May 9, 2024 • 36 mins
Rising private credit stress will inflict losses on investors and spur volatility, Jerry Cudzil, portfolio manager at TCW Group, says in the latest Credit Edge podcast from Bloomberg Intelligence. “Default rates are going to pick up in a really material way in private credit,” he tells Bloomberg News’ James Crombie and Bloomberg Intelligence Senior Credit Analyst David Havens. “We are currently seeing some real stress,” says Cudzil, who expects “accidents” as documentation weakens and pay-in-kind deals proliferate. Cudzil and Havens also discuss the broader financial markets implications of this turbulence, and how current leverage levels compare with 2007. TCW is underweight corporate credit but sees opportunity in collateralized loan obligations and agency mortgages.
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Episode Transcript
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Speaker 1 (00:17):
Hello, and welcome to the Credit Edge, a weekly markets podcast.
My name is James Crombie. I'm a senior editor at Bloomberg.
This week, we're very pleased to welcome Jerry Kudzill, portfolio
manager at TCW.
Speaker 2 (00:28):
How are you, Jerry, Undo your world Javes, Thanks for asking.
Speaker 1 (00:32):
Thanks so much for joining us today. We're really excited
to dig into your market views and outlook. Also delighted
to welcome back David Havens with Bloomberg Intelligence. Great to
see you again, David, you too great to be with everybody.
So just to set the scene a little bit here,
credit markets are rallying again this month. Government bond yields
are dropping and debt'spreads are grinding tighter. You're not really
not getting very much compensation for the risk of default
(00:54):
or downgrade. The mood is pretty uniformly bullish. We just
had the Milk and Global Conference in La. Sounded very upbeat,
especially about US assets and private markets. Even real estate
seems to be getting back into favor, some of it.
Speaker 2 (01:07):
Anyway.
Speaker 1 (01:08):
Issuers are piling in with seeing record levels of bond
and loan issuance as companies take advantage of a window
to raise debt. They seem to be coming around to
the idea that the FED isn't cutting rates anytime soon.
All of this bullishness scenms founded on a belief that
the US economy will avoid recession. Earnings are solid, most
companies can afford to pay the much higher borrowing costs. Fundamentally,
(01:28):
companies are in a good place. On the other hand,
there also seems to be quite a lot to worry about,
from commercial real estate to war, geopolitics, and elections. I
sense a bit of complacency in credit markets, and your firm, Jerry, TCW,
seems to be one of the very few firms acknowledging that,
at least publicly. Brian Whalen, TCW's a fixed income CIO,
(01:49):
recently warned of a credit market reckoning to come, and
Katie Cock, your president and CEO in Milkin, said that
she sees rising stress and the threat of more defaults. So, Jerry,
what's your take. We had people come on this show recently.
We have them all the time talking about a golden
age for credit and the year of the bond. What
(02:11):
are they getting wrong?
Speaker 2 (02:12):
Well, this is exactly this is exactly where we differ.
I think usually people look. People look at the same
data and come to different conclusions. We all have access
to the same information and what we're looking at and
what we're seeing, I would say, is a significant amount
of stress under the surface. At the same time, you're
(02:35):
looking at credit spreads in the markets at essentially global
financial crisis tights. So what we're saying is we'd love
to talk to you about all the weakness we're seeing
under the surface. And we mentioned it before, but we
have a deep team of people one hundred people outside
that we really lean on to try to get as
(02:55):
coincident or forward looking data as we can. All of
the economic data that's that's published obviously is backward looking,
and so we try to We try to do that
as much as we can. But what we're saying is
that the prospective returns giving these starting levels are just
really difficult uh and ANDRE are challenged in the worst
(03:19):
case scenario certainly could lead to significant loss in portfolios
in the near term.
Speaker 3 (03:25):
So, Jerry, this is David Havens from Bloomberg Intelligence. You
you recently wrote your Nervous for Now, UH Now can
last a long time. You brought up the financial crisis
and there was a period of UH of Pacific markets
for four or five years in the in the run
up to that UH. You mentioned that you're seeing some
things below the surface. Maybe you could expand on that,
(03:47):
maybe the top two or three things that make you
nervous for now other than simply spreads are tight and
markets are, you know, sort of throwing caution to the wind.
Speaker 2 (03:56):
Yeah, I'd say, I'd say there's maybe there's a couple
things that I think are really worth talking about or highlighting, David,
because it's a really good it's a really good point. Look,
we saw we saw two thousand and five through two thousand,
you know, leading into the global financial crisis, spreads were
tight for quite some time. So, as you mentioned, markets
(04:18):
can remain irrational longer than people can remain solvent. And
that's that's true in any market. I think as fundamental
managers we always lean on and just to be clear,
what we what we try to do is say, what
are the fundamentals saying to us? And we can't We
don't know what the technicals will mean, we don't know
when they'll turn. But ultimately we sit in front of
(04:39):
our clients, all we can lean on are the fundamentals
So what are we seeing under the surface that concerns us,
because I think that's the that's the biggest question. I'd
say first is labor market data. I'd say headline, the
headline unemployment data, and the labor market data would imply
that the the consumer is healthy. Would we would say
(05:03):
that we think as you scratch even a little bit
under the surface there, we think the unemployment picture does
not look nearly as robust as the headline data would imply.
And that's just just macro perspective. Why does that matter?
In our opinion, the only inflation and only price you know,
(05:24):
pricing power that companies have is going to be driven
by wages. Then when you look at the credit markets,
and I think this is really important, the fault rate
looks really low. I think we can kind of lull
ourselves to sleep with a two percent to fault rate
and leverage finance markets that the fault rate more than
doubles when you look at distressed exchanges and liability management exercises,
(05:45):
and I think we really need to spend time on
this because there's stress that's happening at the company level.
There's willing sponsors and owners that are supporting it allowing
to happen, and there are owners of the debt that
need to manufacture a higher term that are also doing it.
So when you combine these these uh, these kind of
different liights of the stool here you get a real
(06:07):
toxic brew. And that doesn't happen in healthy markets. You
don't see increase in in picks, you don't see increase
in amendments, and you certainly don't see aggressive liability management
exercises in in in healthy companies.
Speaker 3 (06:21):
Right, So, what what might be the spark that could
create a conflagration?
Speaker 2 (06:26):
You know?
Speaker 3 (06:27):
Again, you know we we've had a couple of situations
where it's either been sort of a European debt issue,
it's obviously the the build up of leveraging the financial
as system prior to the financial crisis. We obviously can't
predict a pandemic. But what what what sparks are you
looking out for?
Speaker 2 (06:45):
For? For us, I'd say simply it's the it's the
unemployment picture. It really gets back to the health of
the consumer. We're all hanging our hat on the resiliency
in the consumer, and I think what we've recently seen
is the excess savings from the pandemic. Well, we know
(07:07):
that's all been burned through, and there's been a you know,
a lot of talk around the people pulling down on
their credit cards. Sure, that's that's happened. A lot of
a lot of people talking now about buy now, pay later.
