John McClain - Opportunities in Credit
Album art photo taken by Mike Ando.
Thank you to Mathew Passy for the podcast production. You can find Mathew at @MathewPassy on Twitter or at thepodcastconsultant.com
Please leave us a rating in your favorite app store!
[The Business Brew theme]
Bill: Ladies and gentlemen, welcome to The Business Brew. I am your host, Bill Brewster. This episode features John McClain. John serves as a portfolio manager for Brandywine Global's High Yield and Corporate Credit Strategies. He was kind enough to agree to be my first real credit guest. I hope that I have done him justice by asking good questions. Brandywine Global is very legit. Morningstar gives the High Yield Fund five stars. They assign above average ratings for process and people.
In the words of Morningstar, “The strategy is distinctive, value-oriented approach exploits price inefficiencies that often materialize across smaller high-yield issuers. It earns an above average process rating, comanagers Bill Zox and John McClain execute a disciplined value approach: They buy issues when their market prices are lower than the team's estimate of intrinsic business value and sell them when their initial thesis has played out or when there are better opportunities in the market."
I have gotten to know Bill and John a little bit. I think that they're both good people and I really appreciate them coming on. Again, I tried to frame some of the conversation so that people that are not totally familiar with credit would be able to follow along. I hope I did a good job. John's got an open invite whenever he wants it should you all want more detailed credit questions.
As always, none of this is financial advice. All of the information contained in this program is for entertainment purposes only. Please consult your financial advisor before making investment decisions and do your own due diligence. Enjoy the show.
All right, so, ladies and gentlemen, I'm thrilled to be joined by John McClain of Brandywine Global today. John, thank you for joining. I've been wanting to have a credit conversation for a while and fortunate to be introduced to you and I've enjoyed getting to know you over the process. So, thanks for joining today.
John: Thanks for having me. For the first time and forever fixed income isn't boring. So, hopefully, we'll keep your audience awake here.
Bill: Yeah. It's funny, we're coming through a period where I said to myself, I was like, "Well, let's see in fixed income, I get no yield and no covenant protection, so why would I want it?" It turns out, probably short duration Treasuries weren't a horrible bet. But now I'm looking around and I see actual yield and it looks like spreads are widening a little bit and I'm happy to have somebody that knows what they're talking about on the program to educate people.
John: Yeah, we would agree with you. Going into the end of 2021, high yield was yielding less than 4.5% and now you can get that in one year Treasury. So, we've certainly come a long way in less than a year's time. I believe that what we're seeing now is this regime change from global central banks acting like helicopter parents where they really had the training wheels on the marketplace. Anytime we would run into an issue, central banks would come in and clean up the mess. Now, we're in a position where globally we're fighting inflation, those training wheels are off and your kids going down a hill 100 miles an hour without a helmet on. And so, it's a very interesting time in the marketplace and to your point, now, we're seeing opportunity across asset classes, across geographies, and it's really getting the time to focus on just the best ideas because there are so many ideas in the market.
Bill: So, a lot of my listening base is equity focused I would surmise given what I tend to talk about. Can we just break down for equity folks just like very basic credit? You've got, obviously where the Treasuries trade, then you've got a spread to compensate you for credit risk, and then typically what you get more for taking duration, so longer dated bonds should yield a little bit more. Is that like a fair characterization just from a super, super high level of how to think about bonds in general?
John: Yeah. At the highest level, you have the risk-free rate, which is the government security. In most markets, you have a steepening curve. Meaning, as you go out in terms of lending, lending to government or a company for five years requires one rate of compensation versus 10 years. Typically, the longer that you lend, the more you want to compensate you for interest rate risk and for corporate risk. When we're thinking about the compensation that we need to be required for lending to a business, we start with the risk-free rate, the Treasury. And then as you said, we build up a discount rate, we build up this required rate of return. It's a function of the credit rating of a business, the size of a business, the quality of the management team, the cashflows, the durability of those cashflows. And then what we're also looking at is the bond shell itself.
There is value in the shell of the security. Every security is somewhat different. This is one of the differences between fixed income and equities. If you want to own bank of America, there's one equity and there's probably a thousand different bonds and they have different places in the seniority within the capital stock, you have higher coupon bonds, lower coupon, longer duration, shorter duration, larger size, smaller size issued in a plethora of currencies with different covenants. So, as you mentioned, all of these things go into determining the price of a security from our vantage point.
Bill: When you talk about the bond shell, you're talking about the provisions that are in a bond indenture. You're talking about the actual contract. Is that fair?
John: Exactly. It's also, again, the stated coupon, whether there's any variability in that coupon, some notes float over a period of time, some notes have coupon step ups depending on credit quality and ratings, downgrades, the size of the underlying security, is it in an index? There's a lot of technical issues in the fixed income marketplace that if you're able to be somewhat small and nimble, you're able to exploit. They are not really risks. You get paid for illiquidity discounts in the marketplace even when you're dealing with issue sizes in the hundreds of millions of dollars depending on what index it's in.
Bill: Yeah, that makes sense. I'm going to give you a softball question here, but indexing makes so much sense to me for equities, because like you said, an equity is an equity is an equity. It's just sort of a vanilla security. But each bond can be so different. I have a strong sense that active management in bonds or with debt markets makes a ton of sense, because it requires thought and reading through, where do you want to play in the capital structure, which bond should I own? I get very nervous about the idea of owning a bond index. Is that a correct fear that I have?
John: Yes, it is. Everything that works for equities works against fixed income in terms of indexing and particularly, when we get into the more esoteric and less liquid markets, something like high yield emerging market, corporates, leverage loans, convertible securities, things of that nature. What you see is that the ETFs or the passive vehicles have higher fees relative to what we see in equity. So, you can go buy VOO or SQI at a couple of basis points and active managers may charge you 50 to 100 basis points for large cap. In high yield, what you're looking at with the largest ETF, J&J and HYG or management fees in the 40, 45 basis point type of range versus active management more in the 50 to 75, 80 basis points, you're not getting a real discount here.
Bill: Oh, interesting. That management fee spread is that tight?
John: Yes.
Bill: I did not realize that. Interesting.
John: Then it goes to your point about index construction. So, we talk about all the inefficiencies in our marketplace and there are many, but index construction is certainly one of those things. If you think about a market capitalization weighted index for equities, well, you're going to be dominated by companies like Apple, Amazon, J&J. These are businesses that have wide modes, durable cashflows. They created a lot of shareholder value. If you look at fixed income particularly in high yield, the biggest weights in the index are simply the companies that borrow the most money.
Bill: Yep.
