Oscar Pulido: In case you haven’t noticed, the stock market has had quite a volatile year already. And while for most investors, that’s the focus of the day to day, there’s an area of the market that often gets overlooked: credit. So what is credit? Simply put, it’s the vast market of bonds that companies issue to fund their growth ambitions. And there is a lot that credit can tell us about the overall health of the global economy.
Welcome to The Bid, where we break down what’s happening in the markets and explore the forces changing investing. I’m your host, Oscar Pulido. Today, we’ll talk to Jimmy Keenan, Chief Investment Officer and Global Co-Head of Credit at BlackRock. He’ll talk to us about how companies are adapting to the COVID-19 pandemic, what it really means for a company to default, and how investors can navigate a low interest rate world.
Jimmy, thanks so much for joining us on The Bid.
Jimmy Keenan: Thanks, Oscar. Thanks for having me.
Oscar Pulido: Well, Jimmy, I don’t know about you, but my work from home situation, I’m in a room that has a television and somewhat reluctantly, I have the financial news on in the background just to keep tabs on what’s going on. One of the things I’ve noticed is that the majority of the news flow talks about the stock market. And I think that’s what people are generally familiar with. But you invest in the credit markets and I wanted to ask you just help us understand, what does that mean when we talk about the credit markets?
Jimmy Keenan: Yeah, obviously, the public equity markets are probably the most visible measure of how people think about the markets. And in general, when you’re talking about equities, those are ultimately the ownership of the companies. When you talk about the credit markets, it’s just simplistically the debt of the company. If you thought about owning a home, the equity owner owns the home, but the mortgage is the debt that is lent to that home. It’s the same from a corporate side.
Those equity owners are looking to borrow money to either finance their company for growth or acquisitions. It might be expanding business or just optimizing their capital structure. And so, simplistically, we lend to the health of the cash flows of a business. And at the same time that the equity owns that long-term growth potential, as the debt, you’re ultimately giving that up, but you have a contractual obligation with regards of that company to be able to pay you an interest expense and they ultimately pay you a maturity, meaning pay back your debt in full. And so, from a company’s perspective, most companies will issue some form of debt and they can vary between the risk.
You have what we call investment-grade companies which are going to be your less risky companies and those might be the bigger capitalized companies that you would see in the Dow or the S&P 500. But then, there are lot of smaller companies that have that in the leveraged finance or called the sub-investment grade market, which can include the bank loans, or the high-yield market. And generally, they’re usually a little bit small over company. They have a little bit more risk on them or they might have more financial risk on them. And that is a lot of what we look at from the credit markets and the more you go down or increase risk in credit, the more sensitive you’ll be towards the value of that equity and that cash flow.
Oscar Pulido: So from everything you’re explaining, this sounds like a very big market. How do investors think about the credit markets relative to other investments they’ve made in other asset classes?
Jimmy Keenan: Investors tend to invest in it because it is a diversifier, right? At first, the income is very much a focus and so for our investors, they come in and would reduce either their government bonds or cash in order to invest in the credit market in order to get some income and reduce what we would call duration risk or the interest rate sensitivity. But you also see equity investors move into the credit markets as a way to derisk or diversify the risk. Because the credit is up in the capital structure, meaning it’s more senior than the equity, it has less volatility and less downside risk than the equity markets. And so, it behaves well or better than the equity markets in kind of a downturn like we are seeing today.
Oscar Pulido: And you talked about the visibility that the stock market often has and I’m just reflecting back on the last couple of months as we’ve been living through the coronavirus crisis. The stock market started to sell off in February as it was starting to get a little bit uncertain about what was going on. The credit markets as you’ve described, and you talked about corporate bonds and bank loans, in early March, we really hit an inflection point. What had been a more quiet area of the market really took a leg down. And so, I’m just curious you must have been right in the center of that. What happened? What was the catalyst that caused the credit markets to sell off as well?
Jimmy Keenan: As the reality of the pandemic expanded globally, it created a bunch of uncertainty about what the growth profile would look like and what the earnings profiles look good in companies. You started to see some volatility in February. And you started to see just that equity risk with that uncertainty about earnings start to come down. Obviously, that accelerated as the realities of the pandemic increased and there were a couple things that really happened to your point and what happened in the broader credit markets. I think there was a recognition that the speed at which the virus and itself was going to increase or spread through society and the lack of I would say, the insufficiency with regards to the healthcare infrastructure to combat that, that was a real humanitarian crisis. And then the response to that from a policy perspective was to shelter at home or in simplistic terms, reduce the economic activity and reduce activity broadly speaking. And so, what the credit market then started to see was the reality that, in order prevent the humanitarian crisis was going to shut down the economy and then, beyond I would call equity risk, it then started to create a real risk of potential impairments and defaults through the credit market. Meaning that if the economy was going to go down at such a level of rate that companies wouldn’t be able to pay that down, you might see a big spike in defaults. So, the credit markets then started to reprice and at that time, there was no visibility in that March of what the government aid and support might be alongside the policy of shutting down or shelter in place. What you then started to see is, the cost of capital started to go up and then that becomes a spiral that is what we will call, deleveraging and derisking.
