trade, it's a painful journey to get there.
VINCENT CATALANO: Now, there have been some strong benefits from the fact of the loan rates being as low as they are. Debt service has been fine, even though debt to GDP, a whole range of statistics that are out there showing corporate debt to GDP being at record levels. I think you have sovereigns to GDP also had record levels. And this is what good GDP happening in most cases or at least positive GDP, that's a positive dimension of it.
A negative dimension would be the investors. The investor is looking for pension funds, for example, endowments, insurance companies, what are they going to do when their mandate is to have let's say X percent in fixed income, this reach for yield is grabbing. We've not seen too much in the way of problems, like your thoughts on this, in terms of the faults and risk and stuff like that. But what is your sense of what's going on with that, with the pressures on investors to find rates of return that will enable them to achieve their required returns?
GLENN REYNOLDS: Yeah, it's an interesting dilemma right now, because reach for yield historically is a phrase that connotes reckless lending, reckless investing, therefore feeding on itself and bringing out more of both. But you really haven't had that. This is actually the highest quality origination cycle we've had, for example, in the high yield markets as grading on the curve against past cycles, which, frankly, is not a particularly great curve, because we've had some very bad underwriting cycles. But about half the market now, yield, for example is in the BB tier, which is the highest quality tier where you have exponentially lower default rates than you do in the CCC tier.
So, that high yield bond market really is not of a quality that you've seen in the past. Leveraged loans in the last year and a half have started to go sideways. Because the origination standards haven't changed when it took off some regulatory controls, they had leveraged lending guidance and said they'd issued in the aftermath of the crisis and a lot of reform initiatives taken. But that rules leveraged lending guidance, it was basically knocked down by the GAO and the Republican Congress as being not a rule in effect. And therefore, all of a sudden, you saw a breakneck pace of leverage loan origination back in 2018, when the Fed was tightening, so it was a hot asset class.
So, there are some pockets of excess right now, but nothing like the past. But the reach for yield element is just when you get down to where, for example, high yield par with a coupon at 6%. You go back in time, 90-Day T-bills were 8%, like in 1989, it's a starvation for income that does create a reach for yield, that usually does mean you're taking on more risk than you should be relative to what you're getting paid. But if it's the only game in town, you have to invest somewhere, because if the market blew up in credit and you were in equities, it's going to be a lot worse over there. That's price risk. At least you have cash on cash reinvestment returns, which allow you to build portfolio value, you just maybe not getting paid accurately for the risk you're taking. But that's the case everywhere you look, it's the lesser of two evils in many cases.
But on the issue of pension funds, pension funds have a huge need to pay out money every day. They're paying out to retirees, and that takes cash flow. And that takes income and therefore, where do you find that? You find it in various credit asset classes. And that's when you start to get over your skis in terms of the level of risk you're taking, versus what you should be doing prudently depending on the nature of the portfolio's risk parameters. It's a difficult choice. And there's a lot of new products out there that are coming down the pike.
VINCENT CATALANO: Well, I'm going to turn with a quote here from a report that you recently produced. In this, it gets to the issue of this reach for yield in a bit of a different way. The trend line in pensions has been for higher allocations to credit with private credit and alternative credit among the emerging hot topics. The rise of allocations to asset classes within theory, uncorrelated returns and high illiquidity premiums reflects the pressure on pension plans to generate cash, as well as higher returns.
Sounds like pensions and others, in order to find yield, are moving into this private credit space, which has a whole different dynamic. So, I'm going to give you a little bit of a conspiracy theory as part of this in a moment, which would be fun, but you reach for yield with lower quality. But now, many people are talking about the reach for yield in private credit, money going over to that world, which has a whole different mark to market dynamic than it does with publicly traded issues. Any thoughts on that?
GLENN REYNOLDS: The private credit has been- it's way off the radar screen, it's bubbling up of people who are in the business who are watching it closely. And the main people who are really driving the bus on this are some of the private equity firms that specialized in all different types of leveraged asset classes, very top notch people. But usually, it means higher fees in fixed income. So, when there are higher fees and higher risks, and it's being packaged by some of the guys who brought you some of the past credit cycles with leveraged buyouts, you have to sit with your back on the wall.