John: So, a lot of times, you're dealing with the number three or number four player in the marketplace. If you look at one of the largest weights in our index right now, it's Ford. Ford is fine, but it's not the number one car company by any means and then if you think about how these ETFs work, they actually with JNK and HYG replicate a very liquid subsegment of indices.
This is an interesting nuance as well because our market is about $1.2 trillion in size in the US. So, it's less than half the size of the Russell 2K. You have roughly a thousand issuers or companies roughly 2000 bonds. In some ways, it's far less liquid, but the marketplace is dominated by large market participants, asset managers that run $20, $50, $100 billion dollars in this space. Too large to add value. Really what you're doing here is beta replicating and what you want are very liquid securities that you're able to trade to handle inflows and outflows as an example to be able to quickly reposition your portfolio due to changing macro or microeconomic types of conditions. And therefore, this bond shell of very liquid instruments that the largest issuers issue is persistently overvalued, because the buyside is willing to pay up for liquidity because there is no capacity discipline in our marketplace as well.
Bill: Interesting. Is that so when issued or is that a secondary market issue? If I'm AT&T, do I get a discount simply because I'm providing so much liquidity to the market?
John: Typically, yes, typically.
Bill: Huh, interesting.
John: That's the issue with our marketplace relative to equities as well, so that we have this stated coupon and final maturity. If you don't default when you're issued a rich valuation because you're liquid, you never [unintelligible [00:12:13] that. From our vantage point, what we want to do is take advantage of parts of the market where either the largest asset managers can't compete because they're too big to own some of these securities in any type of meaningful size for their portfolios or where we feel there are less sets of odds. So, we have that micro to midcap type of bias that your equity listeners would relate to.
Bill: Yeah, that makes sense. I'm just going to do one more basic thing for some listeners that may not know. When I was underwriting credit at the bank, the things that we would look at is if were to take a loss, you look at the probability default. Well, this is how we would reserve capital. But the probabilities of default, your exposure at default and then your loss given default is how we looked at stuff. So, I would suspect that the world that you live in looks at things a similar way. Is that true?
John: Yes, it is. So, that's an interesting point as well. It's one of these issues that junk bonds, high yield debt, which is the market that I live in, has a branding issue. In fact, we should really be called limited duration instead of speculative credit because if you think about our marketplace, it's really evolved from the era of Michael Milken in the 1980s when you're lending to really small squirrely types of entities at very high leverage levels with very low-credit ratings. What we've seen is a migration of credit quality, particularly from pre-GFC to today. So, double Bs which are the highest-ranking junk bonds, again kind of an oxymoron there highest rating of the low quality. But they're north of 50% of the marketplace today. They're about 52% of the market. They were about 38% pre-GFC.
The last time that double Bs defaulted at north of 1% per annum was 2002. [audio cut] 20 years since we've seen any meaningful defaults in that part of the market. It's the largest part of the market. Single Bs, which would indicate lower credit quality or about 40% of the market, and the last time that they defaulted at north of 4% was in 2009. Triple Cs are what people typically think of in terms of speculative credit. That's the lowest credit rating, high probability of default. Now, these types of companies will default at a pretty high frequency rate, typically somewhere between 20% on the low end and 45% on the high end. But that's only 10% of our market at this point in time. Really, the excesses of lending have gone into our sister markets, the leveraged loan and private credit markets that also fill up the pie of below investment grade.
High yield has really become much more of a professional marketplace and when you think about the businesses that permeate, I mentioned Ford as an example, but you can't go more than a couple of hours in your day-to-day life without running into a high yield company, whether you're taking a flight on American or Delta or United, or whether you're going to a big box retailer like Macy's or Nordstrom's. We interact with high yield businesses on a daily basis.
Bill: All right, I have two thoughts. So, I'll start with the first. The default rate since 2002 of double Bs, how much of that do you think can be attributable to an environment where refinancing risk was substantially reduced due to what the Fed has been doing?
John: Oh, it's certainly a portion of it, but I think that, again, companies are just better run in terms of making sure that they're not going to default today than they were in 2002. It's an iterative process. Basically, what happened during the GFC, particularly in high yield, was the typical CapStack of the high yield issuer in 2006, 2007 was to have one or two bonds and effectively having balloon payments and not refinancing until you got somewhat close to the final maturity, which meant within a year or two before the final maturity.
What we saw was liquidity crunch and capital markets be closed. The capital markets were actually only closed for about nine months, which is the longest period of time for the high yield marketplace during the GFC. So, companies that defaulted at that point in time had these balloon final maturity payments and didn't have access to capital. We learned from that. Corporate CFOs learned a lot going through the GFC. What we've seen now is a layering out of maturities, a diversification of lending sources. So, you don't just borrow in the high yield bond market if you're a below investment grade company. You borrow in the leveraged loan market, you borrow in the convertible securities market. So, you also typically are borrowing not only in the US market, but in the European or other foreign markets. You have plenty of diverse sources of capital. The diversification of capital base has really helped.
Recently, you could think about a company like Carnival Cruise, which has done several debt refinancings over the past couple of months. One was effectively a secured bond deal and one was a convertible note issuance. So, businesses like this despite having some trouble in the marketplace at this point in time, lack of visibility into forward cashflows, and a bloated balance sheet with a lot of debt, they still have access to capital. I think that this is a very long-winded way of saying that corporations have drastically improved their businesses, their operating margins, as well as their balance sheet in terms of diversification of sources of liquidity.
Bill: When you're getting paid back by assets, I think of that as hard assets. When you're getting paid back by enterprise value or whatever, I think of that as air. So, when I ask this question, that's where my head is coming from. Do you have a sense of how much air is under the market in general, because you talk about American? American is a company that I can't stand from an equity standpoint, but their asset base is something that I would lend to all day long. So, I'm just curious how far they've pushed that thought even if a lot of these companies default, obviously you've got to be able to sell the assets to a buyer. But generally, do you have a sense of what the risk of default is or is that an impossible question to answer?
John: No. Look, so we think about equity market capitalization as our starting margin of safety as debt lenders.
Bill: Huh, interesting. Okay.
John: Because in theory, equity needs to be wiped out before debt takes any type of impairment. I understand that there are some situations where that hasn't necessarily been the case, but the majority of the time, equity needs to be wiped. When we're thinking about lending to businesses, we're certainly and we typically lend to public companies. We do lend to some private enterprises, but with those we're coming up with a private market valuation. We're looking at what the equity market ascribes a value to be and we're making adjustments to things like margins and enterprise value to EBITDA and coming up with our own estimation of our starting margin of safety. Now, when you talk about the airlines, it's really interesting because I think 2020 [unintelligible [00:19:44] creativity from the CFO suite.
Bill: The United deal was a thing of beauty. Didn't Goldman put that together?
John: With that deal that had all of their aircraft.