Sure that's been an increase as well. You typically don't
you don't see the increase in the credit card draw
down in in consumers that that are healthy. As a
(07:30):
matter of fact, now what we're seeing is maintaining of
credit card balances UH pick up in delinquencies that we're
seeing as well, and so it feels like the consumers
really stretched. It's it's we we know that there's a
we we know that prices are high. We know the
cost of living is astronomical. And what we what we're
(07:51):
waiting for and what we think will be pretty significant
is when you can see this this continued increase in
in UH, in unemployment, that's really going to be the
tipping point. I will note that in the in the
employment figures, I think something that that that that probably
should be kind of looked at a little bit further
(08:13):
and we spend a little bit time. We have a
team of people, you know, looking at this and then
the amount of workers who are taking multiple jobs because
of economic reasons, and we've seen that up. We've seen
that increase in a real material way.
Speaker 1 (08:25):
So Jerry your view on the economy. If you think
unemployment is taking up, do you expect a US recession
this year?
Speaker 2 (08:31):
We we do expect the US recession, uh this year.
We are always we're always trying to We're always trying
to be aware and and and be able to succeed
in all markets. So what we would say is, we
don't know how deep the recession will be. Banks are
healthier than they've been in the past, consumers are coming
into this with a significantly healthier balance sheet. This has
(08:53):
been there's been a real appreciation of just net worth
generally between asset prices in real estate and the equity markets.
And so we would just we would we would temper
some of that by saying we do expect a recession.
We do expect the Fed to need to lower rates
and need to lower rates faster than the market perceives.
(09:15):
But the reality is what what we're what we're also
saying is that even a minor or a mild recession,
well whatever kind of recession we get and typically I
don't know, you know, mild recession means significantly wider credit
spreads broadly, and to us, you're not being paid to
absorb any kind of volatility or loss in the marketplace
(09:37):
given where prices.
Speaker 3 (09:37):
Are h So Jerry with with spreads it at historically
tight level, certainly within what I think we would both
we would all agree is tail risk or at least
a tail with the outlook that you have that a
that a recession may occur in the United States, what
does a portfolio management team do? And in the up bond.
Speaker 2 (10:00):
World, Yeah, this is this is the conversation we have
every day because yields are high, right, spreads are tight,
and so everyone is talking about, well, the technicals are
really solid in the in the corporate bond market, they're
really solid in the leverage loan market. Current yields look high.
(10:21):
Yield yields are you can finally earn income in the
corporate world, but you can earn that income because the
risk free rate is high. So what are we doing
in our portfolios. We are moving up in credit quality
across the board. We're doing that in different ways. We're
pulling different levers depending upon the strategies that which we're managing.
(10:43):
So that would mean moving up in quality in corporate bonds,
It would mean shortening our duration in corporate bonds, It
would mean moving into top of the capital structure in
some in some securitized world will triple a clos even
triple a c nbs. And we talked a little bit
(11:04):
about some of the real estate early in the early
commentary as we started, as you started the segment, just
the even real estate's recovered. And we also really like
and find relative value in fixed income in the agency
mortgage market. We think that segment of the of the
market is is really cheap nominally and is really cheap
(11:27):
relative to corporate bonds.
Speaker 3 (11:28):
Okay, So so up and up in quality sounds like
the the idea for now is it does Is there
any sense in your mind to up in credit quality
down in structure anywhere.
Speaker 2 (11:42):
So that we do that a little bit. What we
also try to do is we try to dynamically allocate
throughout the cycle, and to the extent you go down
and structure. Typically there's no alchemy, right David. When you're
trying to enhance your yield by going down in structure,
(12:03):
you are oftentimes selling liquidity, and what that might preclude
you from doing is dynamically allocating your portfolio when volatility
increases to take advantage of some of the dislocations in
the marketplace. So we'll do that. We will take advantage
of some complexity in structure. We've done that in some
(12:23):
esoteric asset backed securities which we find attractive. We've done
that in some structured corporate securities that we find attractive.
But we are making sure that we're also aware and
cognizant of liquidity in the marketplace because you can pick
up significant yield just buying agency mortgages. They traded very
(12:44):
attractive levels. You can stay liquid in the top part
of the capital structure, and colos Colo markets now at
a trillion dollars in the top part of that capital
structure is six hundred billion dollars in size, very liquid,
stay liquid in agency mortgages, which are one of the
more liquid segments of the fixed income market aside from treasuries.
(13:08):
And so you don't really need to sell a bunch
of liquidity to do that, but we'll do it in
pockets where we think we're being compensated.
Speaker 1 (13:15):
I just wanted to back up a bit. Dari Onyle macroview.
The rates thing is interesting to me because it seems
so key right now. We started the year pricing in
six rate cuts this year, now we've gone to one zero,
maybe even a hike. So what's what's the your house view?
Speaker 2 (13:28):
Our house view is that the market has gotten ahead
of itself and gotten too complacent with what we think
the FED will will do, and so our opinion is
that inflation is already coming down. We think some of
the some of the metrics that are critical inputs to
(13:52):
inflation want one of those being rant is a lagged input,
and is is a is a calculated number and not
an observed number in the marketplace. So some of the
observed rents we're seeing are are pretty you know, rolling
over pretty hard. And then what we would say is
(14:13):
that between auto insurance and health insurance, which is one
of the biggest components to the increase in inflation, well,
we think given what's happened to use car prices, which
we think will feed through the new car prices, you
get a little bit of a normalization in auto insurance,
which the FED has no control over whatsoever. So really,
(14:36):
is you know, really that there's nothing interest rate increases
are going to mean for auto insurance. Well, ultimately, what
we're saying is the parts of insurance that the parts
of inflation that will prove to be cyclical, which are
in the Fed's control, have actually already rolled in our
rolling pretty hard. And our opinion is that the inflation
that the inflation numbers that the FED is looking at
(14:58):
on the headline basis don't don't really tell the story.
And so we think the Fed's job has already been achieved. Largely,
I think the Fed's already there, and so our opinion
is that the market's gotten too complacent about that. And
if we see it a little bit of a roll
over the next few months, which we actually think we will,
and you get back to a two point six percent
(15:20):
annualized number and inflation which we don't think we're too
far away from in May. By May, well that's where
we were to start the year, and we had, you know,
and or or in March actually when the FED put
out their summary of economic projections and you had three
rate cuts priced into the marketplace. So our opinion largely
is that you can easily see a scenario where you
(15:41):
get a couple of softer prints, you get confirmation of
this this this labor market as we saw in non
farm payrolls on Friday, and you get you get that
to continue to roll through the market over the next
couple of months, and then you're pricing a few more cuts,
which we think is is is probably the base in
our view.
Speaker 1 (16:00):
But that's pretty bullish for corporate credit. But you're and
yet you're underweight, So I'm kind of trying to reconcile
those two.
Speaker 2 (16:06):
Well, the question around the reason for the cuts, you're
right in the first order, and the market reaction in
the first order has been if we see if we
see rate cuts, that's positive for risk acids. And if
we see rate cuts, then the equity market should rally
and corporate spreads should rally. And what we what we
(16:31):
might see is a scenario where we're seeing rate cuts
because the economy is slowing down, so risk assets are
actually not going to behave well in the in that scenario,
and we haven't we haven't yet seen that. It's more
been about liquidity. It's more been about we have a
discount rate in the risk free rate, we lower that rate,
(16:52):
and then we artificially or or or not artificially, but
we just inflate asset prices higher. That may not happen
to the extent that you're seeing in economic slow down
which the FED is responding to, and that economic slowdown
is leading to a recession that's typically not positive for
corporate spreads, not positive for equity markets. Ultimately, if the
FED gets more aggressive and more accommodative at some point,
(17:16):
it will mean that you can see a remediation and
inflection back in spreads. But we don't think that's where
we don't we don't think that that's where it's where
it's hit.
