Transcript: The Future of Private Credit

Air Date: December 9, 2024 | 12:00 PM, EST

Caroline: Good afternoon, everyone. Thanks for joining us. I'd like to welcome you to this week's Monday Minute live chat, hosted by the Canadian Leadership Congress. Today's topic is Breaking Down (And Building Back Up) Your Fixed Income Allocation. Here to talk about it is Aaron Young, Client Portfolio Manager, CIBC Asset Management. Moderating the conversation with Aaron, we have Andrew Michalak, Director, Funding, Liquidity and Trading, Total Portfolio Management with OPTrust. Welcome both of you. I'm going to hand things over to you, Andrew, to get us started.

Andrew Michalak: Great. Thank you very much, Caroline. Welcome, Aaron. It's really a pleasure to have you here today. I'm excited to dig into some of the fixed income topics that we have today because I think it's really critical for investors not only to understand the risks that are inherent in fixed income allocations, but how the risks are viewed and incorporated from a total portfolio perspective as well. I think it's a really important part of it. Aaron, with that, let's dig into it. I'll start off with, what are the key risk factors that are embedded in fixed income portfolios that you're looking at?

Aaron Young: Thanks Andrew. Thank you, everyone, for having me on the call today. I think you hit on a really key point, Andrew, is that fixed income as an allocation when we speak with asset owners is often treated as this monolith, this single exposure. Although that makes sense in some ways, we also look at fixed income actually as a bundle of risks. We actually think asset owners and our clients can really benefit from going to that next level and really looking at their fixed income allocation across those different risks. I'm oversimplifying here a little bit, but for the sake of argument, we really think of fixed income as a bundle of two key risks.

That's really interest rate risk, so the impact from interest rates going up and down. Then also spread risk, and that's some sort of credit risk, whether it'd be through corporates, securitized, et cetera. We really think if you can break down your fixed income allocation into those two risks, know how much of your total active budget or active risk is coming from both, you actually get some interesting interactions and some interesting ideas about how to allocate your total fixed income portfolio. We like to throw out the word bonds, but bonds actually have some underlying elements that are worth parsing out.

Andrew: That's great, Aaron. Just to follow up, what risk do you think is sometimes underappreciated by investors who are just passively allocating a portion of their portfolio to fixed income?

Aaron: I come from a credit background, that's really my area of expertise. What I find really with investors, especially when looking at say, investment grade credits, other certain securitized products, they are often very focused on spread risk. The additional premium they get for lending to a non-government entity which has default risk, that risk is definitely very high in things like high yield, sub-investment grade, leveraged loans, privates, et cetera.

In investment grade land, if you look at the total return string we get from an investment grade bond, a large amount of both the return and volatility comes from your underlying interest rate exposure or that underlying government bond exposure. It's interesting to see when clients look at something like an investment grade corporate bond allocation, they're very focused on spread, which of course makes sense in the credit risk embedded there. What's really driving the bone in a lot of ways is the interest rate risk.

We always pose the question back to clients to say, "How are your managers not only managing credit risk and doing the deep dive due diligence that's required there, but how are they also managing and mitigating the interest rate risk, which can really take over the total return stream of the portfolio?" Again, back to your earlier question, Andrew, I think that's the lens that we want to approach fixed income allocations in general, is knowing where those two risks lie.

Andrew: I think that's a great point. As you mentioned, there's this potential for certain scenarios where fixed income just doesn't provide that diversification like it has from a historical perspective. It doesn't have that diversification perspective. I think in an environment, especially going forward where inflation has the potential to be higher, where we have government deficits that are rising, I think it's critical for investors really to understand the duration risk that you're taking on, as well the credit risks that are embedded within the portfolio.

On the credit side, I think sometimes it's underappreciated depending how far you are in the credit spectrum, the equity-like risk as well that can be embedded in fixed income portfolios. Both of those factors are really the key factors that investors need to focus on.

Aaron: 100%.

Andrew: Aaron, I wanted to touch on concentration risk from an issuer perspective or even from a sector perspective. How do you think about this when you're building your fixed income portfolios?

Aaron: We're at CIBC Asset Management, we're obviously a Canadian-based asset management firm. Our history, if I go back to our 50-plus years experience, it has been in Canadian government, provincial, and corporate bond markets. What we've learned over time and what we've expanded into is, again, looking at more of a global mindset. That's specifically in response to your question around concentration risks, sector concentration risks within Canadian bond portfolios. Sometimes we get caught in a home bias thinking about Canadian portfolios as the only sandbox to play in.