Bill: They sold the mileage program. They didn't sell it. They got lending against it. They set up a separate entity. It was just absolutely a beautiful transaction. I remember looking at it and I was like, "This is incredible." Financial engineering has really been taken to-- It's very professional now. Let's put it that way.
John: Well, and that's a key point in terms of lending right now, and particularly to hard asset types of entities. When you think of an airline company, you think of airplanes. That market has been growing over a multi-decade period. In fact, when I started my career, I started distressed and I was looking at what are called EETCs, which are effectively pools of aircraft and they're collateralized. That market has evolved over time. Americans are frequent issuer in that marketplace. Then, lo and behold, 2020, when we're all doing our models with revenue at zero and they need to come up with the ability to plug some of these cashflow gaps, they say, "Well, yes, we have a mileage program that is extremely profitable. We can borrow at that box." "Oh, by the way, we have slots, gates, and routes." Some of those markets like a London Heathrow or JFK are very valuable. Some other airline would pay us for those slots, gates, and routes. So, we can securitize deals against this. You looked at the cruise line industry. You had companies like Norwegian borrowing against islands.
Bill: Huh, interesting.
John: So, not all collateral is the same. Certainly, from my vantage point as a lender, we have to be comfortable with the valuation. What we're seeing in the market today, you've seen companies like Sprint and now Dish come to market and borrow against Spectrum. When you're literally talking about air, that's air.
Bill: Yes, that's right.
John: They're able to borrow against those types of valuations. So, I think there's art and science in terms of understanding collateral. What I think that end investors don't typically understand as well is that there are a lot of different pockets of value within a company that can be carved up and borrowed against in times of stress. You encumber assets in times of stress like 2020 and 2021. As the market improves, then you go to refinance secured debt with unsecured debt and you unencumber those assets to be able to have that ability to use those assets again at another challenging point in the market.
Bill: Well, that's got to bring you to a pretty interesting point, because we've been through 2020 and a fair amount of assets got encumbered to get through liquidity problems. Lord knows back then, no one knew what was going to happen. Now, we're potentially looking at a recession. We're looking at a Fed that is less accommodative. It seems as though we may be entering the dawn of an era of opportunity for high yield and debt in general.
John: Yeah, so, first of all, I think people have misconstrued a Fed point. The Fed doesn't care about your 401(k). The Fed doesn't care about equity prices at all. What the Fed cares about is functioning financial conditions. That's why they came into the market in March of 2020. You couldn't spot a Treasury, meaning, you couldn't agree to a price of the biggest, most liquid market in the world during March of 20. If you can't price the risk-free security, you can't price anything else, right?
Bill: Yeah.
John: If the floor is shaking nonstop, the house is going to crumble. So, that's when the Fed comes in. Fed has a dual mandate, but right now, unemployment is up 4% and inflation is running pretty hot still. Yes, we've seen peak inflation most likely, but it's not going down to 2% anytime soon. So, the Fed is not your friend anymore. There're plenty of investors like myself that really grew up post-DFC that haven't seen this type of Fed. The mantra was, "Don't fight the Fed." Well, guess what? Don't fight the Fed here.
What is particularly interesting to me is this dynamic evaluation between fixed income and equity right now, because credit spreads have moved out, but equity risk premiums haven't. When I'm thinking about doing a DCF, what is your required rate of discount for your cashflows at this point in time? It used to be 9%, 10% for a large cap equity type of business. When the 10-year Treasury is at 1%, well, we're closer to 4% now. So, does that mean that required rate is higher? I think yes, but that's somewhat debatable. If you have equities trading at 18, 19 times forward earnings going into a recession where I do think that we'll see some margin compression. I don't think it'll be to the degree of what we saw in 2007, 2008, but we will see some margin compression.
Then the 60:40 allocation which was dead and fixed income didn't live up to its duty of being that ballast point in a portfolio should actually be flipped to 40:60, where you have a lot more fixed income now because duration is defensive in fixed income, but it's offensive or aggressive in equities at this point. I think that what you're going to see too here is this equity mind shift. What really propped equity markets up for the last decade has been growth. Some of it's speculative, some of it is high quality types of businesses. But it's not growth anymore, it's cashflow. That's a real positive from where I'm sitting as a lender.
Company is not going to be lighting money on fire just to deliver McDonald's hamburgers to my doorstep for $5.99. Now, the Ubers and Grubhubs and DoorDashes of the world are going to be focused on profitability. As a lender, I like my companies focused on profitability and then I also like my companies and my CFOs focused on maintaining a reasonable balance sheet. I'm not one of those lenders that says, "Hey, you've got to take 100% of your cashflow and pay down debt." This year, for the last decade, we've had a market that has been fueled by ultra-low plentiful cheap capital. And corporate CFOs did the right thing. They said, "Why wouldn't we borrow at 3%, 4%, 5% to buyback our stock or to pay meaningful dividends to return capital to shareholders?"
Now, capital is a lot more expensive and it's a lot more scarce. We've seen this mindset shift from companies that I think is really important for your audience to understand. So, over the last six months or so, I'll give you a couple of examples. Centene introduced probably what I think to be the first public bond buyback program where they said, "Not only are we going to be buying back $3 billion of our stock, we're going to be buying back a billion of debt, because our debt is trading at 85 cents of the dollar and we're a high-quality business that generates pretty predictable, stable cashflows. Why wouldn't we make some money for our shareholders?"
If you look at a company like DaVita, which is a kidney dialysis type of business, it's struggling a bit, but it still generates very healthy cash low. They have been very aggressive from a share repurchase program over the past decade. On their last earnings call, they said, "We're going to focus on debt pay down now, because the challenges in our business and also where our debt is trading in the 70s and close to 9% type of yield, we think that's an attractive proposition for our shareholders as well." I think what you've seen is this lack of understanding of enterprise values, market cap, business, the debt, and cash. Debt is valued at par 100 cents on the dollar.
If you're downtrading at 70 cents on the dollar that means the debt is overstated in terms of the enterprise value of a business and the equity is understated, if you can collapse that. For a lot of businesses that are generating cashflow that do have assets that they can encumber to go out and collapse that discount on their debt, they're doing it. We're seeing it every single day in the marketplace with public companies coming out and announcing bond buybacks in the open market.
Bill: Yeah, I think I saw Barrick Gold did one. It's interesting, I followed the Malone entities and just the way that Charter specifically has laddered out the debt. Even Qurate, they have a bond out there that expires in 2068. I haven't looked at what it trades at and maybe that one's not even the right one to think of, but they have some that are in the 2040s. Those things have to be trading at nothing relative to what they issued them for. So, I think going into this period, I learned from studying my perception of Buffett.
