A Deep Dive into Credit Investing with Joe Hegener

[00:00:00] Welcome to excess returns where we focus on what works over the long term in the markets.

[00:00:05] Join us as we talk about the strategies and tactics that can help you become a better

[00:00:09] long-term investor. Justin Carboneau and Jack Forehand are principles at validity capital

[00:00:13] management. The opinions expressed in this podcast do not necessarily reflect the opinions

[00:00:16] of Lydia Capital. No information on this podcast should be construed as investment advice.

[00:00:21] Securities discussed in the podcast may be holdings of clients of Lydia Capital.

[00:00:24] Hey guys, this is Justin. In this episode of investment strategies, and then kind of talk through also some of the unique stuff you're doing at the strategy level and kind of where this might sit into an investor's overall investment allocation.

[00:01:41] So that's going to be the full spectrum of securities across the capital stack and kind of comparing the pricing on maybe on a relative basis. Is the second lien note very inexpensive relative to the unsecured debt or the equity even? Or maybe is it just the most robust risk return profile to take a look at the first lien senior

[00:03:03] secured bond in this stage of where we are available, which I guess we could talk about later, but there's some interesting

[00:04:21] arbitrage relative value opportunities within the fixed income universe in the securities that are of homework on the trade-offs between active and passive and structurally what that's doing to the marketplace. And so if you have a passive equity index, there's smart arguments to be made on both sides if that's a good or a bad thing for the market. However, it does absolutely, every dollar that's taken out of active and deployed into passive for an equity index, you're kind of disproportionately plowing those dollars into

[00:05:46] the top market cap weighted names. high yield vehicles, in my opinion, is kind of disproportionately bidding on, or providing a permanent bid rather for the most heavily indebted issuers that are in the universe. Because these passive indices are, it's kind of a misnomer, but I think it gets the point across similar to an

[00:07:00] equity benchmark. It's kind of market cap weighted, taking the edge off a little bit and then trying to be net long the names that we actually do like on a, from a balance sheet and a fundamental standpoint. Jack, will you have to maybe take that idea and create a short ETS that goes short those

[00:08:24] names and see if we can productize? And the equity in that situation is more often not going to zero. It's just a matter of when that takes place effectively. So it's kind of twofold in that hedging component, I suppose. You had mentioned a couple of those core categories like investment grade, high yield, and then you have distressed debt. But can you just kind of talk to those broadly and what types of credit would be on each

[00:09:47] one?

[00:09:48] Yeah, yeah, absolutely. I mean, it's just impossible to take a very minute, very detailed view of every single issuance that's out there and have a true kind of fundamental rating for that. So it's kind of at a high level they're saying, all right, what's the debt to equity? What's the leverage ratio?

[00:11:00] Are there earnings going up or down?

[00:11:03] Very high level checks.

[00:11:04] And as long as they pass all the checks, then you'll get a rating for that bond. compensated by taking the risk here or is it the other way around? I would argue that those top names within HYG, like DISH Networks, for example, it's like an eight or a 9% yield on those bonds. I don't think that's an adequate level of compensation for the risk that the potential restructuring that I think inevitably will take place.

[00:12:20] However, if you kind of zoom out and you look at some of these other high yield issuances these rules. And there isn't really any discretion that's taking place with regards to maybe I shouldn't own that Carvanha Bond or maybe I shouldn't own that Dish Bond. Preston Pyshka It's interesting because what you're talking about plays, we've had Mike Green on the podcast and it plays in a lot into what he's talked about with the equity market, you know, these forced flows that are going into certain things and they create distortions. It's interesting to see that it happens in the bond market as well.

[00:13:41] Mike Green Absolutely. Yeah. And the equity market, you know, we might look at the PE ratio, we might look at earnings growth, and we have an opinion sort of on what the overall market looks like. I mean, do you have similar stuff you look at in the credit market to say like what I think of the overall credit market relative to history? Sure. Yeah. So I mean, overall, you know, and the

[00:16:05] a little bit of runway left and they're holding out kind of waiting for a more ideal opportunity to refinance their debt.

[00:16:07] So maybe they get that opportunity, maybe it's a higher for longer type situation.

[00:16:12] But in my opinion, we are nowhere near And so I think one of the things that I personally underestimated going into this year was how powerful it is and how long of a runway was created during that period of time, that period of excess, frankly. And so

[00:17:41] I do think the lag effect is going to be longer in this tightening cycle than in prior tightening The average cost of that debt is 2.6 percent. So when they roll that maturity into the new rate environment, right? Whether it be, you know, treasuries plus, you know, 300, call it, that will be a really big burden on balance sheets that's gonna eat into earnings and free cashflow profile. And the sustainability of the business model and balance sheet itself will be called into question

[00:20:20] for a lot of issuers.