Again, makes sense, especially if you're managing to Canadian liabilities, you have to manage that risk. Generally speaking, we actually think approaching other markets, whether it'd be US investment grade, US securitized, European markets, high yield to some extent, not only provide opportunities to add value, increase return, but also diversification, both on a sectoral or issuer level. The matter of fact is the US, for example, investment grade market is multiples of the Canadian market.

While we do run mandates that specifically focus on that area of the market, we also find that the opportunities to round out, diversify, decrease the concentration risks that comes naturally by being only Canadian focused is really plentiful for clients. The importance being looking at it on a CAD hedged basis, looking at it from the Canadian investor's perspective to say, "Where can I find relative value or relative diversification in other markets?" The other element really, Andrew, is also liquidity wise. Again, Canadian market, we get caught in the home bias.

US market is multiples more of liquidity on both sides. We often point to investments recently in something as simple as US agency MBS, where the size of that entire market really dwarfs the entire Canadian bond market from governments through to corporates. That is a diversification play not only in terms of risk and return, but also in terms of sourcing liquidity and being able to trade in and out of positions, especially in times of volatility. In our view core in Canada, but looking for opportunities to get exposures to those different risk factors, better diversification, better liquidity outside of the Canadian market.

Andrew: I would add there that it also depends on the asset vehicle that you're expressing within fixed income. For example, if you're allocating to derivatives like credit default swap indexes there, not only do you have different risk factors and liquidity, but you also have different diversification factors not only from a sector perspective, but also just the number of issuers as well. Understanding that concentration risk that you're taking on relative to the broader indices is important, depending on which asset you're going into and if you're building your own portfolio as well.

Aaron: Andrew, that's a really good point around your first question around disentangling a bit of interest rate risk versus credit default swaps, whether it'd be CDX or single-name. There's a great example of where you can isolate the spread risk factor that we were talking about. You can express active decisions purely in that space. You can actually avoid or disentangle the other elements that come with buying say, a 10-year corporate bond where you get that really long interest rate risk.

It's a really good point. We see that as another tool in the toolkit, so to speak. Maybe I'll turn the tables on you a bit, Andrew. Let me ask you a question, especially from your standpoint at OPTrust. From your perspective, how do you guys incorporate fixed income risks looking at how those break down into different factors? How does that play into constructing your fixed income exposure and your total portfolio?

Andrew: I would say traditionally for pension plans, fixed income is often used as a hedge to the interest rate risk of the liabilities. It provides some degree of liability matching there. It's also viewed fixed income, as a diversification asset within the portfolio where you have fixed income providing protection within the downturn. The last thing I would say, traditionally, it's also viewed for the stability as well as the predictability of income over time, which pension plan managers as well as asset managers are looking for.

Having said all that, for pension plan asset managers, it's super important to fully understand those risks as you talked about that are embedded in the fixed income exposures, and not just be blindly allocating a portion of their fixed income. What you need to do is take a more total portfolio approach when making those fixed income allocations. The total portfolio approach takes a more holistic view of all the different risks in all the assets and ensures that the fixed income allocation isn't just viewed in isolation, but where you're aggregating all those risks at the top of the house.

When we think about the total portfolio approach, we're using risk factors such as you talked about interest rate risk, the credit risk, that equity-like risk that you have, a liquidity risk, et cetera. Instead of doing a more simplistic, traditional asset class segmentation, think of your 60/40 portfolio there. For example, even having a higher allocation to high yield fixed income, that has a lot of equity-like risk factors attributed to it. It's important to fully understand all the risk factors that you have, aggregate them, and construct the portfolio to meet your pension obligations or meet your mandate.

I think without fully understanding all the risks embedded not only in the fixed income portfolios, but the total portfolio, portfolios could appear diversified from an asset class perspective, but they may actually be less diversified than investors think. This is a really key important point to have that total portfolio mindset when you're making allocations across the board.

Aaron: Andrew, just to jump on that, I think probably similar to the conversations you have for us dealing with asset owners outside clients, we often have this conversation around compensated versus uncompensated risks. To put it in the context of, again, a liability-aware or a well-funded pension plan, DB pension plan where we're helping manage the money, for us, a lot of the conversation is around your interest rate risk is maybe less compensated, it's better spent matching that relatively closely, and then using that decreased funded status volatility or that closer match to then maybe redeploy in other areas where it's worth you taking a bit of risk.

I think, like you said, maybe more equity-like risk. I think you're earlier questions about fitting in this factor mindset into where you're actually taking active risk and where you're not is really key.