Speaker 1 (17:24):
So just back to real estate, Jerry, I mean, you
talk about it as an opportunity. We've had people on
this show talk about it as a trillion dollar opportunity,
and others are running scared and saying it's going to
bring down the banks. You know, it's going to wipe
out hundreds of regional banks, which would be very problematic
for rule markets. So what's the opportunity for you guys
in terms of real estate?
Speaker 2 (17:46):
We we think we think real estate is an opportunity
in the marketplace. We are not We're not running from
real estate. We do believe it might be and will
continue to be ahead wind for regional banks broadly, we
think that systemically critical banks in the US and the
(18:06):
super regional banks in the US are very well capitalized
in there any kind of real estate stress will not
be a problem for for the systemically critical banks. What
we would say is where where are we seeing opportunity.
We think there's there's opportunity in prime UH in prime
uh cnbs, which is a single asset, single borrowers, where
(18:30):
we're seeing the majority of the opportunity. At this point.
There's been a significant remediation UH in UH in most
markets as as we've as we've talked about, and that
that has not precluded there from being opportunity in specific
areas of commercial real estate. There's been remediation in retail.
(18:51):
There's been remediation in hotel. There has not been remediation
in office too. You know, trade signial figuredly wide offer value.
You have to do a significant amount of homework because
all of these properties are very different. So there's you know,
a lot, a lot of credit work needs to be done,
(19:12):
a lot a lot of on the ground work needs
to be done, and then when you do that, you
can buy very good assets at levels that we think
will will provide very attractive total returns over the medium term,
and that that might take It might take six months,
it might take a couple of years, but we think
(19:33):
owning those assets over the over the medium term will
prove beneficial for our clients.
Speaker 1 (19:39):
But what's changed recently, Jerry? There seems to have been
this impasse between buyers and sellers that you know, the
sellers didn't really want to accept the new valuations which
would much lower. Have they started to become more realistic
in their assessment a little bit?
Speaker 2 (19:51):
Sporadically, some have been forced. We have seen a few
a few forced sells. We have seen a few liquidations.
We've also seen a lot still are seeing the one
year extensions or the modifications. Those are still making their
(20:12):
way through through the marketplace. What what has happened a
little bit is you know, look, you know, interest rates
came down, uh from from last year. They've they've they've
moved back higher. But the one hundred basis point move
lower and interest rates was was helpful. We did see
(20:33):
capital and and money raised. And the longer that rates
sit at higher levels, and the longer that you get
or the closer you get to maturity. You know, the
reality is it just comes up. It just comes up
on people, and you're forced to deal with it. You
just have you have to deal with it in some level.
And so and then transactions beget transactions. So we do
(20:54):
think that over time we start seeing a few a
few liquidations, that'll probably mean more more assets will trade
with the more time that passes. Because you we we
are coming up on maturity walls enough people have have
talked about on this show and many others.
Speaker 3 (21:10):
Jerry, we're a couple dozen minutes into into this podcast,
and amazingly, I don't think we've uttered the phrase private
debt or private credit seems to be just about the
sort of most talked about area in uh in credit
maybe finance these days. Uh, what are you seeing there?
You guys have been engaged for a while. You guys
(21:31):
are affiliated with with Carlisle, which I probably has some insight, uh,
you know, into that market as well. So, so what's
going on from your perspective?
Speaker 2 (21:41):
I'm really glad you asked. Uh, there's a lot going
on in private credit, as we all know. Every and
and you know, milk Milkin's finishing up and obviously the
topic of every conversation UH was was private credit. We
announced our own private credit deal on on Monday with
(22:02):
PNC and TCW has been doing investing in private credit.
We have a private credit team has been investing in
private credit for twenty years. Ninety five percent of private
credit funds have started post global financial crisis, approximately almost
almost all of them, and there's been a lot of
capital that's been raised. And any time you see the excesses,
(22:26):
and anytime you see the shape of the curve as
the way it is meaning the assets are raised, they
look like a hockey stick. There's this massive spike, this
massive j curve, almost vertical in the assets that have
been raised in private credit, and it's the golden age
for private credit, and private credit is going to take
over every liquid market. What we would say is we
(22:48):
believe in private credit long term. We believe that private
credit structurally makes a lot of sense. In portfolios we have,
we have we are investing actively in private credit. What
we would also acknowledge is that we also believe there
is a significant period of volatility between now and what
(23:10):
we believe to be kind of this structural growth in
private credit. We believe the fault rates are going to
pick up in a really material way in private credit.
We think there's going to be volatility in private credit,
and we do not think that private credit is going
to cannibalize the liquid market. We don't think private credit
is a thirty trillion dollar opportunity. We do believe private
(23:32):
credit is a very significant opportunity. We do not want
to undersell that. We do believe that, but we just
want to be careful. Our clients need liquidity. Now. We
talk to our we talk to pension funds. We manage
money for corporations and pensions and cities and hospital systems
across the country, and what we would say is that
there's a place where they can sell liquidity just like
(23:56):
we can, and then there is a place in their
portfolio for quid assets that you're going to need to
carry you out. So there's a lot to talk about,
but what we would say is we are currently seeing
some real stress in private credit, some real weakening of
docks in private credit, and that's a function of the
capital that's been raised, and we think that will most
likely lead to some accidents in private credit.
Speaker 3 (24:17):
Yeah, I mean, it almost seems inevitable that that will happen,
given the amount of growth and maybe some of the
tourists that de vender the sector. They're definitely cross currents
in terms of the opportunity. There are some of the
largest managers in the world saying it is a golden
age for credit, and then there are chicken littles out
there saying the sky is falling. We had similar talk
(24:39):
in the run up to the financial crisis, but that
point we had, you know, financial entities that were levered
fifty to one, one hundred to one and such. Private
credit seems to be much less levered. So even if
we do have some accidents, do you what sort of
a systemic impact do you think that would have?
Speaker 2 (24:56):
We don't think. We don't think that private credit will
will have anywhere near the impact of a global financial crisis.
We clearly the leverage that was in the system. There
were credit hedge funds that were leveraged five to seven
times heading into global financial crisis, and then there were
(25:17):
liquid macro funds that were levered twenty to forty times
going into the global financial crisis. And private credit today
is probably levered one times, right, I mean, we all
so that what we What we would say is that
there's a really nice window into private credit and that's
the BDC market. And the BDC market, by any estimation,
(25:42):
hold somewhere around a third of private credit. Maybe it's
as much as forty percent, but let's say it's, you know,
a little bit less. What we're you're seeing is a
real increase in amendments and a real increase in payment
and kind or pick notes. These are these are where
companies can can't pay their coupons and so what do
(26:03):
they do? They pay you with more more bots. They
call it payment in kind pick notes. Healthy companies don't
pick their coupons. That's not that's not what's happening, right,
So what we would say is there's some real stress
that's that's being masked with some pick notes. That's that's
happening in real time. The flexibility of private credit capital
(26:25):
Colonel and can can deal with that. That that is true.
