OXLC - The 'Macro Question' Some Have Been Asking (What Keeps Me Up At Night?)

2023-11-08 16:27:37 ET

Summary

• Members have asked about the middle market banking crisis and its impact on credit investments like loans, bonds, BDCs, and CLOs.
• The media tends to focus on risks and dangers ("the sky is falling" articles) while markets usually adjust prices and opportunities to reflect increased risks.
• "Risk/reward" is a slippery concept, as readers know. It's risky to be too conservative, as well as to be too aggressive.

Some of my readers have asked me to weigh in about "macro issues," especially what keeps me up at night (or not). Specifically they asked about the middle-market banking crisis, and what happens if it continues. In particular, will more banks pull out of that market? Will that actually help Business Development Companies ("BDCs") by allowing them to take over some of that business from the banks? What will be the impact on CLOs, etc.?

They also asked, more generally, what sort of macro existential challenges could torpedo BDCs, CLOs, credit investments and other portions of our portfolio?

It's Tricky!

In the economic, financial and investing realm it is easy to find things to worry about. That's partly because there is an entire industry (the media and journalism generally) that tends to be focused on finding things that are wrong, or scary, or dangerous. Having spent part of my life as a journalist, I know this to be true.

The train that crashes or derails is the one that becomes the big story, not the thousands that arrive at their destinations safely. That's why we see so many articles about stocks, bonds, loans and other asset classes that tend to emphasize the dangers or what can go wrong. And the more imminent the potential problem, the better. Hence the popularity of "the sky is falling" type stories. Later on, the fact that the sky failed to fall never gets the headlines or attention that the anticipated fall had received previously.

Of course, the fact that a reporter or commentator has noticed that a particular part of the sky might fall means that others have probably also noticed it, and maybe even done something about it. So there often is a lag between the threat itself (or perceived threat), and the story some journalist or media type eventually publishes about it, during which actions occur that may even reduce or eliminate the threat.

In other words, our economy has a lot of moving parts, with millions of "actors" - corporate CEOs and other executives, investment professionals and just plain ordinary investors - constantly taking steps to deal with whatever happens in ways that protect themselves, their companies, their investments, etc.

In the financial world this generally means that when risks are perceived to have increased, "the market" will usually adjust the prices, yields, discounts, and other terms of various asset classes to reflect the increased risks. So by the time that the investing public reads the Wall Street Journal article or sees the story on CNBC about the particular risk, the market may have already reacted to the trend, perhaps weeks or months earlier.

This is why, along with many stories over the past year about the increased risk of default and loss in the credit markets because of anticipated recessions and downturns, we saw an offsetting rise in credit spreads and discounts. So while the risks may have increased, so did the "reward" for taking those risks, with high yielding loans and bonds that might have paid in the mid-single digits a couple years ago rising to the 10-12% range over the past year.

This is why so many investors have learned over decades, even centuries, that there is often "profit in turmoil" for those willing to keep their heads and look for opportunities when markets get a little crazy. "Invest when there's blood in the streets," as Baron Rothschild once said.

Invest in What?

Personally, as I've written about for many years, I prefer credit investments rather than equity investments, during periods of financial uncertainty and volatility, if interest rates and credit spreads have risen in response to the greater perceived risk. Periods like the past year or so. If I can make a 10 or 11% yield merely betting on a company's staying alive and paying off its debts, why should I take the far greater risk of buying its equity, where the payoff to me as an investor depends on it not only staying alive, but also thriving and growing its earnings and dividends?

Suppose you could go to a racetrack and bet on horses merely making it around the track and finishing the race, instead of having to bet on a particular horse to win, place or show? It's sure a lot easier to win the first bet than the second one. The first bet, "merely finishing the race" (even if the horse comes in last), is like a credit bet. The bet to "win, place or show" - i.e. performing better than the other horses in the race - is like an equity bet.

Not only is the first bet a lot easier to win, but you actually have to win the first bet (have your horse finish the race) in order to win the second bet (since your horse can't win the race unless they also finish it).

Bottom line: an equity investment is worthless unless the company also pays off all its credit obligations, so we better have the prospect of making a lot more money when we invest in equity than we would if we merely invest in credit.