As I get older, I've realized what I think I read was not even what I read. But when I was younger, I took that no debt thing very seriously. As I worked at the bank, I learned a little bit more and I realized some of the nuance in the statement. Now, you look at some of these companies that have leverage, but it's laddered appropriately and it gives them a lot of tools in this environment to go out and attack discounts in different ways. Like you said, it was just a share buyback playbook and now, there's real opportunity for corporate CFOs to, I don't know, basically be short bonds by issuing a couple of years ago and buying them out.
John: Absolutely. What an amazing time to do this. We saw record issuance in investment grade and high yield debt securities in 2020 and 2021 at record low rates. So, there's a lot of debt outstanding that is very cheap from a dollar price perspective. If your business that is consistently generating cashflow, why wouldn't you go out and be doing that? Effectively, some of the best capital allocators in the marketplace are in high yield entities. You could think of a company like TransDigm, company like Post, you mentioned Malone and the Liberty Entities, I think businesses like this are going to be paying close attention to where their debt is trading and finding creative ways to take advantage of this.
It's actually interesting when you think about somebody like Post, who's been extremely shareholder friendly. They've done a couple of interesting transactions this year. One, they did an open market bond tender to take advantage of exactly what we're talking about. Two, they also issued in the convertible bond market to go buy back stock. I think this goes to what we're talking about, the diversity of funding sources that are available to particularly skilled capital allocators.
Bill: All right, can we take a step back on that transaction? So, you're issuing in the convertible bond market and in that market you're basically short, in a way, your stock. If the stock increases to the point where the convertible is actually worth something, then you have to issue equity and it's somewhat dilutionary, correct?
John: It depends on if you hedge out that dilution effect. If you use some of the proceeds to enter into a collar where you, in fact, aren't really diluting yourself.
Bill: Wait, wait, wait, how would you enter into that collar? What would the counterparty be promising?
John: You'd be entering that into with an investment bank.
Bill: They would what? They would sell you the shares at a certain price would make sense, right? I'm just trying to think through what they were thinking about, because one hand you're attacking your debt by buying the open market tender. What you're saying is, anyone that's willing to give me whatever the price is on the debt, I will buy as much as you have. On the other end, they're basically issuing a bond that brings liquidity in that's a source of funds, and it's somewhat short their stock, probably not in a big way. I'm just thinking about what their internal dialogue is probably saying about where they think their equity may go versus what they-- It just strikes me as a very smart transaction is basically what I'm saying given the headwinds that we may be looking at.
John: Well, it is interesting that Post issued the convert around $93, I believe, and that's where their stock is trading today.
Bill: Okay. So, your options at the money.
John: Your options at the money. The convert is actually trading six points above issuance price because the premium for the conversion price here is relatively limited.
Bill: How long is the option?
John: Five years in nature.
Bill: Interesting.
John: The premium was set at 17.5%, which is actually pretty low. The conversion price is about $106 on Post. But from my perspective, your point about management, that might indicate that they view their stock as somewhat overvalued at that point in time.
Bill: Their debt is attractive to retire, right?
John: Exactly.
Bill: I don't know. If you give up of dilution and you shore up your balance sheet and can attack that debt, forget about the result of the transaction. That seems like a smart transaction to me.
John: Yeah.
Bill: For the first time in a while, maybe, it's going to be very interesting. The corporate finance departments may get to shine. For a while, it was just like issue debt and buy back shares. Now, we get to find real creativity.
John: Absolutely. I think what we've seen too-- And Energy is a good leaning indicator here, actually, is that in that marketplace the companies that had under-levered balance sheets came into a market where there were a lot of distressed assets that they could pick up at very attractive prices. I think what we're going through right now is a deleveraging cycle. I think it is this monumental shift. The companies that put themselves in the catbird seat to take advantage of the recession that is coming and the washout in terms of equity prices and in terms of business valuations are going to be in a position to buy quality businesses at low prices and then to come back to the marketplace and issue debt again, probably in a lower interest rate environment.
Bill: Hmm. If that is correct as a thesis, what an interesting regime change. So, you sent me some notes before we started, and I was curious-- You said, "High yield as a market has never had back-to-back negative years." Do you mind expanding on that a little bit?
John: Yeah, look, it goes to the asset itself. It's a short-duration asset because high yield companies typically can't borrow longer than 10 years and typically borrow somewhere in the five-to-eight-year range. They have higher coupons, i.e., high yield. The duration is typically in this three and a half to four and a half years, you've got your contractual coupon, you've got your stated final maturity, you've got your default cycle here. And so, what we've seen is that it's a self-healing marketplace as well. So, in 2008, when the market was particularly challenged, the dollar price of the index traded down rapidly. Your coupon doesn't change. If you have an 8% bond at par, you're getting 8%. If that price is at 50 cents in the dollar while you're earning a 16% yield. So, if you started January 1 of 2009 at 50 cents, then you're actually making 16% in terms of carry, not to mention price appreciation opportunities. That's one of the things that we're seeing in this marketplace right now with the debt of our asset class trading around 87 cents on the dollar is that there's not only a reasonable carry in the market, meaning, your coupon. There's also price appreciation opportunity.
Your starting yield, let's say it's roughly 9% right now and the duration is about 4, if we assume nothing happens in Treasuries, then credit spreads have to move by about 225 basis points to generate a zero return for next calendar year. If that were to be the case, then spreads are roughly 450 and 475 basis points. Now you're talking about 675 to 700 basis points, which is typical in a challenging recessionary type of environment. The dollar price is going to move from 87 cents in the dollar into the 70s and we would see a ton of institutional capital flowing into that marketplace, because allocators understand that that is a very favorable price and spread to be lending to, particularly as we talked about before the quality of this marketplace has improved dramatically over the years. The structural seniority in the marketplace has improved dramatically over the years.
We don't anticipate seeing capital markets close for any meaningful amount of length and time. There's no maturity wall to be worried about. We have less than 10% of our market coming due through the end of 2024. So, there's plenty of time for companies to address maturities, either through internally generated cashflow or multiple sources of liquidity. Energy has been one of these headwinds for our asset class in 2015, 2018, and 2020. It's now a meaningful tailwind.
Bill: Oh, when you're talking about energy, you're talking about the energy companies in your asset class have defaulted and taken away from the yield. Is that what you're referring to?
John: Yeah.
Bill: Okay. Yeah, you weren't talking about Energy prices impacting the businesses.
John: Well, Energy prices obviously impact the underlying cashflows of our E&P and oilfield services midstream types of entities, but Energy is roughly 13% of our index. So, it's the largest weighting from a sector component. What we've seen is this fifth in capital allocation priority from corporate CEO, CFOs in energy businesses dating back to really 2014, 2015, because what you saw was an explosion of the high yield asset class, high yield bottom debt about $400 billion in terms of AUM in 2009 and it got up to about $1.4 trillion through 2014.