Oscar Pulido: When you say deleveraging and derisking, can you go into a little bit more detail about what that practically meant for businesses?
Jimmy Keenan: You had businesses or funds in the market that were essentially getting margin calls, which means that, the bank was charging a higher cost of capital to that because the risk and uncertainty of those businesses is much higher and you just saw this vicious spiral of deleveraging in mid-March. And that was going pretty aggressively. And the governments and the central banks and the Fed started to recognize that very quickly and had a very coordinated response with a significant amount of speed and magnitude. And what you’ve seen since then is just the better-quality businesses have all rebounded. They’ve been able to access the markets.
Early in that March period of time, as companies started to get uncertain about it, you saw a lot of news around this with regards to businesses drawing down on the revolver. Meaning, they had bank availability that would be similar to like, borrowing all the money you can on your credit card. Almost every company was doing that and that was continuing to put more and more pressure on the banking system as well, which forced more tightening of capital. So, as you get through this, the Fed programs were significant of scale, they reduced that financial risk and you started to see a stabilization of the market.
Oscar Pulido: So, let’s talk about policy. Although I have to admit I’m thinking about the number of long nights you must have had throughout March as all of this was happening. But one of the things that probably allowed you to start to get some sleep was when the Federal Reserve stepped in and maybe you can speak about the significance of what they did in March because we’ve been accustomed to seeing them buy government bonds for much of the post-2008 period, but they actually took the step to also start buying corporate bonds. Why was that an important decision?
Jimmy Keenan: Yeah. The first thing I would say, the pandemic and itself and the policies around it; there are unique things that are different than any of the downturns that we’ve had. In order to protect humanitarian crisis, there was a decision to shut down the economy, right? And I would say that the response, as you outlined, of the Fed was very aggressive about deploying a variety of programs that existed in 2008 and reenacting them. But also, this was slightly different because of the domino effect as you start to shut down the economy has a significant impact across the supply and demand chain and every single business is ultimately getting affected by this.
There are some businesses that are positive, but in general most businesses you’re seeing top-line declines down from 50-100% and that businesses are not necessarily set up to do that. But what they’re really trying to do and again, how do you bridge this economy in a period of time we were asking the policy makers are asking people to stay at home? Right? And so, the reality of all of the programs that they put in place is stabilizing the financial system.
So, high-quality companies are able to access the liquidity, but also injecting more liquidity directly to make sure that other businesses have means and ways they can access the market or just access liquidity to be able to essentially self-ensure or survive this period of time. And then when you get down to small businesses, that’s where some of the other more government programs and the Federal programs that are trying to inject liquidity right into that to help employment and to help small businesses survive. Because this is obviously, a very difficult period of time for a lot of business owners and a lot of employees.
Oscar Pulido: It certainly is difficult and it’s hard to imagine it getting any worse. I’d like to talk a little bit more about the economy now and when I think about data points like, the jobless claims or the unemployment rate, again, it just seems like, these are numbers that are outliers already. So, just curious, where do you think we are in terms of the stage of the recovery? Is the worst behind us? Do you see a recovery?
Jimmy Keenan: Yeah, that’s a good question. I mean from a starting point, the virus in itself is going to probably define where we are. I think, the financial market instability of March with regards to dealing with the unknown of the impact of the virus on who it will impact and how fast it’ll spread. But also, we didn’t know what the policy response was going to be at that point. So, all the actions with regards to the markets were dealing with unknowns. I think that a lot of that based off of the Fed policy and the ECB and other central banks around the world, that worst is behind us. I don’t think you will see the level of financial instability that you saw in March.
Now, dealing with the fact of the unknown and realizing the weakness of economic data in Q2 and potentially Q3, Q4 and beyond, we are now dealing with the fact that companies are trying to fight for survival as are individuals and people. And so, that’s where businesses, yes, in some cases they’re able to seek liquidity and aid, but at the same time many are reducing expenses in order to try to survive when they have no revenues coming in. And unfortunately, in many cases, that means that, that’s what’s driving the unemployment rate because they are reducing expenses for that point of survival.