Andrew: Great. Aaron, when you're breaking down the risks in the fixed income portfolio, how are you using that information when you're making active management decisions as well as generation of alpha?

Aaron: I think it's definitely looking at what's the role of the portfolio. Again, I delineate a bit between when we manage money for clients who have set liabilities that we're managing to versus say, a client who's more asset-only focused and really looking to produce risk-adjusted returns. At the end of the day, it does go back to my previous comment around where can we take what we feel is compensated risk. Again, I'll focus more maybe in the investment grade space. For us, it's not that there's bad bonds, there's just bad prices.

Really, every issuer that you participate in or every position you take has some embedded risk in it, whether it'd be default or mispricing, et cetera. For us, it's really a relative value lens to say, first of all, identifying what are the underlying risks both from interest rate and from the spread component. Then saying, are we compensated for those risks or are those areas where we don't want to play in because we don't feel we're compensated. For us, it's really a relative value exercise to say, if I have this pool of capital that we manage on behalf of clients, what provides the best risk-adjusted opportunities on any given day?

Then constantly revisiting that thesis every single day to ensure, again, we believe we're deploying the capital in the most optimal risk-adjusted way possible. Again, just to bring it back to the theme of breaking down and building back up, one of the keys of understanding if you're getting compensated for risk is knowing where your risk is coming from. Looking at elements on a pure credit basis versus what's being driven by interest rates or term structure, really getting into the more granular factors of what's driving a total bond's risk is key in knowing where you want to take certain risks and where you actually want to avoid or you feel you're uncompensated.

Andrew: I would say for pension plans, if you take a look at the liabilities and you perform key rate duration analysis of those liabilities, it really gives you a better understanding of where the risks lie across the curve and then provides you a better understanding of how to actually hedge those liabilities. From there, it really gives you that starting point for active management because some plans may be more mature, some plans may have more active members who yet aren't retired. From there, you can provide active management, alpha generation, depending on that economic cycle, so you can manage those risks in a more precise fashion depending on your situation and your pension.

I think when we think about the macro backdrop over the next 10 years, that could potentially look very different than the macro backdrop that we've seen over the past 15 years. There could be higher inflation, there could be higher debt levels that could impact a lot of the different risk factors in fixed income. I do think that understanding those risk drivers and the potential return scenarios, I think that's really important as well.

Understanding the potential scenarios going forward and how that's going to affect returns based on the macro backdrop is important. Allowing managers to take those active tilts within that fixed income portfolio to generate alpha on top through the economic cycle makes a lot of sense.

Aaron: I think, Andrew, just to add on quickly, you hit on a key point there which is also not getting caught in recency bias. If we think about our defined benefit pension plan clients who manage to liabilities and understand that outright duration or interest rate risk is actually helpful/necessary, if we then turn to our more asset-only focused or active return focused clients, they're very much sometimes can get caught in recency bias around, "Interest rate risk is something I don't want exposure to. I experienced 2022 with a large drawdown as central banks repriced monetary policy very aggressively." Our argument is a lot along the lines of what you're saying, Andrew, in terms of back in a zero interest rate policy quantitative easing world from a pure active return perspective, credit was a bit of the only game in town in terms of how can we generate additional basis points and added value.

That formula has flipped on its head a bit. We're actually seeing a lot more interesting relative value opportunities in stuff as boring as developed market sovereign government bonds and playing those curves against each other. That wasn't the case in the ZIRP world of earlier.

Andrew: It's a great point. Again, it depends on that economic environment that you're in. As you mentioned, in 2022, we saw a rise in inflation, central banks started raising rates aggressively. Not only did we have the S&P down 25% that year, we also had long US treasuries down 25% as well. The long fixed income exposure really didn't provide any diversification for investors during that macro environments.

Understanding those risk factors and then the potential outcomes based on the macro backdrop is very important for investors, especially when you're doing active management. Aaron, with credit spreads currently at fairly tight levels from a historical perspective, is it more important now than ever for investors to fully understand that risk that's embedded in fixed income? What are your thoughts on credit spreads at the moment?

Aaron: As we've heard with the rise in base rates with the Fed and the Bank of Canada and other central banks having reposition policy rates higher so quickly, we talked to a lot of investors about All-In Yields, how attractive they are. It's definitely the case. We're seeing yield levels we haven't seen in decades. It is very attractive, just in general for fixed income. There is income back in the market for sure. Now, when we zoom in and double click on spreads specifically, spreads especially in Canada, US investment grade, and like you mentioned high yield, are at nearly all time tights, like very low percentile on a historical basis.