Bill: Wow.
John: So, it grew rapidly, but Energy as a percentage of the index grew from about 8% to about 15% during that time as well. And so, you were able to increase your stock price through debt-fueled M&A in energy businesses during this timeframe. There was a long hangover once the commodity price moved from below $100, where people thought persistently that fracking is this amazing new technology, which we certainly agree it's a valuable technology, but commodity price can change. There is zero intrinsic value in these types of commodity businesses. Once that moves lower, the value of the business is impaired and that certainly was a meaningful headwind to market performance for high yield. The issue there too is the recovery value. So, if you go into bankruptcy and default when oil is trading at $30 or $40, the value of your business is particularly low. So, lenders recover pretty low percentage in those types of environments.
If you're lending to, let's say, Carnival Cruise, and you're in a first lien position, and the value of your debt is $8 billion, and the value of the assets as appraised is $28 billion, you feel pretty comfortable that if they were in a bankruptcy type of situation that you would recover 100 cents on the dollar, even stressing out a number of different types of scenarios. Energy, these management teams shifted their allocation from debt field M&A to living within cashflow, because equity holders told them to do so in 2016, 2017, 2018. And then, ESG certainly came into our marketplace and has had a much more profound impact on lending to these types of businesses.
Equity holders are now telling these management teams, "You are the new tobacco companies. You don't have access to capital like you used to. You run a commodity type of business. So, therefore you need to delever your business aggressively because of the cyclicality of your earnings." That's what Energy companies have done. We used to look at most oil E&P companies trading at three, four, five times leverage. Now I own several companies that trade at net cash. They have more cash on their balance sheet than debt and they still pay you 7% or 8%. We think that that is a very attractive opportunity.
Bill: So, when I look at your portfolio, I also see some what I would perceive to be very high-quality companies. How do you think about the mix of the portfolio of maybe some of these more cyclicals versus some of those maybe better businesses by definition and how you move the portfolio around to lean into one or the other?
John: Well, we always want to take advantage of market inefficiencies. And so, we will look at owning typically higher quality types of businesses, but in instances like where we're at today with energy, where balance sheets are meaningfully better than they have been over the past five to seven years in management teams, capital allocation policies jive with what we are looking for, then we're going to allocate more capital to that part of the marketplace, because we think the inefficiency in energy is partly driven by ESG, partly driven by most managers really getting decimated in multiple cycles and therefore putting the sector in the permanent doghouse. And so, we think that if you're willing to look at today's situation with open eyes, you can certainly pick up a meaningful amount of risk adjusted yields in that sector. I think what we look to do is identify quality management teams and that again would jive much more with your typical equity analysis.
That's because we are the gateway between debt and equity and that's because we are dealing with some possible amount of bankruptcy risk, particularly as you go down into the CCC part of the marketplace. We're very adaptable in terms of where we're allocating capital. I would say that our viewpoint today is we're going into a recession and we want to skew higher quality, meaning higher credit quality in our portfolios. But we're willing to look at situations that we think are mispriced and we will lend to businesses that crave at "distressed levels." If we have confidence in the management team, if we have confidence in the durability [unintelligible [00:43:52] our ability to predict the size of and timing of cashflows and we certainly see a number of opportunities in the marketplace with yields in the 15% to 20% to 25% range that we think are mispriced, but we want to take advantage of inefficiencies that we've discussed a little bit here in terms of technicals, whether it might be a lender that's small off index in a sector that's unloved for a variety of reasons. We want to take those types of risks. We want to take headline risk because we think that's particularly mispriced, but we don't want to take risks in the underlying fundamentals of the business.
Bill: Yeah, that makes perfect sense, especially in a game when your upside is 100 cents on the dollar, because at par that's what you're getting back.
John: Yeah, exactly. One of the interesting dynamics that we see today, and there are several companies and we own these businesses is that you have companies that I think to be our high quality like a Twilio or Roblox that don't necessarily generate cashflow at the stock-based comp, but they have cash massively in excess of their debt. They borrowed in a time where now the coupons on their debt are in the freeze and you can borrow or you can lend to the government for one year at four and three quarters. So, they're in a position right now where they have cash and excessive debt and the yield on their short-term riskless securities is above the interest expense that they're paying on their debt and their debt is, oh, by the way, trading in the 70s and 80s, these companies should be buying back every single bond they could possibly do at this point.
Bill: Interesting. So, you don't think that they should just say, "Thank gosh, we got that done and we should keep it outstanding." You think that they should go out and attack the bond's outstanding.
John: I think it's a compelling opportunity for them to again improve shareholder returns through debt reduction. While I might not think that this is of any particular amount of leverage, we know that the equity holders are typically focused on that equity leverage, particularly in situations where we're not generating persistent free cashflow once you strip out the stock-based comp.
Bill: Yeah, well, that's one nice thing about credit that equity doesn't get any dilution from stock-based comp is actual true free cashflow to debt holders, even though equity gets diluted. From the credit perspective, it doesn't matter.
John: Exactly.
Bill: You want to share your thoughts on private credit, because I heard that they haven't had a markdown this year.
John: Yeah, private credit is one of the very interesting marketplaces because it is opaque. We have insights into that market. We're not actively involved in the marketplace, but certainly we're paying attention to it because as we talked about prior with below investment gradient of high yield bonds, you have leveraged loan and you have private credit. And high yield doubled and tripled in size really from 2009 to 2014 and then we had a hangover in 2015 and 2018. Leverage loans doubled in size really from 2014 to 2018 and they doubled in size at that point in time because they're floating rate. And so, everybody was worried about, "Hey, when is the Fed going to start hiking?" It took a long time and it was pretty slow at that point in time, but a lot of capital came into that marketplace and then they had a tough end of 2018 and then leveraged loans typically have more structural seniority than high yield bonds and have less duration are supposed to protect capital in down markets better than high yield. They did not do that in 2020 because that market had shifted very meaningfully. It's lower credit quality at this point.
What we've seen in private credit now is an explosion of growth in terms of assets, where depending on what you look at, you're over a trillion dollars at this point in the asset class. Direct lending was not really a business during the GFC. So, it's not been battle tested at all here. I'm highly skeptical particularly given when we can go look out at the public BDCs and look at how they're lending and what types of businesses that they're lending to. I think what you've seen is similar to what happened in bonds and loans. You saw a lot of capital come into the space and chase a limited amount of ideas. To deploy that capital, you had to acquiesce to borrowers. Instead of getting 12% yield and warrants, which is what you used to get from Mezz lending in the global financial crisis, you're lending an 8% covenant light to a small widgets manufacturer in Sandusky, Ohio. I think that there's certainly a lot of problems there. In fact, more of the issue is around lending in software and technology. I think that we're in for a real tech wrap in 2023. We've already seen certainly in 2022, unprofitable tech get hammered hard.