And the other thing that I would that I would
mention is that look private credit, the whole story is
that there's a match between the assets that are raised,
uh and then the the loans that are made and
they So what we say is there's a real match.
There's also true that LPs get committed to multiple funds
(26:49):
and typically get called all those funds at the same time,
and then there is leverage, and that leverage doesn't match
the maturity on those loans. And so I don't think
it'll be We don't. We don't think it'll be anywhere
near a systemic issue. We also don't think it is
without volatility, and we also don't think it's without potentially
significant loss, and probably more volatility and loss than some
(27:13):
of the cheerleaders would lead you to belief, but certainly
not as much volatility and loss as some of the
people who would tell you the world and the world
is ending in the sky is falling.
Speaker 1 (27:22):
And when you say more to faults, are you able
to quantify that? I mean, we've got let's say six
percent by some estimates in public high yield at the
moment if you factor in leverage, loans and distress exchanges
and all that stuff. But on the on the private side,
what do you expect and how do you even see it?
Because some of this stuff will just go unto the radar.
Speaker 2 (27:42):
You can, yeah, how do you see it? You only
would see it in what is the impaired assets in
in BDC's and what you might get from some private
credit you know, kind of annual report which you know
if you have to be an investor to see to
(28:02):
see it. Our opinion and any estimation that you'll read,
is that the private credit default rate and the public
credit default rate don't look all that dissimilar. They tend
to they tend to move together. As a matter of fact,
there's there's been a there's a recent report out that
says that the private credit default rate is within fifty
(28:24):
basis points of the public credit default rate. And so
I think it's with anybody's best guess that if you're
seeing a four and a half percent default rate in
the lverage finance markets currently with disdrastic changes and defaults,
it would not it wouldn't be a stretch to think
that you're seeing a very similar default experience in private credit,
(28:45):
even if you're not realizing that today.
Speaker 1 (28:47):
So, in terms of the all of the stuff you
look at, Jerry, and you mentioned relative value earlier, which
is my favorite topic for this show. You see you
see relative value in the mortgage back stuff, but in
sense of like one thing you had to pick right
now and I think you have a global mandate, right,
So what would you put your finger on and say
is the best in credit at the moment.
Speaker 2 (29:09):
Well, I'd say in fixed income it's agency mortgages. So
we would say that as we look at credit, if
we're including securitize credit, I would say it's double A
or triple A clos. The spreads that you can realize
on double A or triple A clos at one hundred
and fifty and two hundred basis points look very attractive,
(29:33):
both on a nominal basis and on a relative basis.
And then as you start to move, as you start
to move out the quality spectrum and the credit spectrum,
what we would say is you're probably supposed to be
in high quality investment grade. That's probably the easiest. That's
(29:56):
probably the easiest investment you can make at five and
a half percent. And if you can take, if you
can take risk and default, you're starting yields on leverage
loans at nine percent, certainly give you, certainly give you
a nice ability to absorb loss and default. You have
(30:17):
to be very specific about what you choose. I mean,
what we would say is, you know you've heard some
of our concerns on credit and liability management exercises and
default rates in LME. So I would you know, we
would caution it's not for the faint of heart. We
would also say that the good news about that is
you're starting You're starting with the current yield that is
(30:40):
nine percent, and that will give you the ability to
absorb some volatility and some loss.
Speaker 1 (30:44):
But all that stuff you're mentioning, I mean, including the
triple A clos must be quite exposed to a big
shake out, you know, if there is an increase in volatility.
I mean, there's lots of things on the horizon. There's
two walls, as an election in the US coming up,
there's all sorts of things that could potentially increase spread significantly.
You know, as you mentioned, complacency seems to be dominating
(31:07):
now that could well change. How do you hedge against
against that? Because you know your your house view, you're
talking about a reckoning, you're talking about well defaults, you're
talking about stress. But but again, at the same time,
you seem to be you know, expressing, you know, somewhat
of a benign view in terms of your portfolio.
Speaker 2 (31:24):
Well, the highest level portfolio of you that I can
give you and we can we can be as transparent
as we can is we are long duration, we are
underweight corporate credit in a very significant way. So we're
higher quality, but we are underweight corporate credit. We are
overweight agency mortgages, and we have a small allocation to
(31:50):
CMBs in the in the grand scheme of things, because
as much as we are finding opportunity there, we are
also aware there's been significant remedia. So when you think
about that, we are we're expressing a very pronounced view
with incremental liquidity and portfolios with higher quality assets in
(32:16):
agency mortgages, a significant underweight to corporate credit, and we
are using a very small part of our risk budget
in areas where we think there's opportunity, but giving ourselves
ample room to add to situations because the reality is
(32:36):
we are supposed to stay invested, we are supposed to
run diverse portfolios, and we don't know when the time
is going to be, when the markets will turn, and
so what do we try to do. We try to
set our portfolios up that can perform in a lot
of different market environments. Right now, the portfolio carries a
little bit more than that of the index thanks to
agency mortgages to be honest, because they trade so relatively wide.
(33:00):
And at the same time, what we think is not
introduce a significant amount of credit risk and and that
and that is going to give us the ability to
we think, carry well while we wait for volatility and
then have the ability to take advantage of that volatility.
Given how we're.
Speaker 1 (33:15):
Set up, and what are you most worried about in
terms of the next six to twelve months, there's.
Speaker 2 (33:20):
A few things that that that really that really concern us.
I'd say the first the first thing is is the
is the consumer and jobs. I mean, we're really focused.
We spend a lot of time on the health of
the consumer because the and and it feels like there's
(33:41):
a lot of folks on one side and and it
and and the world's expensive, and we don't believe the
consumer is is healthy. So I'd say the thing that
concerns us the most, uh, you know, is is the
consumer that will drive that will drive the economy. Obvious,
the long list of geopolitics, we think they're really difficult
(34:03):
to navigate and invest around, and we try to look
through a lot of that. Having said that, the the
the deterioration in geopolitics broadly is worrisome, is concerning, and
that has led to you know, a a a near shoring,
(34:29):
a friend shoring, you know, has led to supply chains,
you know, redundancy that that we're spending some time on
and trying to think through. And it's longer term and
it's longer term impact. And the last thing we spent,
like I said, we spent forty minutes on this call.
Haven't mentioned the letters AI either. I'd say, you know,
(34:52):
a lot of investment, a lot of hype. There was
a lot of hype on the internet in two thousand
and a lot of companies went b So we would
say we believe in AI long term. We believe that
half the companies in the US today have don't even
have the ability to implement anything with AI. And so
there's the real next leg in AI as we see it,
(35:16):
and we believe in AI is the adoption from the
company level. And as much as we think that's gonna happen,
there's definitely a long tailed of some of that. So
we are constructive on AI. We're implementing it here, but
what we would say, it's not not a straight line either.
Speaker 1 (35:36):
Great stuff. Jerry Kudzill, portfolio manager at TCW. Thank you
very much for coming on the Credit Edge.
Speaker 2 (35:42):
Thank you guys, Thanks James, Thanks David, I appreciate it.
Speaker 1 (35:44):
And to David Havens the Bloomberg Intelligence, thanks for being.
Speaker 2 (35:46):
On the show.
Speaker 3 (35:47):
Great being with you.
