DANIEL ZWIRN: When you look dispassionately at the credit statistics out there, you're seeing enormous amounts of debt relative to asset values, you're seeing structures that are very, very weak, where people are not getting appropriately protected as creditors at the top of a capital stack.
At the extremes, if I have incredibly weak covenants, and I charge a really small coupon, well, then I can have no defaults.
There are a subset of opportunities available that are effectively self-liquidating. You can be effectively someone who benefits from the lack of liquidity by having a bid when people don't want it in that subset of situations that are self-liquidating so you yourself don't need that bid.
What is inevitable is either a crisis or a long term malaise.
ED HARRISON: Ed Harrison here for Real Vision. I'm talking to Dan Zwirn, who is the CEO of Arena Investors. Dan, great to have you here for debt week.
DANIEL ZWIRN: Thanks for having me.
ED HARRISON: I think before we came on camera, I was telling you off camera that we're having what's called debt week, with the beginning of 2020. The reason that we're talking about debt is because a lot of people don't understand that debt is actually a bigger market than the equity market is. That's right, isn't it?
DANIEL ZWIRN: Yes, the debt markets overall are far larger than the equity markets across loans and mortgages and tradable bonds, and treasuries, and all the different obligations out there. There's an enormous number of things to choose from when you're thinking about playing the markets.
ED HARRISON: Give me a sense of the comparative size of the market because when I look on television, I get the sense that it's all about stocks.
DANIEL ZWIRN: Yeah, well, you can imagine, there are literally trillions of different opportunities out there and in fact, we've never had more debt than we do now because of the tremendous amount of issuance that happened over the last 10 years. A lot of that debt ends up getting bought by the very same people who issue it when you think about the sovereigns globally. Basically, if you're an owner of an asset, there's never been a better time to raise debt against it.
ED HARRISON: Now, we're going to do a soup to nuts conversation on debt, because my understanding is you look at a full panoply of different markets, where their potential dislocations. I think of it, there's this term that I came across called fingers of instability that accumulate over time and then at stressful points, maybe you'll have a trigger, and it will cause a mini crisis or a larger crisis, like we had in 2008. Your thesis is basically that it's not a question of if, it's a question of when we get to the next crisis.
DANIEL ZWIRN: Yeah, I think there's two parts of it. First of all, there's always some combination of industry product geography where there's a debt crisis ongoing whether that's due to a particular issuer or a particular country or other geography, like a Puerto Rico or a Greece or an Italy, or whether that's related to a particular industry like oil and gas, there's always something going on. When we look at all of the things out there, we're always comparing risk reward and thinking where are people running from, so that we can take a look at where we might want to place ourselves.
At the same time overall, there can be-- at the end of the day, everything's correlated. There are times of extremes like in a way, or a 102 or 98 or 94 where a lot of the issues that arise in one or more market starts to bleed into the other ones. In an ideal world, we like to avoid macro views generally, because markets can be if you will, stupid longer than you can be solvent, so to speak. We try to focus on where the actual idiosyncratic or alpha related distortions are the greatest.
ED HARRISON: One of the things I guess that I'm thinking about is the length of this credit cycle or this business cycle. You hear the term that we're near the end of the cycle and as a result, these kinds of issues are things that we want to talk about. Before I go into what those issues are, because I think you have an interesting framework, what does that term we're late cycle, what does that mean to you?
DANIEL ZWIRN: Well, I would say it's hard to discern and that we simply, as [indiscernible] of a matter, don't have that many data points, depending on who you look, who you speak to, and the data that you look at. Perhaps we have 100 or 300 or 600 years of data, depending on what markets you examine. To draw any particular conclusions other than what goes up must come down is difficult.
Certainly since '08, we have had a series of basically market distortions created by primarily developed market monetary authorities that preclude actual risk from being appropriately priced. It's been a long, long time since there's been legitimate price discovery in the markets. At the end of the day, when you look at even equities, equities are ultimately the derivative of the credit markets. They're just the thing at the bottom of the capital stack.
Over time, people compare dividend yield on stocks with yields on debt. That entire structure has been distorted by monetary authorities effectively underpricing the front end of the term structure of risk reward. What we have is a whole series of distortions that have arisen when that bubble ultimately pops unclear, because when you keep rates flat or negative and there's very little premium put on top of those rates to price risk, ultimately, issuers that are not terribly credit worthy can frequently afford to pay very, very minimal rates to sustain a level of principle and particularly, when structures are really weak, can live to fight another day for years and years and years.