Technology is a big part of private credit. On the public BDCs that we looked at, on the low end, it's somewhere around 13% of one manager's book. On the high end, it's more like 25%. With technology, it is a bit of catnip to private equity, because you have sticky recurring revenue, you have retention rates in the 90%, 95% type of range, you have the ability to price inflation plus several percentage points. And so, you can put a lot of leverage on those types of businesses. But I think what we've seen in software was this proliferation of software during COVID when everybody was working from home. Now as enterprises are going into recession, they're looking at ways to cut expenses. You don't need Zoom and Teams. You don't need the marginal enterprise resource software programs, particularly if you have multiple ones' going.
I think there's a bunch of decluttering that's going to have to go on in the software marketplace. These are businesses that have a lot of leverage on it because of that predictability. So, if retention rates go from 95 to 85 and if your ability to price goes from inflation plus 3% to flat to negative, we're going to see a lot of problems and you're going to have to go through a lot of workouts. I think private credit is going to be sweating a lot of situations in 2023 because you can pretend that there's no markdown during COVID, because delta between Q1 and Q2, the market recovered so quickly that it was fine. If we're in a prolonged downcycle, which I think we're going to be to a degree, you're not going to be able to say that, "My public counterpart enterprise is trading at 15% yield and 70 cents in the dollar, 60 cents in the dollar, I'm holding my loan at par at 9%, I think there's going to be some real problems there." Again, what we talked about private credit depending on what indices or publication you're tracking was up high teens 20% in 2021 and its down low single digits. At this point, I really struggle with the perceived marks in the space.
I think the other interesting aspect is going to be that as an asset allocator you have your private and your public markets. If your public markets have gotten hit as we have been down at high yield at this point about 12% and your private markets are marked down a couple of percent as you look for incremental dollars to allocate, well, one, you're going to be worried about the marks and two, you're going to be topping up the asset classes that have drawn down more severely. So, I think incremental dollars are going to come into the public sphere and we are also seeing in our marketplace private credit going out and buying public securities as well, which is this interesting dynamic because they've raised a ton of capital and that deal flow has slowed down pretty meaningfully in 2022 and we think to be in 2023. So, if you see attractive opportunities to generate yields that are in excess of what you've promised your investors and you can do it in the liquid market, go deploy that capital currently into our marketplace and as your deal flow picks back up, you can sell the more liquid securities and go back into direct lending.
Bill: What are the implications? If private credit does have, I don't know, a hiccup, are the LPs in private credit--? Do they tend to be a little bit more patient or could there be a scenario where? For instance, if you get redemptions in private credit, it seems to me that it's almost by definition less liquid. So, what does that do to the market generally? Does it create potential, I don't want to say, panic but real markdowns because assets that might have to trade, right?
John: Well, it is really like how patient are your end investors. To a degree, I think the end investors are going to be pretty patient. This is primarily institutional capital that looks at cycles over multi years. So, I think there'll be patience there. But I don't think incremental dollars are going to be coming into the space. I don't think they're going to be going out because of the lock up periods and the structures around that. I don't think incremental capital is going to be coming in. I think really what you're going to see is whether or not the lending standards were as strong as were led to believe and whether or not these managers have the capability to handle a number of workouts all at the same time. I think that's really going to be the issue is how much stress does that put on your investment team, if you have multiple lending situations going through non-accrual periods.
Bill: That makes sense. You better be ready to own what you own is what I'm thinking, so, we'll see. Do you mind talking about your concept of long CEOs, short politicians?
John: Oh, yeah, sure. What we mean by that is [audio cut] America, at the end of the day, it's focused on stakeholders, it's focused on profitability. I think that we're seeing already that they're going to be proactive on labor force. Meaning, reduction in labor force before we go into the recession. We've had this view right over the last three to six months of an economy that's starting to turn. Meanwhile, you're getting record cashflows coming into your business at that point in time. So, you have a fortified balance sheet, you continue to get cashflow to come in, and you're going to be focused on managing your business for the long haul, because you're paid very handsomely to do so. That's very long credit. Again, what we've seen companies coming into the market buying back their debt, we've seen meaningful slowdown in M&A activity. So, all the things that are shareholder friendly, but not necessarily debt holder friendly have started to slow down.
Meanwhile, I think from the political standpoint of things, politicians are focused on appeasing constituents across the globe and we think that there's going to be the risk of a lot more policy errors in the marketplace. We got our sneak peek with what happened in the UK with the mini-budget and just how quickly the gilt market got completely out of hand and you had to have the Bank of England come in and purchase government securities again in the open market, so you're doing QE as you're supposed to be doing QT. I think there's certainly a risk in Japan with a new minister coming in for the BOJ and I think that politicians are really going to have to earn their stripes. As we talked about before post-GFC, it was spend, spend, spend and Central Banks are going to be there to ensure that the economy keeps muddling along at a minimum. Now, politicians are going to have to make hard choices. I'm not necessarily sure I want to bank on them relative to corporate CEOs.
Bill: That makes sense. Something that I was thinking about when you were talking about the Bank of England and having to do QE, I want to preface this question by saying, I have allocated to managers in the past that have held cash. I have thought like, "That's not really your job. That's my job." So, that's where I'm coming from when I ask this question. How are you thinking about whether or not the Fed's current position, like, how wide spreads could get? Are you concerned at all from a mark to market basis with deploying capital or is your theory like, "Look, we have capital in the door, our job is to invest it, and we are through cycle no matter what. We just need to minimize credit losses and things will take care of themselves."
John: Yeah. We've run a number of different strategies. Some, we use cash as a portfolio tool and others where we're effectively benched against an index and an asset class. We're going to keep a reasonably low amount of capital. I think that our marketplace is one that lends itself actually to holding excess capital because it changes so quickly and those liquidity dynamics are particularly challenging. Liquidity has really dried up in our marketplace post-GFC and then really post-2014 as well. And so, we get paid handsomely to provide liquidity in the marketplace. There is that ability to generate excess returns through holding cash and being that liquidity gateway in a market where we think we have information and analytical advantage. Typically, what we're thinking about and this comment is much more around the mutual funds that we manage. They're open-end and investors require daily liquidity and we provide daily liquidity. So, you have to have a cash buffer at a minimum to handle any redemptions and also to be aware of the subscriptions that you're taking.