While we find sometimes investors can get lured into the All-In Yield being advertised by indices and markets, we caution against going to what may be the providing the highest headline yield in terms of corporates, et cetera. Because, again, going back to our original thesis here, if you break down the risks that you're getting exposure to, on the upside a lot of your yields actually coming from base rates, so government of Canada bonds, US Treasuries, base rates like SOFR, or CORRA, CDOR in Canada, those are elevated. The additional premium you get from taking out credit risks are not elevated, they are very tight.

It's not to say we don't think you should be investing in credit, we have expertise in credit, we still have exposure in things like investment grade and high yield, but we do think this backdrop, you need to be very selective. This isn't broad based, I want to own credit in any and all its formats indiscriminately. We think it's got to be really focused on issuers, first of all, where you've done your independent underwriting of their credit quality and where you think there's value and also being nimble in the way you do it.

For us right now, if you think about how we have exposure to the credit spectrum within investment grade and high yield, very short term in nature. Our actual credit spread duration, as we call it, which is really fancy way of saying, we have really low credit spread duration. Shorter on the curve, we don't need to go by 10, 30-year corporate bonds. We don't think we're compensated for that risk. Then even looking at what we think of as

quasi-credit, securitized paper, even things like US agency MBS that at one point were trading at spreads equivalent to high yield, things of that nature, credit adjacent, we think actually offer better risk to reward because higher quality, more liquidity, but without giving much in terms of compensation and spread.

Andrew: That's great, Aaron. Why don't we transition to the private markets now? How are risk considerations different when you approach private markets? How does this really contrast with the public markets?

Aaron: It's interesting to see the industry build this bifurcation between privates, publics, alternatives, traditional. We get it in some respects, but we also like to push back against that notion a bit. Let's say on a private credit standpoint, it is very much structurally different than what we do on the public side, whether it's high yield, IG, or leveraged loans, but it's still credit.

That's our argument to clients is to say, again, from a risk factor perspective, from the underlying risk that feed into your private credit allocation, it's different in some respects, but it's also not. Again, your private credit total return is composed of a base rate, like SOFR, a credit spread, so your compensation for lending to that private entity. We're really pushing clients to say, again, back to our original question, what are the key risk factors and how do privates fit into that?

We would argue private credit specifically and middle market direct lending, which is the core of the market, you need to ask your managers and we ask ourselves when we originate loans, how much of the All-In Yield that I get is coming from just the rise in the SOFR rate, going from zero up to north of 5%, versus the actual additional credit compensation I'm getting for lending to these middle market, call it 50 million-plus EBITDA companies.

When you pull in the liquidity element, the fact that these are illiquid investments, again, does it make sense in the context of the other areas of value that exist? I would argue you could do the same thing on the private equity side versus your public equity. They're different, but they're similar and they need to fit in that same risk return context.

Andrew: How do you approach the concentration risk in the private markets when you're building those portfolios?

Aaron: It's a really good point. I think that's really where we lean into a few things. One of them is how that allocation looks relative to public markets. Back to your earlier question, Andrew, about concentration in, say, public investment grade markets, private credit in many ways is a nice complement to that because you're getting exposure to those middle market companies, which just frankly aren't large enough to issue public debt, whether it's high yield or investment grade. If you want true exposure to, say, the Canadian or US economy, I'll pick on Canada, you're getting a lot of telcos, utilities, financials within the public sphere.

You can complement it nicely with a private credit allocation that's, say, more industrials, consumer services, healthcare, and the like, areas that maybe just aren't as represented in public markets. Then I would also say going outside of the core middle market direct lending, we're doing a lot of conversations with clients about asset-based lending, NAV financing, et cetera. You got to know your risks there. For sure they're definitely more niche markets, but that also gives you different exposures not only in terms of lenders or borrowers and sectors, but also just structure whether it'd be highly secured paper versus a second lien or mezz debt, really lets you build a well-diversified private and public credit portfolio across all the different avenues and verticals that you can think of.

Andrew: That was great, Aaron. It's probably a great place to conclude here. Thank you very much for all your insights. It was great.

Aaron: Awesome. Thank you to you, Andrew. It was a great conversation.

Caroline: Thanks to both of you. That was a terrific discussion. That wraps this week's Monday Minute. We've got a lot of exciting content and great interviews lined up for our future Monday Minutes that you won't want to miss. Be sure to go to our website, leadershipcongress.ca to sign up for our very informative and timely CLC newsletter. In the meantime, thanks for joining us. See you next time.