[00:20:22] You got into the question I wanted to ask next,

[00:20:23] which is this whole idea of, you know,

[00:20:25] we probably could have a segment of the podcast

[00:20:26] called Should Jack Be Panicked?

[00:20:28] And what you've been- lending funds and there's so much cash sitting on the sidelines right now. We have kind of positioning for the doomsday scenario where all of a sudden there's all these great loans and credit opportunities out there that are super inexpensive. That typically, when hundreds of billions of dollars are being raised and sitting in

[00:21:41] dry powder, being ready, kind of waiting in the wings, right? I mean, that's kind of how we're positioned, frankly, is we wanna be short the names that are kind of asymmetric to the downside and long the names that are asymmetric to the upside and hopefully have kind of a net neutral approach to taking on market beta.

[00:23:00] Because, you know, honestly, I wouldn't be surprised

[00:23:03] if the S&P 500 rallied for the next three to four months that were hiring us, what do we do effectively? We didn't make 7% and last year we made one and a half or something along those lines. And so that barbelled approach was still kind of optimal in those 10 years ago, call it. But now we're actually getting paid quite handsomely to be in

[00:24:22] cash, to be on one side of this barbell. environment. We pride ourselves on digging deep into your LinkedIn and stuff when we have people on. And I saw this quote that I thought was really cool on your LinkedIn from a while back. And it was, you said, "'The importance of bifurcating between the cyclical and the secular horizon is a staple in macro analysis.'"

[00:25:42] And I'm just wondering if you could talk about that

[00:25:43] and then we'll talk about macro a little bit more.

[00:25:44] Yeah, for sure.

[00:25:45] So that's much more,

[00:28:05] There was a lot of uncertainty with regards to lockdowns and what oil energy demand would look like.

[00:28:06] But we knew that if you shut down a rig, it takes 12 to 18 months to start that back up

[00:28:12] again.

[00:28:13] It's not like a light switch.

[00:28:14] You can't just turn that on and all of a sudden it starts producing.

[00:28:19] And so after they shut down pretty much every our process. And I think you're starting to get into that. The first step really is the macro analysis, kind of zooming out and what sectors look really interesting right now. a lot of investment strategies that are successful, but they're very negatively convex. And what I mean by short Caesar's palace, right? We own them as hedges in the portfolio and they have a specific role to play. And at the time we bought them, they were 10% out of the money because that's kind of

[00:32:22] the nice, positively convex kind of c And so, that's, I guess, a small example, but it's effectively what we're trying to do. Going back to the macroeconomic stuff, how much do you care about like going the level above the sectors? How much do you care about, we're on Twitter all the time, I don't know

[00:33:41] if you are, but right now you've got your hire for longer guys, you got your recession guys,

[00:33:44] there's all kinds of debate going on. How much does that matter to you in constructing your And defining the scenarios is a pretty integral component of our process. There's the concept called expected value, where you're effectively assigning probabilistic weights to various scenarios. So a very simple example is just say like a binary outcome.

[00:35:03] Either rates go up 100 basis points or down 100 basis points. or the S&P is down 15% in a month, or maybe it's up 15% in a month. The difficult part, where it becomes more of an art than a science is applying the probabilistic weights to each of these scenarios. And that's kind of anybody's guess.

[00:36:21] And that's what we spend the most time

[00:36:22] trying to think about macroeconomically.

[00:36:25] I'm personally in their eyes that I do think you're going to kind of err on that side of caution. And that to me was the most worrying thing as we talked about before, all these refinancings

[00:37:44] that are coming due in the next 18 months. and what it's going to do to the earnings profile of some of these businesses. I mean, we're talking about the potential for the entirety of free cashflow generation to be allocated to debt service, you know, to debt interest services effectively. And you know, what does that do to price earnings, right?

[00:39:01] If there are, if there are, if there's no free cashflow and all that.

[00:39:05] So I do think we're in for a rude awakening over the next 12 months. I mean, the fiscal deficit, the fiscal spending situation is really concerning, honestly. I mean, right? It's just that Stan Druckenmiller has been kind of shouting from the mountaintop for the last year or so, but his estimation, I think it was something like 30% or something

[00:40:20] like that of US GDP is going to have to be allocated to just servicing our debt in not that were just that short, the long end of the curve. So I do think, you know, back to that, like cyclical, secular, you know, analogy that maybe cyclically, the long end is probably a buy, in my opinion, at the same time over a longer period of time, especially if we start

[00:41:40] to get some more kind of public chatter about the sustainability of our debt. You know, in order and to actually generate tax revenue and collect it, which hardly anybody pays taxes in certain countries. And it never took place. That reform never happened. Arguably, those countries' fiscal balance sheets are worse now than they were in 2012 and 2013.