When we look at the world, we don't want to focus on what the greater fool may do or what might happen. We try to focus on places where those distortions have presented themselves typically in some particular, again, geography or industry, etc., that allow us to hopefully take advantage.
ED HARRISON: I want to get to that, this specific markets that we're going to be talking about, but first, let's go to your framework in terms of what you were thinking about in terms of where these fingers of instability are. That's because since 2008, there've been some institutional changes within debt markets. I think you enumerated five basically that are critical to thinking about how this could play out. Can you go through step by step, maybe we'll go through the five, one after the next?
DANIEL ZWIRN: Sure. Well, I would first say I enumerated those five factors in an academic paper. There's only a subset of those things that we see that were able to be substantiated in an academic level. It's not to say that there are no other factors that we see in the marketplace every day, but it's hard to get your arms around some of the numbers.
With regard to those five, I would start with collateral. At the end of the day, a number of folks look at default rates as an example. When they think about the quality or lack of quality of debt obligations, what we have seen is that at the extremes, if I have incredibly weak covenants, and I charge a really small coupon, well, then I can have no defaults. People tend to-- agencies and other evaluators of credit, look at coverage meaning how much cash there is to cover the obligations that I have from my debt instrument.
Well, again, if I don't charge a whole lot, then I can have high coverage and I can be comfortable. Nevertheless, I may have an actual overall obligation that's very large. In fact, maybe larger than my asset value. We like tend to look at leverage, not coverage. When you just dispassionately look at the amount of leverage in the system across corporate property, structure, finance, consumer and other personal applications out there, what you see is an enormous amount of debt relative to the underlying asset value.
Actually, you have a tremendous appreciation in asset levels. What is not necessarily understood is the degree to which people perceive there to be substantial equity value, because debt is cheap and lenders tend to-- there are situations where lenders tend to price very low because they perceive a lot of equity value. Those two things are not independently evaluated. They're effectively a zero sum.
ED HARRISON: Basically, you're saying that equity is the residual value with debt at the top of the stack?
DANIEL ZWIRN: Correct. We're at historical highs in terms of the enterprise value divided by cash flow that people are willing to pay for businesses or assets. Part of that is because we can access very cheap and large amounts of debt that allow us to make equity returns that we otherwise wouldn't have been able to make. At the same time, providers of debt are saying, well, this, I have real confidence that my loan to value is relatively low because of all the equity that these people with equity are willing to put in underneath me. Effectively, it's like two drunken sailors keeping themselves up. At some point, one of them might stumble over.
When you look dispassionately at the credit statistics out there, you're seeing enormous amounts of debt relative to asset values, you're seeing structures that are very, very weak, where people are not getting appropriately protected as creditors at the top of a capital stack. You're seeing terms in duration, which effectively, we have not seen the intrinsic risk of duration priced as low as it has for decades. Everything is set up for such that people are not getting compensated for risk they're taking.
If you look at the stats across the-- and I think we go into the second area, the ratings agencies, you're seeing a tremendous amount of BBB relative to the rest of high yield. Why is that? Because there's a very particular subset of investors that will only invest investment grade and above. There are tremendous incentives to do a whole lot of numerical gymnastics to be able to access an investment grade rating that otherwise perhaps 10 years ago, wouldn't have been given in order to access that group of investors that tends to be comfortable taking a relatively low return for any given risk that they're assuming.
ED HARRISON: Let me back up on two things because yeah, and by the way, when you were saying that, I was thinking about David Rosenberg, as I spoke to him, and he was talking about this too, I want to get a point in about the credit quality of BBBs relative to what they were before. The interesting thing, I think maybe this is a rhetorical question on some level, because you mentioned the Fed and other central banks in the developed economies. Why is it that these investors are not being compensated for extending out for duration, or for taking on the risk that they're taking off?
DANIEL ZWIRN: I think it comes down to the sheer supply and demand. There's only so many issuers. There's such a tremendous volume of capital that needs to be deployed, it needs to attempt to get some level of return, that people are willing to accept historically low levels of return when they think about the return they're getting relative to the other alternatives they have. When you see, unfortunately, a vicious cycle where if you lower rates, you make that hunger for yield all that greater and we'll have people who are willing to buy more of it and take less return over time until the market tells them no.