Speaker 1 (35:49):
Check out all of David's excellent analysis on the Bloomberg Terminal,
and please do subscribe wherever you get your podcasts. We're
on Apple, Spotify and all other good podcast providers, including
The Bloomberg Terminal. Give us a review, tell your friends,
or email me directly at jcrombieight at Bloomberg dot net.
I'm James Crombie. It's been a pleasure having you join
us again next week on the Credit Edge.
Hello, and welcome to the Credit Edge, a weekly markets podcast.
My name is James Crombie. I'm a senior editor at Bloomberg.
This week, we're very pleased to welcome Jerry Kudzill, portfolio
manager at TCW.
Speaker 2 (00:28):
How are you, Jerry, Undo your world Javes, Thanks for asking.
Speaker 1 (00:32):
Thanks so much for joining us today. We're really excited
to dig into your market views and outlook. Also delighted
to welcome back David Havens with Bloomberg Intelligence. Great to
see you again, David, you too great to be with everybody.
So just to set the scene a little bit here,
credit markets are rallying again this month. Government bond yields
are dropping and debt'spreads are grinding tighter. You're not really
not getting very much compensation for the risk of default
(00:54):
or downgrade. The mood is pretty uniformly bullish. We just
had the Milk and Global Conference in La. Sounded very upbeat,
especially about US assets and private markets. Even real estate
seems to be getting back into favor, some of it.
Speaker 2 (01:07):
Anyway.
Speaker 1 (01:08):
Issuers are piling in with seeing record levels of bond
and loan issuance as companies take advantage of a window
to raise debt. They seem to be coming around to
the idea that the FED isn't cutting rates anytime soon.
All of this bullishness scenms founded on a belief that
the US economy will avoid recession. Earnings are solid, most
companies can afford to pay the much higher borrowing costs. Fundamentally,
(01:28):
companies are in a good place. On the other hand,
there also seems to be quite a lot to worry about,
from commercial real estate to war, geopolitics, and elections. I
sense a bit of complacency in credit markets, and your firm, Jerry, TCW,
seems to be one of the very few firms acknowledging that,
at least publicly. Brian Whalen, TCW's a fixed income CIO,
(01:49):
recently warned of a credit market reckoning to come, and
Katie Cock, your president and CEO in Milkin, said that
she sees rising stress and the threat of more defaults. So, Jerry,
what's your take. We had people come on this show recently.
We have them all the time talking about a golden
age for credit and the year of the bond. What
(02:11):
are they getting wrong?
Speaker 2 (02:12):
Well, this is exactly this is exactly where we differ.
I think usually people look. People look at the same
data and come to different conclusions. We all have access
to the same information and what we're looking at and
what we're seeing, I would say, is a significant amount
of stress under the surface. At the same time, you're
(02:35):
looking at credit spreads in the markets at essentially global
financial crisis tights. So what we're saying is we'd love
to talk to you about all the weakness we're seeing
under the surface. And we mentioned it before, but we
have a deep team of people one hundred people outside
that we really lean on to try to get as
(02:55):
coincident or forward looking data as we can. All of
the economic data that's that's published obviously is backward looking,
and so we try to We try to do that
as much as we can. But what we're saying is
that the prospective returns giving these starting levels are just
really difficult uh and ANDRE are challenged in the worst
(03:19):
case scenario certainly could lead to significant loss in portfolios
in the near term.
Speaker 3 (03:25):
So, Jerry, this is David Havens from Bloomberg Intelligence. You
you recently wrote your Nervous for Now, UH Now can
last a long time. You brought up the financial crisis
and there was a period of UH of Pacific markets
for four or five years in the in the run
up to that UH. You mentioned that you're seeing some
things below the surface. Maybe you could expand on that,
(03:47):
maybe the top two or three things that make you
nervous for now other than simply spreads are tight and
markets are, you know, sort of throwing caution to the wind.
Speaker 2 (03:56):
Yeah, I'd say, I'd say there's maybe there's a couple
things that I think are really worth talking about or highlighting, David,
because it's a really good it's a really good point. Look,
we saw we saw two thousand and five through two thousand,
you know, leading into the global financial crisis, spreads were
tight for quite some time. So, as you mentioned, markets
(04:18):
can remain irrational longer than people can remain solvent. And
that's that's true in any market. I think as fundamental
managers we always lean on and just to be clear,
what we what we try to do is say, what
are the fundamentals saying to us? And we can't We
don't know what the technicals will mean, we don't know
when they'll turn. But ultimately we sit in front of
(04:39):
our clients, all we can lean on are the fundamentals
So what are we seeing under the surface that concerns us,
because I think that's the that's the biggest question. I'd
say first is labor market data. I'd say headline, the
headline unemployment data, and the labor market data would imply
that the the consumer is healthy. Would we would say
(05:03):
that we think as you scratch even a little bit
under the surface there, we think the unemployment picture does
not look nearly as robust as the headline data would imply.
And that's just just macro perspective. Why does that matter?
In our opinion, the only inflation and only price you know,
(05:24):
pricing power that companies have is going to be driven
by wages. Then when you look at the credit markets,
and I think this is really important, the fault rate
looks really low. I think we can kind of lull
ourselves to sleep with a two percent to fault rate
and leverage finance markets that the fault rate more than
doubles when you look at distressed exchanges and liability management exercises,
(05:45):
and I think we really need to spend time on
this because there's stress that's happening at the company level.
There's willing sponsors and owners that are supporting it allowing
to happen, and there are owners of the debt that
need to manufacture a higher term that are also doing it.
So when you combine these these uh, these kind of
different liights of the stool here you get a real
(06:07):
toxic brew. And that doesn't happen in healthy markets. You
don't see increase in in picks, you don't see increase
in amendments, and you certainly don't see aggressive liability management
exercises in in in healthy companies.
Speaker 3 (06:21):
Right, So, what what might be the spark that could
create a conflagration?
Speaker 2 (06:26):
You know?
Speaker 3 (06:27):
Again, you know we we've had a couple of situations
where it's either been sort of a European debt issue,
it's obviously the the build up of leveraging the financial
as system prior to the financial crisis. We obviously can't
predict a pandemic. But what what what sparks are you
looking out for?
Speaker 2 (06:45):
For? For us, I'd say simply it's the it's the
unemployment picture. It really gets back to the health of
the consumer. We're all hanging our hat on the resiliency
in the consumer, and I think what we've recently seen
is the excess savings from the pandemic. Well, we know
(07:07):
that's all been burned through, and there's been a you know,
a lot of talk around the people pulling down on
their credit cards. Sure, that's that's happened. A lot of
a lot of people talking now about buy now, pay later.
Sure that's been an increase as well. You typically don't
you don't see the increase in the credit card draw
down in in consumers that that are healthy. As a
(07:30):
matter of fact, now what we're seeing is maintaining of
credit card balances UH pick up in delinquencies that we're
seeing as well, and so it feels like the consumers
really stretched. It's it's we we know that there's a
we we know that prices are high. We know the
cost of living is astronomical. And what we what we're
(07:51):
waiting for and what we think will be pretty significant
is when you can see this this continued increase in
in UH, in unemployment, that's really going to be the
tipping point. I will note that in the in the
employment figures, I think something that that that that probably
should be kind of looked at a little bit further
(08:13):
and we spend a little bit time. We have a
team of people, you know, looking at this and then
the amount of workers who are taking multiple jobs because
of economic reasons, and we've seen that up. We've seen
that increase in a real material way.
