Performing Credit Quarterly 2Q2023: Fighting the Fed

The U.S. economy refuses to follow a single storyline. In the last six months, the gross domestic product has grown, while gross domestic income has contracted; the labor market has added jobs at a robust pace, but average hours worked have declined; and leading indicators have often disagreed with their lagging counterparts. This complexity may be a byproduct of the tug-of-war currently occurring between the U.S. federal government and the Federal Reserve. While they were closely aligned during the pandemic, they’ve often been working at cross-purposes over the last year, as the former’s desire to keep the economy churning has clashed with the latter’s interest in throwing sand in the gears. As a result, the most widely forecast recession in U.S. history, the long-awaited Fed pivot, and the relief the latter could provide to companies and investors all keep getting pushed further into the future.

Tug-of-War

The Fed is in the midst of the most aggressive interest-rate-hiking cycle in 40 years, having already increased the fed funds rate by 500 basis points. Headline inflation has responded, dropping by 6.1 percentage points in one year to 3.0%. Meanwhile, core inflation (excl. food and energy prices) has been stickier. While it has begun to slow meaningfully in recent months, due to the deceleration in rising shelter prices (which represent over 40% of core inflation), it’s still only 1.8 percentage points below its recent peak in September 2022. And at 4.8%, it remains more than double the Fed’s 2.0% target.¹

The persistence of high core inflation speaks to the resilience of the U.S. economy and, relatedly, the aggressive fiscal policy the U.S. government has pursued in recent years. The Biden administration has engaged in one of the largest campaigns of economic stimulus in U.S. history, the impact of which has been compounded by the fact that it followed immediately after the Trump administration’s own record-breaking fiscal splurge. (See Figure 1.)

Figure 1: Recent U.S. Fiscal Spending Has Been Unprecedented by Postwar Standards

Source: U.S. Bureau of Economic Analysis, as of January 2023

The Biden administration’s first major spending legislation was the $1.9 trillion American Rescue Plan passed in early 2021. In combination with the stimulus released in 2020, the 2021 relief package helped Americans compile over $2 trillion in excess savings during the pandemic – a very different savings pattern from those recorded after recent recessions.² (See Figure 2.) This stockpile buoyed economic activity in 2021 and 2022 – and likely also bolstered inflation as supply chains struggled to meet demand. It's unclear exactly how much excess savings remains or how widely distributed it is among income groups. But a research report from the Federal Reserve Board of San Francisco estimates that roughly $500 billion was left as of March 2023, and the authors believe this amount could support economic growth through the end of 2023.³

Figure 2: Excess Savings Is Almost Exhausted, but May Support Growth Through Year-End

Source: Federal Reserve Bank of San Francisco

Importantly, the Biden administration’s spending plans have gone beyond short-term relief. In under three years, the administration has passed the $1 trillion Bipartisan Infrastructure Law; the $280 billion CHIPS and Science Act; and the Inflation Reduction Act, the country’s largest-ever investment in renewables and green infrastructure.⁴ The latter includes $370 billion in climate-related spending that, despite the legislation’s name, is likely to put upward pressure on inflation, at least in the near term.

While the dollar figures attached to the above legislation will be allocated over many years, the eye-popping amounts have already sent a clear message: The U.S. government is strongly committed to (a) boosting U.S. manufacturing; (b) subsidizing investment in the green energy transition; and (c) promoting policies that can help the U.S. gain or maintain an edge in new technologies.

The private sector has clearly taken note. Spending on U.S. manufacturing construction in 2023 has nearly doubled year-over-year, and the annual rate is roughly triple the average during the 2010s.⁵ (See Figure 3.) This spike in spending – which may be helping to partially offset the impact of rising interest rates – has likely been driven by the subsidies that the Inflation Reduction Act has provided for electric vehicles and other clean energy technologies. Finally, it’s notable that the messaging of the two major U.S. political parties suggests that – even though investment in green technologies might vary depending on who’s occupying the White House – the broad shift toward more interventionist economic policy and direct support for U.S. manufacturing and infrastructure will continue regardless.

Figure 3: Manufacturing Construction Spending Has Spiked Under the Biden Administration

Source: U.S. Census Bureau, as of May 31, 2023

Higher-for-Longer

What conclusions can investors draw from this tug-of-war? We believe it’s reasonable to assume that the economy will “muddle through” in the coming quarters, meaning it may slow but not enough to enable the Fed to engage in significant interest rate cuts.