Rule number one from our perspective as open-end vehicle managers is, it's your cash, you do with it as you please. So, if you're looking to redeem, then we've got to have cash on hand to handle that. We bake in a lot of liquidity sources. So, we never have to be a liquidity taker in the marketplace. Cash is one component of it, but we'll own investment grade securities, we'll own short duration securities that, again, we think don't change in price meaningfully in the vast majority of market environments. We're consistently paying attention to the market and looking at absolute and relative value opportunities. So, we have a healthy cash balance relative to, I think, our competition over most cycles, but we will quickly deploy when we see opportunities in the marketplace that are technically driven and that technical aspect is typically liquidity coming in or going out of the market. When it's coming in, we're selling into strength and when it's going out, we're buying into weakness.
The interesting part of our marketplace is just that impact that passive capital has and how we can see it reflected on a day-to-day basis because the ETFs aren't anywhere near the size that they are in equity markets, but their underlying impact on the marketplace is extremely high, because they are forced buyers and sellers. They're replicating an index, you take capital, and you've got to buy something, you've got to buy your index, you lose capital, you've got to sell something, you've got to sell your index. And their typical way of accessing this liquidity is through sending out creation and redemption baskets. This is all transparent. So, as a money manager, I can see what the ETFs are looking to do.
You can look at whether or not they're trading at a premium or a discount to their net asset value. And so, you can ascertain what side of the market they're going for and we see where they're looking to source or take liquidity. We're happy to be on the other side when we have this kind of analytical and information advantage because we know exactly what they're willing to pay for security or where they're willing to sell based on that premium or discount to NAV.
Bill: Interesting. How does that work? I'm sorry to ask such a basic question, but I don't know how the premium or discount to NAV would impact where they're willing to buy or sell.
John: Well, it's the authorized participants that are transacting on behalf of the ETFs. If you're trading at a premium, if I'm an authorized participant, I want to go buy the cash bonds and I want to sell the ETF.
Bill: Mm hmm. Okay.
John: So, I can collapse that discount.
Bill: Okay. It's basically like an arbitrage transaction.
John: It's literally arbitrage.
Bill: Okay.
John: This basket depending on what ETF you're dealing with on what day, it could be 50, 100, 200 names, but it's observable. Where we live in the marketplace too with somewhat of the smaller off-the-run types of securities, if you're trying to complete an entire basket, maybe you've got 99 out of 100 names and you need that 100 names, so you're less price sensitive there.
Bill: Oh, interesting.
John: That's where we can really take advantage of some of those things being the liquidity fulcrum in a position where somebody else isn't willing buyer or seller, we can be when we think that we are getting paid handsomely relative to where we think the intrinsic value of security is, because we know that today an ETF is taking money in and they want to buy, and tomorrow they're getting money out and they want to sell.
Bill: Yeah.
John: You can rinse, wash, and repeat with this.
Bill: Well, that's a nice thing for them to have to provide to the market. Who's your perfect investor, I guess, is the way to think about it? I know that the answer is probably someone that doesn't call and has infinite duration, but if somebody likes what you've been saying and what this interview it resonates with them, who do you think is somebody that should consider your funds? Can I even ask that question, by the way?
John: Yeah, probably. I assume so.
Bill: All right. Well, we'll send it to compliance and they can tell me to cut it if they want.
John: Yeah.
Bill: I'm just thinking about from a duration standpoint, I know you run open-end funds and I know that, as you said, liquidity can come and go. But if someone were placing capital in this type of strategy, what kind of duration should they be thinking about locking up capital for is the question that I'm thinking about. Maybe I'm asking for myself.
John: Well, in terms of how we think about managing money, we think about full market cycles. A cycle has shortened in length, certainly over the past couple of decades here, but it's typically a three-to-five-year type of time frame. I would say that, again, the nice thing from our perspective with fixed income, the stated coupon, and final contractual maturity is that if we are right in terms of avoiding mistakes and allocating to good businesses, so avoiding losers and picking some winners, we will win over time because the discounts will get collapsed. The liquidity discount, the headline risk, the off-benchmark type of risk, all that stuff will get collapsed as a bond matures or as the market coalesces around our viewpoints on certain risks. And so, that can take time. It usually doesn't take three to five years, but we typically think about our holding period in somewhat of that type of timeframe.
Bill: Yeah, that makes sense. Well, I'm done with the formal part of this interview, if you're okay with this. So, I'm going to ask you, how the hell did you keep your head on straight in 2020? I was listening to some of the interviews that you and Bill were giving, and it was very, like, you guys were right for the right reasons, and you were pretty calm. What was that like for you?
John: I don't think I was calm. Maybe I was calm.
Bill: Well, you portrayed yourself as calm. [laughs]
John: I was calm talking to shareholders. It's a combination of two things. It's having a strong partner at work, which Bill is a fantastic partner. Bill Zox, who's my portfolio manager on the strategies that we manage. He and I have worked together for, at this point, almost nine years and we effectively finish each other's sandwiches. So, having somebody that you inherently trust, not only from investment making decision, but also as a person is critical. He was fantastic and all of the investment team that we worked with was fantastic during that timeframe. It's really also having a strong partner at home not to really deviate from the investment side of the podcast. But again, having a phenomenal wife, who was extremely patient and very much understood the severity of what was going on in markets and contextualizing that relative to what was going on in the world as well with a couple of little kids at home.
I think having two little kids at home help ground how serious things were. If I had made a mistake at work, which you do basically every day at this point. You make some mistakes, but you come home and your kids are smiling and happy to see you, I think that really helped in terms of maintaining some stability in a very violent market.
Bill: It's going to be interesting. I think from a COVID perspective, one of the takeaways that a lot of us had is how nice it was to be around family and I hope that sticks over the long term. I think that was one of the few really big benefits to society that came out of that whole fiasco. So, we'll see. I don't know, man, but I think Charlie Munger's advice, "Marry the right person is the single most important thing." I don't think Charlie is the only person that's ever said it, but it's a game changer, man. When you can count on your partner at home, it's completely different.
John: I would be nowhere without my wife. She is definitely my better half.
Bill: Yeah, I feel the same way. You think that's just like a man thing? You think that we're just like inherently the anchor or you think that--? I don't know, sometimes I wonder. All my friends say the same thing. [laughs]
John: I just think my wife is incredibly supportive and incredibly empathetic and also will call me on any of my bad behavior as well, so incredibly grounding.
Bill: Yeah.
John: In this business, you develop an ego if you don't have one. It's very easy to get lost in the market the day to day and having somebody that can pull you out and say, "Hey, here're your responsibilities right now." That's me and the family here.
