In Real Time
In Real Time
Credit Dislocation: What inning are we in and how much opportunity remains?
In Episode 6 of In Real Time, we speak with Ray Costa, Managing Director, Corporate Credit at BSP. Ray discusses where we believe we are with the current dislocation and if opportunity still remains for investors.
Key topics covered:
- Current market dislocation in comparison to previous periods of tumult
- Has the investment opportunity passed us by?
- Mechanics of deal sourcing in a special situations practice
- Are certain sectors preferred for BSP?
Views expressed are those of BSP. Past performance is not necessarily indicative of future results. All investments involve risks, including possible loss of principal. There can be no assurance that an investment will be able to implement its investment strategy and achieve its investment objectives.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
Hello, and thank you for joining us today. August 31st, 2020, for this edition of in real time, our short series of podcasts. My name is Chris Broadhead. I'm a managing director at benefits, free partners or BSP. We understand that many of you are still joining us from home today, as we continue to navigate the COVID-19 pandemic together. And we hope that you and your families and friends are safe and healthy for those that may not be as familiar with BSP. Here's a brief primer established in 2008. Benefits treat partners is a leading New York city based alternative asset management firm with more than 230 employees that collectively serve as a large part of the alternative investment arm of Franklin Templeton. Our guest today is Ray Costa. VSPs managing director of corporate credit and head of the special situations practice. Thanks for being with us today. Right? Thanks for having me, Chris and Ray, for purposes of this short flash podcast, I'm going to do my best to limit the amount of questions which will help us keep this recording to less than 10 minutes. Today's topic is dislocation in the marketplace, which is where you spend every waking work hour, given your tenure and experience through numerous periods of dislocation. I was wondering what similarities and differences you see between this current period compared with 2001, 2008, 2011, and other periods of dislocation you've seen throughout your career.
Speaker 2:Uh, really the major difference that I see in today's environment than those other four cycles that you mentioned is they're all macro in nature, but the Oh one Oh eight, 11 and 16 cycles, they all had various different catalysts, but they all created a tightening of financial conditions, which had an economic effect. And the ability to reverse the tightening of financial conditions had an immediate impact on the, uh, on the economic environment and the investing environment. So there was a level of control that, uh, the, you know, either other market participants or in the Oh eight, 11 and 16 examples, government entities in central banks could have direct control on reversing the negative outcomes and the negative feedback loop that was feeding its way through the market. We've seen recently a similar situation where you've seen significant intervention and significant, you know, central bank, government intervention or reserve markets. But in this case, COVID is different because COVID has a bottom line impact that cannot be effected by increasing liquidity, into markets and loosening financial conditions that is not going to make somebody go to a restaurant that is not going to make somebody go to a movie theater or get on an airplane. Those things are outside of a governmental and financial liquidity type controls. And that is where COVID is different. And if COVID has a more lasting impact on the economy, I think that that we're going to see, you know, higher prolonged default rates than we had in those other cycles and potentially a greater impact on maybe not as big a part of the credit markets, but on the part of the credit markets that are impact a greater impact and a longer impact than we've seen in those other cycles.
Speaker 1:Great. Thanks Ray Ray, with so much noise in the political and investment marketplace, what do you use as your sources of truth to keep your compass AMED true North?
Speaker 2:Well, we always start with facts now in any situation, there is, there are facts that are provable and undeniable, and then there are things that you theorize, and then there were variables that are outside of your control. So when we are analyzing an investment, we're always going to start with the facts about the business itself, what is going on inside the company and where does it source its materials from what is its process to produce, to produce its product and who are its customers and how are they affected? And you can come up with a baseline of your investment thesis in and around that. Then there are things that you're going to have to theorize about as it relates to, uh, you know, what are the variables that are gonna impact those kind of three, you know, the basic tenants of building the building blocks of a business, how do you source and make your material? How do you sell it? What are the variables? And we're going to analyze that the political environment and the rules that we operate in are all things that we can't come up with. Factual. We have, we have a factual set of baselines of what they are today, but we cannot project how they're going to change over time. We could only price them in as risks. So one of the nice parts that I like about being in financial markets is there are a lot of facts while you're always dealing with variables and uncertainties. And the political environment is certainly one of them. Uh, we tend to try and make our investments on things where we can have the great majority of a decision based on things that we believe to be factual.
Speaker 1:Equities are inching to all time highs, maybe sprinting all time highs and with spread recovering from the market shock in the spring. A lot of investors are wondering if they missed out on the opportunity. And how would you respond to that question?