Again, consider the complex economic picture. On the one hand, spending on durable goods has slowed, average hours worked have been trending downward since 2021 (despite a slight increase in June 2023), and consumers are dealing with the aftereffects of a sustained period of negative real wage growth,⁶ including rising credit card balances and declining savings.⁷ But on the other hand, spending on services is increasing, many employers appear reluctant to lay off workers, and both wage growth and retail sales have recently started to outpace inflation.⁸

As a result, we may see economic activity moderate and corporate earnings weaken in the near term, but not enough to warrant a substantial reduction in interest rates. Although inflation should decline as shelter prices slow over the coming months, returning to the Fed’s target may prove challenging. Base effects will be less helpful moving forward, and positive real wage growth could spur faster price increases.⁹ Indeed, history suggests that reaching this goal may require the economy to face positive real interest rates for a meaningful period of time. And even if inflation eventually returns to the target, that doesn’t mean interest rates will trend back toward zero.

Meanwhile, other forces may put upward pressure on interest rates. For one, there’s the need to finance high government spending. The Treasury has already issued more than $1 trillion of debt since June, due to the buildup caused by the debt ceiling standoff,¹⁰ and much more is expected to come before year-end. Moving forward, the combination of rising government borrowing and quantitative tightening may mean the upward push on interest rates will often exceed the downward pull, especially given the federal government’s shift toward onshoring and industrial policy. Globalization is believed to have played a major role in tamping down inflation – and, by extension, interest rates – in recent decades, so deglobalization could have the opposite effect.

Thus, recession or no recession, we think the probability of higher-for-longer interest rates is far greater than the likelihood of near-term cuts. Therefore, we believe leveraged finance markets are likely to experience higher default rates going forward even if the economy avoids a recession. Capital structures prevalent at companies today were put in place when interest rates were near zero and access to financing was taken for granted. As elevated interest rates make their way through the global financial system – which has racked up over $12 trillion in low-rated debt¹¹ – the asset bubbles created during the easy money era could deflate painfully, causing a rash of downgrades, distress, and, eventually, defaults.

In short, we believe we’ve shifted into a higher interest rate regime and that investment returns in the coming years will be closely correlated with the prudence investors displayed in the easy money era and the skill they exhibit when navigating the new one.

Credit Markets: Key Insights for 3Q2023

What trends, risks, or opportunities are Oaktree experts focused on today? Below are key insights that we believe investors should keep in mind when navigating today’s markets.

(1) Private equity-owned companies with unhedged floating-rate debt may face increasing stress

In the decade before 2022, many sponsor-backed companies financed leveraged buyouts by borrowing heavily in the broadly syndicated loan and private credit markets – and the majority of this debt had floating rates. Over the last year, reference rates for these loans have jumped by roughly 500 bps.¹² Therefore, these companies are now facing sharply higher borrowing costs, unless they hedged a substantial portion of their interest rate risk.

And most did not: Roughly two-thirds of the $1.4 trillion U.S. leveraged loan market was unhedged at the end of 2021, after which hedging costs skyrocketed. (See Figure 4.) Importantly, many of these borrowers put in place capital structures that may prove unsustainable in a higher-interest-rate environment. The average leveraged loan had a debt-to-EBITDA ratio of 6x at YE2021, and this calculation was often based on aggressive EBITDA adjustments, meaning true leverage was probably often greater.¹³

Thus, even if these highly leveraged borrowers don’t have near-term maturities, they may still breach covenants (if their loans had any) or, worse, run into liquidity issues as they seek to service spiking interest costs. As a result, borrowers may increasingly need to request concessions from their lenders or additional equity injections from their owners. This may further limit the capital available for new deals, benefiting those managers not facing legacy portfolio issues.

Figure 4: Most of the Leveraged Loan Market Was Unhedged Before the Interest Rate Spike

Source: Market size from Pitchbook LCD; percentage of hedged loans based on Oaktree estimate; both as of June 30, 2023 

(2) Residential real estate is well positioned to weather the interest rate storm

While rising interest rates have negatively impacted the entire real estate market, we believe the U.S. residential market is well positioned to withstand the current downcycle. First, the supply/demand mismatch in the housing market will likely provide support for prices. The supply of housing has been limited since construction slowed following the Global Financial Crisis. (See Figure 5.) And the situation has been exacerbated by many homeowners’ unwillingness to sell and thereby relinquish their low mortgage rates: Over 85% of homeowners in the U.S. have a 30-year mortgage rate below 5%, while the average rate for new mortgages has risen to 6.8%.¹⁴