Bill: Yeah. I think that's something I need to work on is being able to get a little more present. But I tend to agree. I developed of an ego and then the nice thing about the market is, it'll kick it right out of you just as you get it too. Now, I'm rebuilding it, but hopefully in a healthier way.
John: Incredibly humbling. This market, really, over the past three to four years has been incredibly humbling. Every time, I think we're doing something right as a team, something changes. The most challenging part is to be right for the right reasons, the worst is to be wrong for the right reasons-
Bill: Yeah.
John: -where you can certainly go back and second guess. But yeah, absolutely, a very humbling marketplace.
Bill: It's interesting. The next time that people are on average saying, "Just look 10 years out," I'm going to try to remind them, "Do you remember what 2018 to 2022 felt like and how long 10 years?" That's only four. Ten years is a really long time.
John: Absolutely. The rate of change of everything, I think that encapsulates as a society rate of change is rapid. We're going through a fundamental shift from globalization to deglobalization. Technology is advancing in incredibly fast clip. So, I think shortening cycles makes sense. I'm not saying, I want to be the microwave generation or the Twitter generation, but shortening cycles is important here. I think that's the challenging thing, again, of running open-end capital is that your time horizon is the shorter of yours and your end investors.
Bill: Yeah.
John: We have to be very cognizant of that as well is that the leash that you have as a manager is shorter today than it was five to ten years ago.
Bill: Yeah. That's a tough juxtaposition when there's edge in thinking long, I believe. I think that there's a 60% probability that's right, maybe 70%. And then, meanwhile, the leash is getting tighter. It creates an interesting tension.
John: Absolutely. It's interesting particularly in [unintelligible [01:09:56] not many people really avoided the carnage this year. It was pretty hard to avoid generically speaking. There wasn't a magic bullet or a rock to hide under, but Bill and I were talking about this and we said, the most logical explanation is that the people that would have avoided it got stopped out in one of the last ten cycles that they were too conservative in.
Bill: Yeah. What was it like running your strategy over the last 10 years? It must have felt like, well, every day seems like rates are suppressed and spreads get tighter. It must have been really frustrating.
John: Yeah, it's changed and evolved pretty meaningfully over the past decade. There have been meaningful changes in terms of market structure and how the market transacts. If you go back to pre-GFC when you had CDS, liquidity was as plentiful as you could possibly think and it was very easy to move around in markets. Certainly, that's changed as we've eliminated prop desks and as our market has gotten more transparent. It's kind of funny transparency is actually bad for liquidity.
Bill: Why is that?
John: Well, the cynic in me would say that, "Wall Street cannot make as much money off of us at this point in time." And so, if it's less profitable, they're going to be less engaged in providing liquidity.
Bill: Okay.
John: The way to think about it is how our market works. There's something called TRACE, which is a Trade Reporting and Compliance Engine. If I do a trade with somebody on Wall Street and we decided to go by 2 million [unintelligible [01:11:39] bonds, well, that trade gets posted within 15 minutes of the transaction occurring, and therefore everybody can see that that transaction occurred. And so, if I'm a dealer and let's say, I shorted 2 million bonds to me, in the past pre-2014 that trade may not show up. Only the dealer and I knew that that trade occurred. And so, the dealer would have days to potentially-
Bill: Yeah, more time to go cover.
John: -go cover. And also, nobody would know where they sold bonds as well. So, they could cover a point lower or two points lower. Now, typically the bid-ask spread, meaning, the price between where a bond is bought and sold is typically a quarter point. That's even getting moved lower through competition from electronic trading platforms like market access. So, it's not as profitable. Therefore, we think that liquidity has become much more challenged.
Bill: Yeah, that makes sense, because the liquidity providers can't make as much just providing liquidity, so they disappear and then you're left with market participants that either want to buy or sell, right?
John: Absolutely. So, that's really led to new participants. Like I said, market apps is coming in. There's a number of other platforms, but they're really the market leader here. One of the big things that has changed in our marketplace is the ability to transact all to all. Meaning, we can transact on that platform and interface with another buyside counterparty. We would know who were dealing with, but I think that as liquidity has dried up in the marketplace, people in my position on the buyside asset management standpoint have had to figure out how to pull in more liquidity sources because the sell side hasn't been as willing to step in.
Bill: Hmm. It's interesting how many pockets of illiquidity there are right now. I feel people like Grants were writing about this in 2018 and it just didn't quite matter. Maybe I'm misciting the year, but there have been people that have been saying for a while that liquidity is substantially reduced. I guess, it feels like it hasn't mattered, but it also feels like it's going to matter at some point in a big way. Maybe that's wrong.
John: No, absolutely. I think we saw liquidity matter meaningfully in March of 2020 and that's why, again, the Fed stepped in. A lot of people like to criticize the Fed, but they get an A+ for timing and aggressiveness in March of 2020, which was the alphabet soup of programs to keep the market afloat, the unlimited backstop effectively in terms of buying across asset classes coming into corporate debt all the way down into high yield as well, which was a little bit surprising, buying high yield. We weren't surprised that they were going to buy investment grade. But having that liquidity backstop was important because you can turn cash into anything, but you can't turn anything into cash. The problem in fixed income markets and even in equity markets to a degree as well is that people think you can. If the market goes no bid, meaning, nobody is willing to buy what you're wanting to sell even at effectively any price that leads to a lot of problems.
I think that the fragility of financial markets has continued to expand. I think that you also are seeing the largest asset managers, in my opinion becoming systematically important. Banks get regulated because one of the large banks goes, there's real problems. At this point, if you're managing $7, $10 trillion dollars of capital. It feels like there could be some systematic issues at a point in time.
Bill: Yeah, with a lot of the bigger shops, there's a fair amount of leverage on the books too, yeah? Don't they lever to get higher returns in a lot of these places. I guess, what I'm really thinking about is, if liquidity decreases and somebody holds a book of credit and they're levered, I don't know what are the knock-on effects if we don't have people that are willing to step in and create the market. Maybe I'm making a bigger issue than it is.
John: Well, I think it is very interesting to look at. The easiest things to point to are really the ETFs. As you dip down in terms of size, in terms of credit quality, the more esoteric you go, you'll see that in points of market stress, the premiums and discounts to NAV grow. The question is at what point could something break?
Bill: Yeah.
John: We saw some pretty meaningful discounts and these are in unlevered vehicles now, if you're looking at the closed-end funds or some of these levered ETFs, there are the ability [unintelligible [01:16:46] we've seen ETFs, the VIX ETF get unwound very quickly. So, the short volatility trade, long volatility trade, it's a dangerous type of game here when you're adding leverage and I think there's certainly from a regulatory standpoint, I think we need to be careful about giving all the types of tools that we are giving to end investors.
[music]
[Transcript provided by SpeechDocs Podcast Transcription]