Speaker 1 (08:25):
So Jerry your view on the economy. If you think
unemployment is taking up, do you expect a US recession
this year?
Speaker 2 (08:31):
We we do expect the US recession, uh this year.
We are always we're always trying to We're always trying
to be aware and and and be able to succeed
in all markets. So what we would say is, we
don't know how deep the recession will be. Banks are
healthier than they've been in the past, consumers are coming
into this with a significantly healthier balance sheet. This has
(08:53):
been there's been a real appreciation of just net worth
generally between asset prices in real estate and the equity markets.
And so we would just we would we would temper
some of that by saying we do expect a recession.
We do expect the Fed to need to lower rates
and need to lower rates faster than the market perceives.
(09:15):
But the reality is what what we're what we're also
saying is that even a minor or a mild recession,
well whatever kind of recession we get and typically I
don't know, you know, mild recession means significantly wider credit
spreads broadly, and to us, you're not being paid to
absorb any kind of volatility or loss in the marketplace
(09:37):
given where prices.
Speaker 3 (09:37):
Are h So Jerry with with spreads it at historically
tight level, certainly within what I think we would both
we would all agree is tail risk or at least
a tail with the outlook that you have that a
that a recession may occur in the United States, what
does a portfolio management team do? And in the up bond.
Speaker 2 (10:00):
World, Yeah, this is this is the conversation we have
every day because yields are high, right, spreads are tight,
and so everyone is talking about, well, the technicals are
really solid in the in the corporate bond market, they're
really solid in the leverage loan market. Current yields look high.
(10:21):
Yield yields are you can finally earn income in the
corporate world, but you can earn that income because the
risk free rate is high. So what are we doing
in our portfolios. We are moving up in credit quality
across the board. We're doing that in different ways. We're
pulling different levers depending upon the strategies that which we're managing.
(10:43):
So that would mean moving up in quality in corporate bonds,
It would mean shortening our duration in corporate bonds, It
would mean moving into top of the capital structure in
some in some securitized world will triple a clos even
triple a c nbs. And we talked a little bit
(11:04):
about some of the real estate early in the early
commentary as we started, as you started the segment, just
the even real estate's recovered. And we also really like
and find relative value in fixed income in the agency
mortgage market. We think that segment of the of the
market is is really cheap nominally and is really cheap
(11:27):
relative to corporate bonds.
Speaker 3 (11:28):
Okay, So so up and up in quality sounds like
the the idea for now is it does Is there
any sense in your mind to up in credit quality
down in structure anywhere.
Speaker 2 (11:42):
So that we do that a little bit. What we
also try to do is we try to dynamically allocate
throughout the cycle, and to the extent you go down
and structure. Typically there's no alchemy, right David. When you're
trying to enhance your yield by going down in structure,
(12:03):
you are oftentimes selling liquidity, and what that might preclude
you from doing is dynamically allocating your portfolio when volatility
increases to take advantage of some of the dislocations in
the marketplace. So we'll do that. We will take advantage
of some complexity in structure. We've done that in some
(12:23):
esoteric asset backed securities which we find attractive. We've done
that in some structured corporate securities that we find attractive.
But we are making sure that we're also aware and
cognizant of liquidity in the marketplace because you can pick
up significant yield just buying agency mortgages. They traded very
(12:44):
attractive levels. You can stay liquid in the top part
of the capital structure, and colos Colo markets now at
a trillion dollars in the top part of that capital
structure is six hundred billion dollars in size, very liquid,
stay liquid in agency mortgages, which are one of the
more liquid segments of the fixed income market aside from treasuries.
(13:08):
And so you don't really need to sell a bunch
of liquidity to do that, but we'll do it in
pockets where we think we're being compensated.
Speaker 1 (13:15):
I just wanted to back up a bit. Dari Onyle macroview.
The rates thing is interesting to me because it seems
so key right now. We started the year pricing in
six rate cuts this year, now we've gone to one zero,
maybe even a hike. So what's what's the your house view?
Speaker 2 (13:28):
Our house view is that the market has gotten ahead
of itself and gotten too complacent with what we think
the FED will will do, and so our opinion is
that inflation is already coming down. We think some of
the some of the metrics that are critical inputs to
(13:52):
inflation want one of those being rant is a lagged input,
and is is a is a calculated number and not
an observed number in the marketplace. So some of the
observed rents we're seeing are are pretty you know, rolling
over pretty hard. And then what we would say is
(14:13):
that between auto insurance and health insurance, which is one
of the biggest components to the increase in inflation, well,
we think given what's happened to use car prices, which
we think will feed through the new car prices, you
get a little bit of a normalization in auto insurance,
which the FED has no control over whatsoever. So really,
(14:36):
is you know, really that there's nothing interest rate increases
are going to mean for auto insurance. Well, ultimately, what
we're saying is the parts of insurance that the parts
of inflation that will prove to be cyclical, which are
in the Fed's control, have actually already rolled in our
rolling pretty hard. And our opinion is that the inflation
that the inflation numbers that the FED is looking at
(14:58):
on the headline basis don't don't really tell the story.
And so we think the Fed's job has already been achieved. Largely,
I think the Fed's already there, and so our opinion
is that the market's gotten too complacent about that. And
if we see it a little bit of a roll
over the next few months, which we actually think we will,
and you get back to a two point six percent
(15:20):
annualized number and inflation which we don't think we're too
far away from in May. By May, well that's where
we were to start the year, and we had, you know,
and or or in March actually when the FED put
out their summary of economic projections and you had three
rate cuts priced into the marketplace. So our opinion largely
is that you can easily see a scenario where you
(15:41):
get a couple of softer prints, you get confirmation of
this this this labor market as we saw in non
farm payrolls on Friday, and you get you get that
to continue to roll through the market over the next
couple of months, and then you're pricing a few more cuts,
which we think is is is probably the base in
our view.
Speaker 1 (16:00):
But that's pretty bullish for corporate credit. But you're and
yet you're underweight, So I'm kind of trying to reconcile
those two.
Speaker 2 (16:06):
Well, the question around the reason for the cuts, you're
right in the first order, and the market reaction in
the first order has been if we see if we
see rate cuts, that's positive for risk acids. And if
we see rate cuts, then the equity market should rally
and corporate spreads should rally. And what we what we
(16:31):
might see is a scenario where we're seeing rate cuts
because the economy is slowing down, so risk assets are
actually not going to behave well in the in that scenario,
and we haven't we haven't yet seen that. It's more
been about liquidity. It's more been about we have a
discount rate in the risk free rate, we lower that rate,
(16:52):
and then we artificially or or or not artificially, but
we just inflate asset prices higher. That may not happen
to the extent that you're seeing in economic slow down
which the FED is responding to, and that economic slowdown
is leading to a recession that's typically not positive for
corporate spreads, not positive for equity markets. Ultimately, if the
FED gets more aggressive and more accommodative at some point,
(17:16):
it will mean that you can see a remediation and
inflection back in spreads. But we don't think that's where
we don't we don't think that that's where it's where
it's hit.