I think, you will continue to see that maybe not at the same pace, but I think you’ll continue to see some of those levels go up in the short term. Hopefully, that will be balanced as again, we have more data. You will start to see the reopening of the economy and you’ll start to see some level of economic activity start to come back up and I think that’s a positive. So, from a data perspective, I think Q2 will probably be the worst from a realized point of the macro data from the economic activity because I don’t think we’ll come back to the same level of economic shutdown. But what that does mean is that, as you get into Q3 and Q4, the unknowns are different industries, different regions, the slope of recovery is going to vary based off of behavioral changes, but also just some of the damage done based off of the last several months and the weakness in certain economies. We will deal with more defaults and more bankruptcies.
Oscar Pulido: So, what does that mean when a company defaults? You also used the term bankruptcy, which just sounds like a scary term. But you’ve also talked about companies needing to survive during this period. So, do you have concerns about the ability for some of these companies to pay back their debt? You talked earlier about this contractual obligation that they have when they issue a bond to an investor to pay on that bond, but is that contractual obligation at risk and how do companies deal with that?
Jimmy Keenan: Yeah, it’s a great question. I’d say, in any recession or in any normal environment, there are companies that default. Default ultimately means they fail to pay on an obligation and that might be the debt on that, but it also might mean they fail to pay one of their suppliers or their landlord depending on what kind of real estate the company incorporates. All of those are going to be contractual obligations of the company. And if they’re not making enough revenues in order to pay those then, yes, they may have to restructure that. So, that happens in normal times, but in normal times, it’s a minimal amount. In a recession, many companies may not necessarily be positioned for different levels of recession or how it may affect those companies. And yes, so you do see restructurings increase in that environment.
To the question of what does that mean? Nobody wants to default. It’s not a great thing. It’s not necessarily planned. However, it doesn’t necessarily mean the company goes out of business. Sometimes you restructure because you need to because your business has changed or the environment has changed and in order to operate more efficiently, you need to restructure your balance sheet to today’s environment. And when businesses have taken too much debt or have too high of a debt burden on there and ultimately, don’t have necessarily the earnings, what a restructuring means is that you’re taking that debt profile and all the contracts that the company has and you’re ultimately restructuring them, so that the business can run and operate in today’s environment without the burden of debt.
I would say, for lack of better words, choking the company. The goal of all that is to be able to keep a company operating, keep people employed and allow this business to function with a better capital structure. So, defaults aren’t the end of the world. They ultimately allow a company to rebalance itself that it can operate and then hopefully, should be good for employment and healthy. But as you do that and you stabilize those companies, you allow for the economy to kind of start to run again.
Oscar Pulido: It sounds like when you talk about restructuring if I were to use a simple example, if I, Jimmy, had owed you $10 over the next year and you realize that now I’m financially burdened and I’m going to have trouble paying you back that $10. Perhaps you come to me and say, look you can pay me those $10 over the next 18 months instead or maybe over the next two years, or maybe I have to pay you $11 back over the next two years. I’m trying to simplify, but is that is that sort of what happens at these individual company levels?
Jimmy Keenan: Yeah, and every situation is going to be a little bit different on what’s best. I mean, in the short term what you see right now is, most creditors and equity owners and operators meaning, the management teams themselves, recognize the current environment and the crisis and everybody’s working together to try to allow for companies to get through this in an optimal manner. But there are other businesses that are going to face real challenges with regards to that debt and so, yes. What you’re referring to is, the conversations that are going on which can be complex just because of the legal obligation and how many people own it and trying to get everybody on the same page.
So sometimes, it requires going through a bankruptcy process and a court in order to get all of your debt and all of your equity holders all on the same page. It’s kind of like, if you owned a home and you had a high level of debt on that home, and necessarily couldn’t pay the mortgage, your first conversation is going to be with the mortgage provider, can you have some level of forgiveness there or change terms? But ultimately, if you can’t pay, then you may restructure that and the bank still has value, but that house still exists. And in most cases, when you’re talking about a company, those companies will still exist. There are cases where you will see liquidations or companies close down because they can’t operate. But in general, most businesses are going to restructure and if it’s a good business and viable, it will try to operate and yes, come to some agreement with its both its debt holders and its equity holders.
Oscar Pulido: Jimmy, that’s really helpful. You’ve painted a really good picture about what the credit markets are, how they function, and you’ve also talked about your view on the economy. But let’s talk about investing in credit markets. With the Fed having cut rates to zero and government bonds yielding very little, how does that impact what you’re seeing in this space?