[00:43:03] And for the first time in a very long time, you know, with regards to those peripheral countries. And it also provides us some air cover to start to tiptoe in and extend duration and on the US side of things and start to get long. Just two more for me before I hand it back to Justin. I would ask about the stuff you talked about with your process earlier. You know, having a quantitative and a fundamental process,

[00:44:21] you know, two parts of it,

[00:44:22] maybe think a lot about what we deal with

[00:44:24] on the equity side, because we're quantitative investors,

[00:44:26] but there's a lot of debate value and scenario analysis, that quantitative component of the underwriting process is really, really important for us to... How do we rigorously define what the worst case scenario of this trade looks like? And how can we structure a investment thesis into that Aladdin system and run a risk on what the portfolio looked like. And these risk officers would go to the group and say, all right, well, what's my risk? And we'd kind of laugh and say, well, what do you want it to be? Because it totally depends on what the assumptions you're making are, right?

[00:47:02] I mean, are you using a correlation matrix when you look at a company and you're evaluating its debt, like you mentioned Verizon, we could use that as an example, if you're evaluating Verizon relative to the way I'm evaluating or Verizon as an equity manager, if I want to dig in there and figure out why I should invest, what are sort of the important differences in terms of the things you're looking at on a balance sheet or the types of things you're looking at

[00:48:22] that maybe an equity investor wouldn't be looking at? and down to effectively size themselves appropriately relative to their new revenue footprint or their new revenue structure, right? So there were a lot of businesses that experienced gangbuster years in 2021 and early 2022, especially retail, because of all the stimulus and everything like that, where their

[00:49:41] revenue was through the roof and they had this huge my goodness, top line's down 20%, negative free cashflow for the quarter. And that might look really dire and it might create a big sell off. And then that would give us an opportunity to go in there and say, hey, wait a second. Management has already said that they're addressing problems X, Y, and Z,

[00:51:01] and they just need a couple of quarters

[00:51:04] to readjust their expense side of the balance sheet,

[00:51:07] or excuse me, the income statement. anything to avoid a restructuring because that would wipe out the equity. And so they, they will throw good money after bad all day long, trying to get, you know, trying to turn the ship around, so to speak, when what would be the best thing for the business is to just to restructure right then and there. But that might not happen for a long time. And they might run the business into the ground and the other way around, um, you know, who owns,

[00:52:25] who owns the debt, you know, they're, especially in a distressed business.

[00:53:22] on the debt itself, right? Is it a cut, you know, a lot of debt was issued,

[00:53:24] what we'd call cove light,

[00:53:25] where it gives the company, the debtor,

[00:53:29] a lot of flexibility with regards to what they can do

[00:53:32] with their underlying business and the assets.

[00:53:34] And so there are a handful of bonds that are out there

[00:53:38] that technically are first lean secured bonds,

[00:53:42] secured by the assets of the business.

[00:53:45] And yet you've got the management team

[00:53:47] stripping assets out of the beautiful things about ETFs is you can actually look inside an ETF on any given day and see what the fund is holding. I was just looking at the ETF that you're sub advising for Simplify and it really is a unique set of different holdings in there.

[00:55:03] You know, you have the corporate bonds, you have some country debt exposure in there, so much using Chatsgpt for the workflow. Although we're certainly leveraging it as a business. It's been really helpful from an account management standpoint and also a content creation standpoint. At some point, I definitely expect to see a lot more kind of AI focused

[00:56:25] integration within the processes that we're leveraging now. time, the productivity of wells, they're looking at how full are the Walmart parking lots, how full are these highways and how many trucks at any given period of time are of processes. But inevitably, technology is gonna make its way, I believe, and kind of replace all of us. But, you know, hopefully I still have a job

[00:59:02] in, you know, five, 10 years.

[00:59:03] Well, hopefully they'll still need someone to sit there

[00:59:06] and articulate the strategy

[00:59:07] and talk to other humans about it. if it's kind of a scary or an emotional catalyst. And, you know, if, you know, as an individual investor or as a manager, if we've spent a lot of time and thought constructing a mousetrap or a strategy in a particular way, then ideally that strategy holds up

[01:01:25] play itself out. A lot of people try to get cute. You know, something will happen. They'll say, oh, and they'll go in there and start day trading or, or they're, you know,

[01:01:28] they'll, they'll pull the ripcord and sell out completely. And with the benefit of hindsight,

[01:01:33] that's usually a mistake. I'd say just, you know, stick to your guns, stay the course,

[01:01:37] you know, try to be thoughtful about the approach.

[01:01:40] Well, that's a sound piece of, uh, invites for sure. We agree with that. Um, if people