Returning to current reality: If I can make an "equity return" of 10% or more investing in credit, why would I want to take all the additional risks of investing in actual equity, unless I was confident of making a lot more?

That's why, in the recent environment, I've focused so much of my attention on credit investments, with positive results.

Compared to What?

One thing to remember is that risks do not exist in isolation. As an investor, unless we can afford to go "risk free" and move all our money into low yielding Treasury Bills, we have to invest in something in order to generate income. As income investors, many of us focus on high-yielding credit or other fixed income asset classes (e.g. corporate loans, high yield bonds, and BDCs, which while we buy the equity, are essentially portfolios of actively managed senior secured loans.)

These would undoubtedly suffer during a recession or downturn. But if we are buying them for their steady distributions, then my assumption is those steady distributions would remain largely intact, even if there were some reductions. By contrast, in a similar scenario (recession or economic downturn), I expect a typical "dividend growth" portfolio, with a yield of 1-2% (like the S&P 500's 1.5% yield), would perform even worse, since there might be no growth at all or even a drop in price, and you'd only be earning 1.5% while you gritted your teeth and waited patiently for the turn-around.

Distribution Cuts

Let's look at a high income portfolio. Supposed you had a $1,000,000 portfolio yielding about 10%. That's a base income of $100,000. (Obviously we can scale this example up or down as we see fit; I like working with nice round numbers.)

If you had recession level defaults of 5%, and ended up losing 50% of average principal on the defaulted loans or bonds, your average fund would lose 50% X 5%, or 2.5% of its portfolio. That would be a portfolio wide loss of 2.5%, so it would reduce your portfolio by 2.5%, to $975,000, and your income at 10% would drop from $100,000 per year to $97,500.

But suppose instead of a garden variety sort of recession, like the one they were predicting recently but still hasn't happened, we had a really "Great Recession", which is actually what they called the one in 2007/2008; and defaults hit about 10%. Assuming the same level of loss - 50% of defaulted credits - our overall loss on our portfolio would be 50% X 10%, or 5%. That would be a loss of $50,000 of a $1,000,000 portfolio, so the income would now be 10% of $950,000, or $95,000, a 5% drop from the original $100,000.

In fact, with our portfolios, where many of our credit investments are in secured loans, and not in unsecured bonds, the collateral protection would probably return 60-70% of our principal, so the loss would only be 30-40%, rather than 50%. So a default rate of 10% would only result in a loss of 10% times, say, 40%, or 4%, rather than 5%.

But suppose in addition to the losses from loans and bonds defaulting, some of our other funds ended up cutting their distributions for various reasons. We'll assume 20% of our funds cut back their distributions by 20%. That would be a portfolio wide cutback of 20% X 20%, or 4%. That would be another $4,000 cutback in our distribution income, bringing it down to $91,000, a total of a 9% drop in distribution income.

Bottom Line

A 9% drop in income, given a "Great Recession" sort of scenario, is not that bad. During the actual Great recession of 2007/2008, I wasn't yet using the term Income Factory® but had already embarked in that general strategic direction, and I remember in the aftermath of the crash being able to reinvest my portfolio income in funds at huge discounts. I remember hearing from friends in the credit market that healthy loans and high yield bonds were trading at 60 cents on the dollar. That explains why CLOs at the time were able to reinvest their excess cash flows in loans at those levels, which resulted in big capital gains later when the loans matured and repaid at par, 100 cents on the dollar.

That's why reports on CLOs today refer to those years as providing the highest returns ever achieved by CLO investors. It also explains why the managers of funds like ECC , OXLC and others talk about how attractive the CLO market has been recently as CLOs have been able to pick up new loans at bargain prices (not the bargains of 15 years ago but still very attractive).

Regarding the specific question about whether BDCs and CLOs might pick up the slack if middle-market banks were to weaken or become smaller players in middle market corporate loans, I think they would (and probably already have, to some extent). Many of the BDCs that are run by Ares, Apollo, Carlyle, Blackrock, Barings, etc. have such great contacts with the private equity community that they have better pipelines than the banks to a lot of new business.

In a future article we will review the results of our various credit asset classes so far this year. Spoiler alert: While senior loans, high-yield bonds and CLO funds have done very well, BDCs have led the pack.

This is a longwinded answer to the questions a number of readers have been asking. I look forward to continuing our discussion.

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