Meanwhile, demand for housing remains robust in many markets – so much so that homebuilders typically don’t need to carry large inventories of finished homes to attract homebuyers. Maintaining lean inventories has supported developers’ bottom lines, which has helped enable many homebuilders to buy down interest rates for borrowers (i.e., pay upfront fees to reduce the mortgage rate for all or part of the borrowing period). As a result, home prices, sales pace, and homebuilder profits have held up in many markets, even as the cost of a residential mortgage has more than doubled since the end of 2021.¹⁵

Additionally, we believe the residential real estate market has become more resilient in the last decade. This is partly because of regulations enacted in the aftermath of the GFC, such as the Dodd-Frank Act, and the declining popularity of financial products that proved problematic during that crisis, like short-reset adjustable-rate mortgages. Moreover, current owners have record-high levels of home equity, and those who took on mortgages in the last decade were subject to much tighter credit standards than those who borrowed before 2007.¹⁶

Finally, government policymakers – perhaps remembering the economic scarring caused by the GFC – showed a willingness to support homeowners during the pandemic, including with forbearance programs and foreclosure moratoria. They may seek to do so again if they grow concerned about weakness in the housing market. As a result, we believe residential real estate investors capable of identifying bargains today may be well positioned moving forward, even if interest rates remain elevated.

Figure 5: Tight Housing Supply Could Support Residential Real Estate Prices

Source: John Burns Research and Consulting, Federal Reserve, Census Bureau; as of 1Q2023

(3) CLO equity investors today should focus on total return potential and track records, not just arbitrage

Media coverage of the CLO market in recent months has increasingly highlighted the shrinking CLO arbitrage and the supposed negative implications for CLO investors. But this conclusion is based on an outdated understanding of the +$1 trillion CLO market and misses the larger story: the unprecedented increase in total return potential and improved optionality CLO equity investors are seeing today.

CLO arbitrage refers to the difference between a CLO’s financing costs and the income generated by its underlying loan portfolio. In the past, CLO managers typically purchased leveraged loans at or above par, so the potential profit for holders of CLO equity (the unrated notes subordinate to all other CLO debt) was based almost entirely on this arbitrage. However, today, the loan market is trading at a discount to par, providing CLO equity investors with an additional avenue for profit, as managers can buy discounted loans that should appreciate toward par as they near maturity, unless they suffer losses from defaults.

Moreover, two options that most CLO equity investors receive have become much more valuable in an environment where loan prices are low and interest rates are elevated. First, after a two-year no-call period, CLO equity holders can exercise their option to liquidate the loan portfolio to capitalize on price increases. Second, they have the option to lower the CLO’s cost of debt by refinancing. These options were obviously far less valuable when interest rates were near zero and the loans market was trading above par.

Of course, loans are trading at a discount partly because of rising concerns about credit risk. Many investment banks are predicting that defaults in the loan market will average 3-5% over the next two years with below-average recovery rates.¹⁷ But CLOs are structured with the expectation that the loan market will weaken during the CLO’s lifetime: That’s why CLOs don’t have mark-to-market provisions and do have deleveraging mechanisms that kick in if the performance of the underlying portfolios deteriorates. Additionally, default forecasts for the entire loan market shouldn’t be confused with the likelihood of defaults and losses in specific managers’ portfolios.

In short, we believe today’s market environment is creating a rare total return opportunity for CLO equity investors, but we also think the key to taking advantage is identifying CLO managers with extensive credit expertise and the ability to navigate a complex environment.

(4) Markets may begin to price in refinancing risk among high yield bonds sooner than many investors are expecting

As we’ve noted multiple times in the last year, we don’t expect the high yield bond default rate to spike dramatically in the near term, as maturities in this market don’t start to increase meaningfully until roughly 2027 because of the wave of refinancings that occurred in 2020-21. But it’s important to remember that a responsible company needing to refinance in 2027 will do so in 2025 or 2026, and the market is forward-looking, so it may begin to price in concerns about rollover risk as early as 2024.

When companies do seek to refinance, they’re obviously likely to face much higher borrowing costs. The average high yield bond coupon is currently around 6.0%, with a yield close to 8.5% at current prices – and we see little reason to believe the interest rate environment is going to change significantly in the near term.¹⁸ While companies that borrowed intelligently and used the money to improve their fundamentals may have little trouble refinancing, those that gorged themselves on cheap debt may find themselves in a challenging position if interest rates remain elevated. And investors may also find themselves in a tough spot if they fail to recognize that – in market terms – 2027 isn’t that far away.