3 ways to keep it simple (and earn solid returns)

For many asset classes, rapidly rising interest rates made investing far more difficult. Picking out quality stocks, for instance, takes time, requires analysis, and commands a premium away from other opportunities. 

In the bond market, government bonds should have been a shield against falling equities - instead, long-duration bond yields (in particular), shot up and caused most conventional portfolios to struggle throughout 2022 and parts of 2023. 

One part of the investment universe that was spared was the global credit market. KKR's head of global macro called it in their 2023 outlook and re-emphasised it in its most recent mid-year outlook.

"The massive increase we have seen in short-term interest rates in many instances has created attractive total return opportunities across several parts of the global capital markets without having to stretch on leverage, volatility, and/or risk," McVey and his colleagues wrote. 

Their approach then, as it is today, is to "keep it simple".

But how can you create and maintain a 'simple' allocation to credit even as the world moves to a "higher for longer" interest rate regime?

KKR's Jeremiah Lane will tell us how in this episode of The Pitch.

Lee: How do you create and maintain a simple credit allocation?

Lane: When we talk about "keep it simple", what we mean is that you don't have to work as hard in today's credit environment to generate a great total return for investors, as you did in the era of zero interest rate policy.

If you could invest in a diversified portfolio of loans and bonds of pretty high quality and get around a 9% total return in USD, and that's pretty attractive.

If you look at long-term averages of what an index of loans and bonds have delivered, for most of the last decade they were delivering a little bit north of 4%. And so there's dramatically more return available with just vanilla investing in these asset classes - you don't need to originate your own loan. You don't need to try to do distress for control and take a company through bankruptcy. You don't need to sacrifice liquidity.

There are easy ways to make good returns in this market.

Lee: Talk me through the three main areas where you are finding simple value in today’s market?

Lane: The first is just including in the portfolio portfolio, a diversified set of pretty high quality loans and bonds.

We think of this as providing ballast. A lot of what we do in this portfolio is to take concentrated, high conviction positions and credits and add in a more diversified portfolio of names that we are really confident in. It means that, if we're wrong on the margin, if the economy is a little bit more difficult than we expect it to be, then we have some really good companies that we think will continue to perform well and continue to pay us a lot of interest.

The second area is that we've been investing in CLO tranches. Specifically, we've been really interested in the BBB part of the CLO spectrum. The BBBs can withstand approximately 25% cumulative defaults on the underlying portfolio before you lose any principal in the instrument that we're investing in, and that assumes a 50% loss given default, which is significantly worse than the historical experience. 

So we see that as a very risk remote asset. You can have a default wave that exceeds what was experienced in the financial crisis and you're still not going to lose any money. We think you can do substantially better than that if you're really actively paying attention to what's going on in these names and you're actively managing them.

And then the third area would really be short duration. Short duration is one of our favourite themes in the credit market. We've been doing that in our GCOF strategy since inception. This is a focus on 2024, 2025, and maybe early 2026 maturities. You have a unique moment, especially as a fully levered company approaches its maturity, where as a lender, you can approach them and negotiate what an extension would look like.

Maybe we'd like better documentation, maybe we would offer to extend with a substantial increase in the spread that we're earning, maybe the company will pay us a number of points up front as a fee.

That's a great way for us to add a little bit of outperformance into our portfolio.

Lee: We’ve spoken about a “higher for longer” rate environment which is your base case for the US. How does that affect asset allocation or asset picking?

Lane: What we're thinking about when we talk about "higher for longer" is that we are very sceptical of the market's view, which you can observe through the implied rate paths that are observable in the market.

We're very sceptical that the Fed is going to quickly pivot to a lot of rate cuts. I think currently, the market calling for four rate cuts this year and that's already down a bunch from a few weeks ago when it was calling for six rate cuts. We think it's fewer still. I think our house view is three cuts.

That makes us sceptical that bonds are going to rally a lot. The only other way that bonds could rally a lot is if there was a lot of spread compression. We don't see the case for significant spread compression.

So it really goes into our thinking around the relative value between loans and bonds and the total return that we might earn between them and it's probably what, at the asset class level, puts us more in favour of loans today.

Lee: What market conditions would it take for KKR to become more complex again?

Lane: One of the things that we're really proud of with this strategy at this point is that we've been running it for over 15 years. So this is a strategy that we started with a separate account in 2008. We have a global co-mingled fund, and then, we offer it in a couple of flavours in Australia.

I think the moments in time where we had to work harder were certainly the moments, some of the moments of zero interest rate policy, where there was so much suppression in the amount of rate and spread that was available in the market that to deliver a decent total return to the investor, you need to consider finding an off the run deal where you could earn a little bit of excess spread. You needed to enter into a club deal where maybe you wouldn't have quite as much liquidity.

I think if those characteristics came back into the market, we'd have to think about going back into pulling some of those alternative levers in order to deliver return to to investors. I just think it's very unlikely.

I think that zero interest rate policy hasn't been a big success in the eyes of the Fed. And it's unlikely that they're going to rapidly re-embrace it.

To learn more about the KKR Global Credit Opportunities Fund (AUD) ("GCOF (AUD)"), click the link here. You can also find out more about KKR CREDIT INCOME FUND (ASX: KKC) here.