The asset class with more upside than equities in FY23

After a good 13-year bull run for global equities markets, the party has stalled - even if only temporarily - as higher rates take a hit on the sky-high valuations. But one investor's trash is another's treasure. And there's one asset class that can outperform in this turbulent environment. 

That's according to KKR's Jeremiah Lane, who believes that credit markets, particularly high yield, have a bright year ahead. 

Why? The uncertainty, Lane argued, is already in the price.

"Credit has already widened really significantly and as a result a lot of that uncertainty, we believe, is priced in," he said. 

Even after the sell-off we have witnessed so far for equities, valuations still remain high considering all the question marks that remain, he said. After all, we are yet to witness the earnings recession that much of the market has predicted. And if that does indeed take place, the S&P 500 could still be trading on a relatively high PE of 19 times, Lane added. 

So is he buying or waiting for an even bigger capitulation for credit markets? In this Expert Insights interview, Lane discusses the opportunity set in credit spreads, the prices on those assets, and inflation's role in returns.

Note: This interview was recorded on the 15th of September. You can watch the video or read an edited transcript below. 

Edited Transcript

What is your outlook for global credit markets?

Jeremiah Lane: 

One of the things I think is really interesting in credit right now is that credit has already widened really significantly and as a result, a lot of that uncertainty, we believe, is priced in.

And so when we think about what the return has been, historically it's been 8.5% net. And for a long time, we've told investors we think we can return an 8-10% US-denominated return. And I think we would say we think we're at the high end of that right now in this environment. It's a result of the higher government rate, as a result of wider spreads, as a result of lower prices, and all of the sell-off that we've seen in the first eight months of the year.

I think the outlook for credit markets is uncertain right now. I think on the fundamental side, we have a very uneven macroeconomic environment. We see businesses that started to struggle in the fourth quarter of last year that are expected to perform really well looking into the fourth quarter of this year. And then we see businesses that are exposed to housing, in particular as an example, where they've been performing extremely well and looking forward, we expect them to be really weak. 

How much value are you seeing in credit versus equities?

We see a lot of value in credit and we see a lot of value in credit versus equities specifically. 

Equities have sold off, but if you look forward and I'm speaking about US equities, we expect there to be downward revisions in earnings estimates for this year and next year. And if those downward earnings revisions take place, we think there's a scenario where you end up at as high as a 19 times PE at today's prices, even after the selloff that we've already had. 

So we see that as a pretty full valuation going into what we expect to be a pretty uncertain environment and a potentially difficult macro environment. And so to us, equities certainly don't look cheap. They're not nearly as expensive as they were, but I think there are still some indications they're reasonably expensive.

When I compare that to where credit is, we see credit as cheap. And when we look at where the high yield market sits today versus a five-year historical average or a 10-year historical average, and I'm talking about on a spread basis, on a yield basis, on a price basis, over many of those time periods, we're in single digit percentile. 

So only a few percentage points of time have been wider on a spread basis, have offered more yield, and have been at a lower price. So a lot of the pain I think we expect to come has already been reflected in high yield. 

And I think from our seat, it's not as clear that it's been reflected in equities. One of the things we think is attractive for this fund is a replacement for some equity exposure because we feel like the environment is set up for us to be able to deliver our returns. And it's more suspect whether the equity market will be able to deliver returns as it has historically.

Have we seen the bottom yet in credit markets?

It's interesting. When I compare the recent selloff to prior selloffs, what we haven't seen yet is capitulation selling. When I go back to what we saw in COVID, we saw a moment, it only lasted a couple of weeks, but we saw a moment of true capitulation selling. 

If we go back to February 2016 when energy markets in the US were selling off a lot, we saw a few weeks of real capitulation selling in that time period. We have not seen that yet this time, and I do think there's a scenario where spreads go wider, and prices go lower. 

What I would also say is - historically, those moments of capitulation selling have been some of the most fruitful investing environments for us. We're not putting together a diversified portfolio where we're in everything in the market. We're putting together a concentrated portfolio of really high-conviction ideas, we're looking across the thousand-plus issuers in which we have investments. We're distilling it down to a small number of names where we have really high conviction and we want to make bets on. 

And so I do think there's a chance it goes wider. I do think if it goes wider and we get that moment of capitulation selling, I think that's going to be really good for us. We've been taking advantage of the opportunities the market has been giving us, but not in broad sector plays. We don't see a sector that has gotten decimated yet that we're really, really excited about investing into. But one of the strengths I think of this strategy is we can focus on some very idiosyncratic opportunities.

I'll give you a recent example. This is one of the names which became a top 10 position for us in the second quarter, it's a business called PSAV. They rent the audio-visual equipment used for in-person conferences. Needless to say, this is a COVID direct hit and it's a business that was firing on all cylinders pre-COVID and almost overnight just completely shut down.

Because it went through such a sustained period of weakness, the rating agencies significantly downgraded it. The opportunity we identified in the second quarter when we made it a top 10 position was that really, after several starts and stops on reopening (they started to reopen then Delta hit, they started to reopen then Omicron hit), finally, the business was firing on all cylinders. And in the second quarter, they actually had periods where they had comparable revenue and EBITDA to what they delivered in the second quarter of '19.

So it was finally getting fully back to the levels of profit that it had before, but it was still rated very poorly. And as a result, we've been able to buy a first lien piece of paper that matures in a little over two years. We were able to buy it in the low 90s, and we're getting a 7% cash-on-cash return just from the coupon that they're paying. 

We also have seven points of upside, which potentially we will receive only at maturity, but we think more likely is we receive a year or so prior to maturity. And if we're right, we think that's a low to mid-double-digit type total return. 

It's an opportunity that really exists because it's very poorly rated. And as a result, the buyer base is pretty small. It's had a really sustained period of disruption, but if you look at what it's actually doing now, it's doing well and it's an opportunity we're really excited about.

How is inflation eating into credit market returns?

So what we're seeing with inflation right now is a trailing 12-month number which is very high. But when you look at expectations for what's going to happen going forward, already to some degree, the price of oil has started to come down, already to some degree the price of food items has started to come down. 

There's a broad expectation that inflation will normalise at a substantially lower number than the reading we're getting right now. And the question in the market is whether it's going to normalise at a number low enough for the Fed to be satisfied.

So we see a high likelihood that we're going back into the 3-4% area. We see an uncertain likelihood that the Fed's moves are aggressive enough or are sufficient to go back to the 2% area they want to be in. 

When we think about the returns of the opportunities we're pursuing, we're measuring those against other opportunities we have in the market. So we look at a first lien term loan of a business that we really see as performing well and fully recovered from COVID, but it's offering us a low to mid-double-digit total return. We see that as attractive, especially versus other investments which are available in the market right now.

Learn more about investing in private credit