Speaker 1 (17:24):
So just back to real estate, Jerry, I mean, you
talk about it as an opportunity. We've had people on
this show talk about it as a trillion dollar opportunity,
and others are running scared and saying it's going to
bring down the banks. You know, it's going to wipe
out hundreds of regional banks, which would be very problematic
for rule markets. So what's the opportunity for you guys
in terms of real estate?
Speaker 2 (17:46):
We we think we think real estate is an opportunity
in the marketplace. We are not We're not running from
real estate. We do believe it might be and will
continue to be ahead wind for regional banks broadly, we
think that systemically critical banks in the US and the
(18:06):
super regional banks in the US are very well capitalized
in there any kind of real estate stress will not
be a problem for for the systemically critical banks. What
we would say is where where are we seeing opportunity.
We think there's there's opportunity in prime UH in prime
uh cnbs, which is a single asset, single borrowers, where
(18:30):
we're seeing the majority of the opportunity. At this point.
There's been a significant remediation UH in UH in most
markets as as we've as we've talked about, and that
that has not precluded there from being opportunity in specific
areas of commercial real estate. There's been remediation in retail.
(18:51):
There's been remediation in hotel. There has not been remediation
in office too. You know, trade signial figuredly wide offer value.
You have to do a significant amount of homework because
all of these properties are very different. So there's you know,
a lot, a lot of credit work needs to be done,
(19:12):
a lot a lot of on the ground work needs
to be done, and then when you do that, you
can buy very good assets at levels that we think
will will provide very attractive total returns over the medium term,
and that that might take It might take six months,
it might take a couple of years, but we think
(19:33):
owning those assets over the over the medium term will
prove beneficial for our clients.
Speaker 1 (19:39):
But what's changed recently, Jerry? There seems to have been
this impasse between buyers and sellers that you know, the
sellers didn't really want to accept the new valuations which
would much lower. Have they started to become more realistic
in their assessment a little bit?
Speaker 2 (19:51):
Sporadically, some have been forced. We have seen a few
a few forced sells. We have seen a few liquidations.
We've also seen a lot still are seeing the one
year extensions or the modifications. Those are still making their
(20:12):
way through through the marketplace. What what has happened a
little bit is you know, look, you know, interest rates
came down, uh from from last year. They've they've they've
moved back higher. But the one hundred basis point move
lower and interest rates was was helpful. We did see
(20:33):
capital and and money raised. And the longer that rates
sit at higher levels, and the longer that you get
or the closer you get to maturity. You know, the
reality is it just comes up. It just comes up
on people, and you're forced to deal with it. You
just have you have to deal with it in some level.
And so and then transactions beget transactions. So we do
(20:54):
think that over time we start seeing a few a
few liquidations, that'll probably mean more more assets will trade
with the more time that passes. Because you we we
are coming up on maturity walls enough people have have
talked about on this show and many others.
Speaker 3 (21:10):
Jerry, we're a couple dozen minutes into into this podcast,
and amazingly, I don't think we've uttered the phrase private
debt or private credit seems to be just about the
sort of most talked about area in uh in credit
maybe finance these days. Uh, what are you seeing there?
You guys have been engaged for a while. You guys
(21:31):
are affiliated with with Carlisle, which I probably has some insight, uh,
you know, into that market as well. So, so what's
going on from your perspective?
Speaker 2 (21:41):
I'm really glad you asked. Uh, there's a lot going
on in private credit, as we all know. Every and
and you know, milk Milkin's finishing up and obviously the
topic of every conversation UH was was private credit. We
announced our own private credit deal on on Monday with
(22:02):
PNC and TCW has been doing investing in private credit.
We have a private credit team has been investing in
private credit for twenty years. Ninety five percent of private
credit funds have started post global financial crisis, approximately almost
almost all of them, and there's been a lot of
capital that's been raised. And any time you see the excesses,
(22:26):
and anytime you see the shape of the curve as
the way it is meaning the assets are raised, they
look like a hockey stick. There's this massive spike, this
massive j curve, almost vertical in the assets that have
been raised in private credit, and it's the golden age
for private credit, and private credit is going to take
over every liquid market. What we would say is we
(22:48):
believe in private credit long term. We believe that private
credit structurally makes a lot of sense. In portfolios we have,
we have we are investing actively in private credit. What
we would also acknowledge is that we also believe there
is a significant period of volatility between now and what
(23:10):
we believe to be kind of this structural growth in
private credit. We believe the fault rates are going to
pick up in a really material way in private credit.
We think there's going to be volatility in private credit,
and we do not think that private credit is going
to cannibalize the liquid market. We don't think private credit
is a thirty trillion dollar opportunity. We do believe private
(23:32):
credit is a very significant opportunity. We do not want
to undersell that. We do believe that, but we just
want to be careful. Our clients need liquidity. Now. We
talk to our we talk to pension funds. We manage
money for corporations and pensions and cities and hospital systems
across the country, and what we would say is that
there's a place where they can sell liquidity just like
(23:56):
we can, and then there is a place in their
portfolio for quid assets that you're going to need to
carry you out. So there's a lot to talk about,
but what we would say is we are currently seeing
some real stress in private credit, some real weakening of
docks in private credit, and that's a function of the
capital that's been raised, and we think that will most
likely lead to some accidents in private credit.
Speaker 3 (24:17):
Yeah, I mean, it almost seems inevitable that that will happen,
given the amount of growth and maybe some of the
tourists that de vender the sector. They're definitely cross currents
in terms of the opportunity. There are some of the
largest managers in the world saying it is a golden
age for credit, and then there are chicken littles out
there saying the sky is falling. We had similar talk
(24:39):
in the run up to the financial crisis, but that
point we had, you know, financial entities that were levered
fifty to one, one hundred to one and such. Private
credit seems to be much less levered. So even if
we do have some accidents, do you what sort of
a systemic impact do you think that would have?
Speaker 2 (24:56):
We don't think. We don't think that private credit will
will have anywhere near the impact of a global financial crisis.
We clearly the leverage that was in the system. There
were credit hedge funds that were leveraged five to seven
times heading into global financial crisis, and then there were
(25:17):
liquid macro funds that were levered twenty to forty times
going into the global financial crisis. And private credit today
is probably levered one times, right, I mean, we all
so that what we What we would say is that
there's a really nice window into private credit and that's
the BDC market. And the BDC market, by any estimation,
(25:42):
hold somewhere around a third of private credit. Maybe it's
as much as forty percent, but let's say it's, you know,
a little bit less. What we're you're seeing is a
real increase in amendments and a real increase in payment
and kind or pick notes. These are these are where
companies can can't pay their coupons and so what do
(26:03):
they do? They pay you with more more bots. They
call it payment in kind pick notes. Healthy companies don't
pick their coupons. That's not that's not what's happening, right,
So what we would say is there's some real stress
that's that's being masked with some pick notes. That's that's
happening in real time. The flexibility of private credit capital
(26:25):
Colonel and can can deal with that. That that is true.
And the other thing that I would that I would
mention is that look private credit, the whole story is
that there's a match between the assets that are raised,
uh and then the the loans that are made and
they So what we say is there's a real match.
