Why a recession is not priced into credit markets (and why it's not a bad thing)

I think that given the strength that we still see in the economy, given our assessment of the earnings reports that are coming out of companies that we're invested in, we see slowing. We don't see so much slowing that it's creating big problems for companies and some of the slowing, I'd say frankly, we see as healthy. 

We see some businesses that have struggled with labour availability, with supply chain consistency, product availability, et cetera. We see some of those problems getting alleviated by the fact that we've got some slowing in the market and business can go back to normal from how it was disrupted during COVID.

One of the reasons I think that's happening, and I'll give you an example of a sector, is what we're seeing in the healthcare sector. So, in healthcare, historically healthcare has been a recession resilient sector, people need healthcare services regardless of what's happening in the economy. When you look at healthcare in 2022, it was a really difficult sector. Healthcare businesses, because of the way healthcare is paid for in the US it's a complicated payer mix. You have some government pay payments, you have some insurance company payments, you have some self-pay. 

Typically, prices for all of those healthcare services are set at the beginning of the year, and then they are just constant over the course of the year. The government doesn't let you change the price that it's willing to pay in the middle of the year. In turn, healthcare services are relatively people intensive to deliver. And so, what the healthcare services business struggled with is that they were had consistent pricing over the course of the year, but they had huge wage inflation for what they were having to turn around and pay doctors and nurses.

As we roll into this year, there's actually been a lot more labour supply in nursing than we've seen since the pandemic really started, and that's starting to take some of that wage pressure out of the system. We see that business, which had a very difficult 2022 going back to it's healthier long-term structure. 

That's an example of how we think that some of the cooling of the economy and some of the cooling of inflation can actually be a real positive for the businesses that we're tracking. 

LW: Does the soaring cost of financing bother you?

Lane: It doesn't bother me per se. I think that it really goes back to what I was saying about the inflation impact is that it does put some onus on our analyst to really understand whether or not the businesses were invested in are appropriately set up to deal with a substantially higher cost of funds.

So, going back to the middle of last year, we asked the analysts to go through and survey our largest 75 investments across our leverage credit platform and look at how hedged they were.

• Did they have substantial amounts of floating rate debt? 
• Had they put in place interest rate swaps to turn it into fixed rate debt? 
• Had they set up their capital structure to have a mix of floating rate debt and fixed rate debt? 

I would tell you that candidly, the results of that analysis was that a lot of companies had not really set themselves up to deal with elevating interest rates. However, fast-forward to today, one of the big trends that we're seeing right now is we're seeing companies refinance loans, which are 100% floating rate with a mix of loans and bonds, and so they're mixing more fixed rate debt into their capital structure.

It's also interesting that right now if you have a one-month floating rate or a three-month floating rate loan, you're paying around 4.5% on the base rate. If you actually swap that into a three-year fixed, you can actually substantially reduce your cost of funds because the market is expecting the Fed to stop hiking and start cutting. 

We are seeing actually more companies layer on some hedges to take advantage of that reduction in cost of funds that they can get. So, I like that we can earn higher interest rates. It means that we can deliver a better total return to our investors. It does create a requirement that we appropriately diligence the cash flows, the businesses we're invested in to make sure that they can handle where interest rates are moving to.