ED HARRISON: One of the things that hits me when you talk about this is this whole concept of servicing debt. Debt service costs being the marker versus leverage. To me, that smacks of hubris in the sense that as soon as rates go up, those debt service costs go up and suddenly, you have what seemed like low default rates not become low.
DANIEL ZWIRN: Sure. Well certainly, that's certainly the case with regard to floating rate obligations. Ultimately, even fixed rate obligations as a reprice will be priced against the available floating rate and move up themselves. What I think is not taken to account by investors frequently is the fact that there's a level of correlation between risk free rates and premium to risk free. If you see a real move up in risk free rates, ultimately, you frequently see big moves up in spreads.
At same time if both happen, you have potentially a reevaluation of the underlying asset yields necessary to appropriately compensate investors for owning assets or enterprises, and therefore a material decline in not only asset values as you perceive, but also more importantly, equity values that are subordinate and effectively managed by that debt. These things can spiral out of control as they have in prior crises. That said, again, there's tremendous incentives on the part of monetary authorities to keep rates low as well as support the term structure of risk through other means, including buying obligations directly in the marketplace.
I think while a crisis is not inevitable, it may be highly likely and in fact, it may ultimately be preferred, because I would argue that what is inevitable is either a crisis or a long term malaise. Where, as an example where you have Japan, already at and potentially Europe going. That's not such a great thing either. We have this tremendous number of distortions happening because risk isn't appropriately priced and because price discovery is not out there.
In fact, that leads to the third issue, which is that-- in addition to the fact that collateral is relatively misjudged in terms of its underlying risk, and in addition to the fact that it's not necessarily evaluated appropriately by available agencies, you have the fact that in the wake of the crisis, the number of people who are willing to make markets in fixed income across the world is very low, and to the extent that they're willing, their abilities is in turn very low.
ED HARRISON: Why is that?
DANIEL ZWIRN: Well, I think part of it is that there's been a tremendous level of pressure, perhaps rightly applied post-crisis on banks, that that participate in market making. One, to effectively put capital up against certain obligations in their balance sheet at levels that really preclude them from owning that risk in the first place. Second, through the Volcker Rule and other rules that they have to follow, there is a tremendous level of pressure for them not to effectively take a proprietary position. Unfortunately, in over the counter markets, the difference between making an OTC market and taking a proprietary view is very hazy. Why take that risk when the downside of doing is so great?
ED HARRISON: That means basically, liquidity has been shrunken over time.
DANIEL ZWIRN: Tremendously so. As an example, we, in our business, we owned a few million bonds of a-- have a $400 million issue and decided, after doing additional work, that we didn't want to be involved and it took us almost two weeks to get out of just a couple of million bonds. The reality is, and that turns to a another factor we see out there, not one of the five, but as a general whole, there have not mentality which is that if you already have, whether it's corporate, again, property, consumer, etc., there's really no lower bound on the level at which you can borrow. If you are have not, there's really no price you can pay to get access.
What happens is if you have an obligation of one of those have nots, it's effectively a permanent holding until you effectively get your hands on the assets either through a maturity or covenant violation, etc., and effectively forced the monetization. That then leads to yet another factor, which is the mismatch in assets and liabilities across many of the entities that have been raised in order to house a lot of this fixed income.
You'll see in mutual funds, shorter term, shorter duration hedge funds, ETFs and others, situations where there's a presumption that you'll be able to sell the obligations in order to deal with redemptions that's not really there. In fact, even in the last couple of years, you've had situations in Europe where there are property trusts, effectively, that own giant real assets that are levered, that are daily liquidity open ended and people somehow still are surprised when in fact, the redemptions come that they can't effectively sell those buildings on demand.
ED HARRISON: I call this fake liquidity basically in a sense that the underlying asset is illiquid and then you have a liquid trading ETF or other asset on top of that, and people get the sense that I can get in and out of this when actually the underlying asset, there's a mismatch there.
DANIEL ZWIRN: Either you in fact, won't be able to get out and redemptions will be suspended, or there'll be relatively low correlation between the price of the ETF in which you're invested and the actual price action in the underlying assets. Either way, you're not getting what you thought you would get.
ED HARRISON: You could see net asset values of