2 sectors facing headwinds as cash rates and inflation remain elevated

So from a fundamental standpoint, amidst rising rates, we've actually seen high-yield issuers be more resilient to the changes. Because it's a fixed rate market, we've obviously seen a lot of price volatility in the security prices that we're investing in - but we're seeing stronger company fundamentals supporting those capital structures. So, the cost of capital has gone up, but companies are able to finance themselves.

On the loan side, it's not a one-size-fits-all answer. But I think in general, the fundamentals are under more pressure in the loan book. Surprisingly, the leverage in our loan portfolio - despite it being at the top of the capital structure - is higher than the leverage in our unsecured bond portfolio. That's a little counterintuitive.

Because it's a market with floating rate exposure, we're seeing the changes in the cost of capital being felt much more. So, interest coverage is coming down pretty quickly in the loan book relative to high yield. In general, I would say we're more cautious on the fundamentals on the loan side of the equation and we're seeing investment opportunities created by that dislocation as well.

LW: Are you seeing an increase in deleveraging in the US? 

Richard Schoenfeld: We have seen companies that are having to bring more creative thinking to capital structures today. In general, with the changes in interest rate policy, we're seeing returns that historically flow to the equity part of the balance sheet transition to paying more interest expense to debt holders, which is great in our seat.

But along with that comes refinancing of challenging capital structures, which is getting more tricky. And so, we have seen issuers in general show a bias to bring down leverage. Oftentimes, in some of these refinancing solutions, sponsors or equity holders have to contribute new equity to get those deals done and to control the interest expense that they're paying on their balance sheet. I wouldn't say that's a theme that's showing up across the board, but certainly, that has been involved in many of the trickier situations out there.

LW: Are you seeing a rise in defaults? 

Richard Schoenfeld: So we have seen defaults tick up decently so far in 2023 year to date. I think one of the key metrics that we look at is the default rate is picking up faster for smaller issuers - the number of defaults is outpacing the dollar-weighted defaults. 

I think the other big trend that we've seen so far is that upon the event of a default, the recovery rate, the ultimate outcome that investors are seeing in those defaulted situations, has come down. I think on a go-forward basis, we're expecting that trend to continue. 

There are sectors that we expect to be disproportionately harder places to be. We're doing our best to avoid those sectors and those companies. But given the changes in the cost of capital and the volatility in financing markets, we're expecting defaults to continue to tick up.

LW: Is that because we are coming from a low base to begin with? 

Richard Schoenfeld: So I would say defaults are at a more typical level. They might've been a bit understated when you go back to the 2021 period, just because financing markets were very open to issuers. And so, there was an ability to kick the can down the road for companies that had shown sufficient strength to access the market. Companies could go to the loan market, the bond market, the convertible market, and the equity market. And so, there were a lot of ways to address any need for capital. 

That access to capital is getting more complicated today. So I think you have seen a step up in default rates so far from what was a fairly low level to begin with. But we had seen defaults, in particular, the energy sector in the early COVID recovery period was a sector that saw disproportionate defaults. That has been cleaned up in the 2020-2021 period. Energy has been a default-prone sector historically and we're seeing stronger performance amid higher energy prices, with many of the weakest balance sheets already having been dealt with.

LW: Which other sectors are you seeing cracks in today? 

Richard Schoenfeld: We are seeing cracks in two sectors - the first being healthcare. The number of issues in the market seems to grow by the day and week. Taking hospitals as an example, you've got nurse labour and doctor labour that's gone way up. The cost of medical devices and equipment has risen, but their regulatory constraints on what companies can or are not able to do in terms of passing that on to the end consumer. And so, healthcare has been a place of pretty real stress in the market.

The other sector that I would say we're watching very closely - thematically, we view this in the camp of a more secular decline-type of industry, but cable and telecom are segments with pretty levered balance sheets to begin with. You've seen more treading water in terms of top-line performance, but some impact from margins. And so, the combination of higher cost of capital, declining valuations, and a lack of growth has made those trickier places to invest.

Because many of the healthcare businesses are asset-light businesses, those situations where you go into default can be pretty painful from a maximising value process. I would say we could see some opportunity from a more positive lens in some of these cable/telco situations. And so, while I expect to continue to avoid many of the healthcare situations, I think we'll dip our toes in cable/telco at the right time.

Richard Schoenfeld 

LIT

KKR Credit Income Fund (KKC)

Global Fixed Income

View

Managed Fund

KKR Global Credit Opportunities (AUD) A

View