And for pensions, the ultimate, the white whale is you want to find high return assets that bring you income, provide uncorrelated returns, and do it where it therefore enhances your portfolio returns if everything else is correlated. So, when equity sells off, high yield bonds sell off, the idea is a private credit won't. And when I say high illiquidity premium, the punch line I've been using is one man said liquidity premium is another man's mis-market portfolio, because it doesn't trade, it doesn't have transparency. But it has high income, but it has high income for a reason, because there's a lot of risk.
So, the whole issue with pension is, is that appropriate for pensions? And we would say yes, it is. But it really depends on what your overall risk allocation is, just you hear people on pensions say, I can't buy junk bonds with my pension. Well, all it is, is a credit risk asset along a risk return spectrum. Some of the same pension funds own lots of equities that are primarily driven by price. Now, if private credit falls apart, chances are your equity portfolio isn't either. So, it comes down to doing the right thing around balancing the risk of returns and relative liquidity within that portfolio.
Because that have to pay out. I did a study of the top hundred pension funds and the defined benefit plans in the corporate space and the median payout rate from those that's cash written- check written every year is over 7% of the portfolio. So, you have to make 7% in returns just to stand still. And if you're paying that out in cash, you can't even get that level of cash flow in a high yield bond portfolio by itself, which wouldn't be a prudent diversification anyway. So, it makes it a very expensive proposition for companies to make sure that they can keep these plans in wind down mode, because many of the defined benefit plans now are closed.
Not with the states. Not with the cities. Not with the fire departments. But with private corporations, they've all shifted over to defined contribution. But that requires cash flow and risk. There's no way to function in this market without taking more risk. And usually, risk brings out bad behavior, underwriters develop new products. And lo and behold, you revisit the same old patterns. To this time, they'll have a lot less liquidity because of the reform that was done as the Volcker rule. So, it could even be this better quality this time, but the market liquidity of these assets is much worse.
VINCENT CATALANO: But you also have the dynamic there. And here's my conspiracy theory aspect of it, you have the pricing of the asset. Okay, so I'm a pension fund, I make an investment in private venture. I don't have the mark to market. I'm going to get valuations along the way, of course. But those valuations are skewed more towards a 3, 5, 7 year time horizon, maybe longer.
And so, whatever the value is, that's determined by the independent valuation that's done becomes my value. And therefore, I am meeting my goals and needs, which hopefully, that debt or if it's equity, in some cases, will be there later on. And actually pay off. That type of thing. You hear any conversation about it? Because I never do. I bring this up and people look at me, like I have three heads.
GLENN REYNOLDS: It comes up all the time, because when we're talking about taking on additional- some of the people we talked to, a lot of them are in hedge funds or pension managers. And you talk about some of the trends. And for example, that private credit asset class could be north of a trillion dollars by next year. So, it's time to become a standalone asset class. And it's basically off the run, small and mid-cap, or more often than not, very small cap, private loans. So, if you don't like leverage loans that have some liquidity transparency and some filing requirements, how are you going to feel about private credit?
So, as you look at it, you go, this could go horribly wrong. But the people who have managed it, I haven't, some of the best people in the business. They're also some of the best people in the business of generating fees. So, it's always had natural dynamic, but illiquid assets. And when we did our study on that defined benefit plan, you have plenty of equities, and they call those Level 1 securities because they're exchange traded, very reliable price discovery. And they have Level 2, which are corporate bonds, high yield bonds, emerging market debt, because there, it's less liquid, but relatively high quality observable inputs.
And there's Level 3, which is a jump ball, and they try to make it respectable, and they have good auditable valuation studies. But it's a question mark and it's not liquid. Then there are these ones that are NAV-based- net asset value based. And those are very often limited partnerships, highly off the run private equity type of ventures. So, the quality of the marks in good times is not necessarily going to hold up in bad times. And the people who package and sell these products very often are the ones vowing them at during the good times and running for cover in the bad times.
VINCENT CATALANO: Now, there's a lot of dry powder that sits out there in the private world, is there not?
GLENN REYNOLDS: Oh, gosh, yes. And they've been very adept at raising it probably from pensions, but also increasingly, they're tapping more on the high net worth and wealth management practices to get more private equity, there's a lot of investable funds to put to work.
VINCENT CATALANO: I want to read another quote from your report. This is in regards to leveraged buyouts. And in the past as we talked about before, about rates and short rates rising and things of that sort, one of the things that's happened in the past has been the whole leveraged element dynamics