Speaker 2:I think if you're looking to make your returns based on pure beta, then in that case, you will have missed the opportunity. You know, the overall credit conditions in the market are very favorable right now. And for companies that are not as impacted directly by the impacts of COVID for, or the economic impacts of COVID, that the ability to purchase those securities, that meaningful deep discounts is probably come and gone. And that's true from a high level. But as I said before, in your first question, there's large parts of the service economy that I believe will be dealing with the consequences of COVID for the months and maybe years to come. And we are really only five months into these crises. And, uh, many of those businesses have the toolkit to be able to weather short term storms, many businesses do, but many don't. And it is our belief that over the next, you know, six to 18 months, they're going to be many businesses that are going to struggle operating in an economy that's operating far less than a hundred percent capacity utilization, certainly industries that are, there are more industries that are more impacted than others, and those will struggle the most. And there are industries like big tech that are big winners. So when you think about the overall market, yeah, the fangs are gigantic winners fundamentally. So the rally in their stocks make sense. However, in my mind, I think some of the securities in the debt markets, particularly those ones that are related to companies that are directly their revenue line is directly in the line of fire from the social implications of the COVID writers. I think today they will be vulnerable and there will be many vulnerabilities that will show themselves in the next six to 18 months. So from a phenom mental ground up, will there be a high default rate? I think there will be. And I think there's going to be a lot of opportunities in special situations and dislocations. And I think that we can live in a world where we have an SNP that's near the all time high. We can have investment grade spreads that are near the old time tights. We can have double digit unemployment and near double digit default rates. I think we could be in a world where all four of those things could coexist. So I do not think overall the opportunity has passed, except if you were looking just for the big beta trade where the entire credit market collapses and recovers. All right. So living in a world where all those things are simultaneously true, let's, let's talk about the best way for you and your team to spend your time. How does deal sourcing differ for the special situations group at VSP compared with VSP typical private debt practice? Well, it's a different business model. Do remember a private debt businesses, a banking like business, where you're outsourcing the ability to provide new capital to companies, whereas a special situations business you're primarily purchasing existing debt at a discount that's already been placed into the market and then potentially providing new capital to help those companies. But you've already invested in discounts and credits. So our process is different. We're not outreaching to companies trying to figure out where to provide new credit, where screening through and looking through all of the markets, the private debt markets, the CLO markets, the bond markets. And we're looking to find where there is credit that is priced at a discount. And then we are trying to leverage our already existing knowledge base at benefit street that we've built up through our par lending and banking, like businesses to find intriguing opportunities to, you know, capture that discount. Uh, maybe the best way to put that, whether it be through, you know, making investments that we believe will be credit or making investments where we may believe that we may have to turn our credit at the equity stakes. We believe that those securities are priced at a meaningful discount to their intrinsic value. So it's a very different business model. And ours is one where, you know, we leverage and we think about our banking and pour businesses is very foundational in terms of providing us the library, uh, and the screening tools to be able to identify those opportunities. Okay.
Speaker 1:Enough of that last question, we're about six months into the pandemic here, which sectors are showing you the best opportunities given your practice, and which do you see as just too risky to lend it to
Speaker 2:Into, at this point in time? You know, one of the things that we did at the very beginning of the pandemic at benefits rate is we, we put every industry into a category bucket. We created three buckets and basically broke them into industries that are relatively not impacted by COVID or if they are, it's more shorter term in nature. Those being like healthcare and telecom, Tel technology and parts of the food chain in the second category was more things that were impacted by the economic fallout from COVID in those industrial businesses, your cyclicals, your consumer businesses. And then the third bucket are companies in industries that are directly impacted by the social changes relative to COVID airlines, rental cars, restaurants, hotels, casinos, you know, and what have you. So we start there. So if you want to answer that question, certainly your category threes are the most opportunity. And the most return, if you have a belief that COVID in society and medicine will create a solution to this, it's a matter of when you know, industries, like I said, hotels, gaming, uh, casinos restaurants, airlines, rental cars are all places where there's lots of opportunity right now, there is still opportunity in that category to space, where are industrial businesses that maybe supply the aerospace sector, supply the automotive spectrum supply into, you know, service like businesses that are our top lines of being affected. So the customer's being affected. They're feeling that on a second order. So there's a lot of opportunity there there's less opportunity right now in that category one bucket. Whereas if those businesses, from a fundamental perspective, aren't be impacted by COVID, uh, they are, you know, they're trading just fine right now. So from that perspective, I would say, you know, it's, it's the category threes is where the most opportunity is right now. And there's still lots of discounts that paper, there's still a fair amount of category, two kind of industry and more industrial type of opportunities where it's affected by the economy, but not directly by the COVID virus. And from a risk perspective to places we've been shying away from our industries that have been already in trouble prior to COVID and that's energy and retail. And the reasons that we shy away from them are that they already had so many challenges prior to COVID COVID just has accelerated what was already a very problematic investing environment and those two sectors.
Speaker 1:Right. Well, thank you so much for your time today, Ray. I think we kept it to close to 10 minutes and thank you all for joining us today. Be safe and be well and stay tuned for our next edition of in real time.
Speaker 2:Thank you for your time. I appreciate the opportunity. Thanks, right.