There's also true that LPs get committed to multiple funds
(26:49):
and typically get called all those funds at the same time,
and then there is leverage, and that leverage doesn't match
the maturity on those loans. And so I don't think
it'll be We don't. We don't think it'll be anywhere
near a systemic issue. We also don't think it is
without volatility, and we also don't think it's without potentially
significant loss, and probably more volatility and loss than some
(27:13):
of the cheerleaders would lead you to belief, but certainly
not as much volatility and loss as some of the
people who would tell you the world and the world
is ending in the sky is falling.
Speaker 1 (27:22):
And when you say more to faults, are you able
to quantify that? I mean, we've got let's say six
percent by some estimates in public high yield at the
moment if you factor in leverage, loans and distress exchanges
and all that stuff. But on the on the private side,
what do you expect and how do you even see it?
Because some of this stuff will just go unto the radar.
Speaker 2 (27:42):
You can, yeah, how do you see it? You only
would see it in what is the impaired assets in
in BDC's and what you might get from some private
credit you know, kind of annual report which you know
if you have to be an investor to see to
(28:02):
see it. Our opinion and any estimation that you'll read,
is that the private credit default rate and the public
credit default rate don't look all that dissimilar. They tend
to they tend to move together. As a matter of fact,
there's there's been a there's a recent report out that
says that the private credit default rate is within fifty
(28:24):
basis points of the public credit default rate. And so
I think it's with anybody's best guess that if you're
seeing a four and a half percent default rate in
the lverage finance markets currently with disdrastic changes and defaults,
it would not it wouldn't be a stretch to think
that you're seeing a very similar default experience in private credit,
(28:45):
even if you're not realizing that today.
Speaker 1 (28:47):
So, in terms of the all of the stuff you
look at, Jerry, and you mentioned relative value earlier, which
is my favorite topic for this show. You see you
see relative value in the mortgage back stuff, but in
sense of like one thing you had to pick right
now and I think you have a global mandate, right,
So what would you put your finger on and say
is the best in credit at the moment.
Speaker 2 (29:09):
Well, I'd say in fixed income it's agency mortgages. So
we would say that as we look at credit, if
we're including securitize credit, I would say it's double A
or triple A clos. The spreads that you can realize
on double A or triple A clos at one hundred
and fifty and two hundred basis points look very attractive,
(29:33):
both on a nominal basis and on a relative basis.
And then as you start to move, as you start
to move out the quality spectrum and the credit spectrum,
what we would say is you're probably supposed to be
in high quality investment grade. That's probably the easiest. That's
(29:56):
probably the easiest investment you can make at five and
a half percent. And if you can take, if you
can take risk and default, you're starting yields on leverage
loans at nine percent, certainly give you, certainly give you
a nice ability to absorb loss and default. You have
(30:17):
to be very specific about what you choose. I mean,
what we would say is, you know you've heard some
of our concerns on credit and liability management exercises and
default rates in LME. So I would you know, we
would caution it's not for the faint of heart. We
would also say that the good news about that is
you're starting You're starting with the current yield that is
(30:40):
nine percent, and that will give you the ability to
absorb some volatility and some loss.
Speaker 1 (30:44):
But all that stuff you're mentioning, I mean, including the
triple A clos must be quite exposed to a big
shake out, you know, if there is an increase in volatility.
I mean, there's lots of things on the horizon. There's
two walls, as an election in the US coming up,
there's all sorts of things that could potentially increase spread significantly.
You know, as you mentioned, complacency seems to be dominating
(31:07):
now that could well change. How do you hedge against
against that? Because you know your your house view, you're
talking about a reckoning, you're talking about well defaults, you're
talking about stress. But but again, at the same time,
you seem to be you know, expressing, you know, somewhat
of a benign view in terms of your portfolio.
Speaker 2 (31:24):
Well, the highest level portfolio of you that I can
give you and we can we can be as transparent
as we can is we are long duration, we are
underweight corporate credit in a very significant way. So we're
higher quality, but we are underweight corporate credit. We are
overweight agency mortgages, and we have a small allocation to
(31:50):
CMBs in the in the grand scheme of things, because
as much as we are finding opportunity there, we are
also aware there's been significant remedia. So when you think
about that, we are we're expressing a very pronounced view
with incremental liquidity and portfolios with higher quality assets in
(32:16):
agency mortgages, a significant underweight to corporate credit, and we
are using a very small part of our risk budget
in areas where we think there's opportunity, but giving ourselves
ample room to add to situations because the reality is
(32:36):
we are supposed to stay invested, we are supposed to
run diverse portfolios, and we don't know when the time
is going to be, when the markets will turn, and
so what do we try to do. We try to
set our portfolios up that can perform in a lot
of different market environments. Right now, the portfolio carries a
little bit more than that of the index thanks to
agency mortgages to be honest, because they trade so relatively wide.
(33:00):
And at the same time, what we think is not
introduce a significant amount of credit risk and and that
and that is going to give us the ability to
we think, carry well while we wait for volatility and
then have the ability to take advantage of that volatility.
Given how we're.
Speaker 1 (33:15):
Set up, and what are you most worried about in
terms of the next six to twelve months, there's.
Speaker 2 (33:20):
A few things that that that really that really concern us.
I'd say the first the first thing is is the
is the consumer and jobs. I mean, we're really focused.
We spend a lot of time on the health of
the consumer because the and and it feels like there's
(33:41):
a lot of folks on one side and and it
and and the world's expensive, and we don't believe the
consumer is is healthy. So I'd say the thing that
concerns us the most, uh, you know, is is the
consumer that will drive that will drive the economy. Obvious,
the long list of geopolitics, we think they're really difficult
(34:03):
to navigate and invest around, and we try to look
through a lot of that. Having said that, the the
the deterioration in geopolitics broadly is worrisome, is concerning, and
that has led to you know, a a a near shoring,
(34:29):
a friend shoring, you know, has led to supply chains,
you know, redundancy that that we're spending some time on
and trying to think through. And it's longer term and
it's longer term impact. And the last thing we spent,
like I said, we spent forty minutes on this call.
Haven't mentioned the letters AI either. I'd say, you know,
(34:52):
a lot of investment, a lot of hype. There was
a lot of hype on the internet in two thousand
and a lot of companies went b So we would
say we believe in AI long term. We believe that
half the companies in the US today have don't even
have the ability to implement anything with AI. And so
there's the real next leg in AI as we see it,
(35:16):
and we believe in AI is the adoption from the
company level. And as much as we think that's gonna happen,
there's definitely a long tailed of some of that. So
we are constructive on AI. We're implementing it here, but
what we would say, it's not not a straight line either.
Speaker 1 (35:36):
Great stuff. Jerry Kudzill, portfolio manager at TCW. Thank you
very much for coming on the Credit Edge.
Speaker 2 (35:42):
Thank you guys, Thanks James, Thanks David, I appreciate it.
Speaker 1 (35:44):
And to David Havens the Bloomberg Intelligence, thanks for being.
Speaker 2 (35:46):
On the show.
Speaker 3 (35:47):
Great being with you.
Speaker 1 (35:49):
Check out all of David's excellent analysis on the Bloomberg Terminal,
and please do subscribe wherever you get your podcasts. We're
on Apple, Spotify and all other good podcast providers, including
The Bloomberg Terminal. Give us a review, tell your friends,
or email me directly at jcrombieight at Bloomberg dot net.
I'm James Crombie. It's been a pleasure having you join
us again next week on the Credit Edge.
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