Jimmy Keenan: Yeah. I think there’s a short term and a long-term view on that. I mean, from a long-term perspective, I think we have some challenges. When we came into 2020, we had a lot of aggregate debt in the global economy and since the financial crisis over the last 10 years, we’ve done a lot with regards to shifting that debt from households and banks on to government balance sheets and central bank balance sheets, but we still had this lower growth, lower interest rate environment globally speaking coming into 2020 because of the debt burden. Obviously, the response to the pandemic is something that and rightfully so, the governments have stepped in here to ensure the health and welfare of the people and the economy.
But the expense of that is ultimately incurring a lot more debt on to the government level. So, I think the reality of this and there are different policy responses to deliver, but in all likelihood, you’ll have volatility, but it is going to continue to put downward pressure on growth and downward pressure on, ultimately, rates which are determined by that growth and inflation. And so, from a long-term perspective, I do think that will keep global interest rates at very low levels. And so, when you think about that, if we can stabilize growth and get through this, which we will, science will win, society will get through this, we’ll start to stabilize at a growth level but we will still have to deal with that debt burden. And when you think about how do you put your portfolio together? Because at the end of the day, if we’re going to be dealing with global interest rates at very low levels, it is hard for people to supplement their income that they get from their jobs with income that they get from their savings for a long-term retirement.
Oscar Pulido: And what about in the short term?
Jimmy Keenan: I think in the short term, it’s all about where we are from the recovery here. What’s the shape of the virus in itself? What’s the policy from here out and what that means from the level of economic activity? And then how that flows down into how do you price risk assets, whether you’re talking about government debt, in general, fixed income or corporate debt or equities. And that’s going to be the more short-term issue. And I think there are a lot of opportunities out there. The worst may not be behind us in all things, but I would say, March through May has been a pretty severe period of time. And so, from a long-term perspective, it’s a pretty good time to invest in a broad range of assets. Although, I think you need to be careful. From a short-term perspective, if you need liquidity, then I think, you balance your portfolio differently.
Oscar Pulido: There’s a narrative or I guess, an observation by a lot of folks who are watching the market that the stock market has recovered, but it’s really a handful of companies that are driving that recovery and that there’s a few winners and most of the stock market actually still underwater for the year. And the winners are companies in technology and some in the healthcare space. Is that also the case in the credit markets, Jimmy? Is it really about a handful of companies or a handful of sectors or industries, or is it more broad-based in terms of what you’re seeing as an investment opportunity?
Jimmy Keenan: One, it is a bit more broad-based. When you think about the high yield market and the loan market in general, you’re dealing with smaller businesses. So, some of them have very strong secular tailwinds with them and are doing well in this environment, but in general it’s not as consolidated as you see the big cap equity companies. But at the same time, you’re talking about as you think about the diversity of different industries and different spaces, there’s a broader range of winners and losers associated to that and businesses struggle. And so, we see it right now in areas like oil and gas. The virus itself and the downturn of the economy has slowed demand, but there are also supply issues associated to that.
So, that has put real pressure on oil prices and therefore, has put all pressure on all things related to the energy markets. And you’ll see other things around lodging, leisure, entertainment that are, I would say, struggling in today’s environment, but at the same time across the credit markets, there’s still a lot of software companies, a lot of tech, cable, a lot of hospitals and healthcare businesses and pharma companies and you have a broader range of bifurcation where companies are doing well in this environment, but at the same time, other businesses that have really been hurt because of the current shift in how the economy is operating like, people are still eating, but they’re not eating at restaurants or eating at home. So, take out has become better than restaurants and things like that. And that will evolve over time, but certainly as we get through this, I do think there will be behavioral changes and businesses will need to adjust to those trends.
Oscar Pulido: And Jimmy, at the beginning the year before we hit this period of talking about the coronavirus, one of the things that we were talking about and we’re still talking about today is sustainability. BlackRock has taken a very strong stance on sustainability and the view that climate risk is investment risk. And I’m just curious in the corporate bond arena or the credit arena that you invest in, how important is sustainability in the investment decision-making process?
Jimmy Keenan: Yes. Sustainability has obviously got a big trend. I would say over the course of the last several years as sustainable investing and ESG or environmental and social and governance-related risk, we’ve defined it differently and we’ve now broken down our process across our teams to define and understand those risks. At the end of the day, we do believe that those trends, those companies who are going to score higher in those measures around those sustainability measures will ultimately be better performers. And at the same time, those who are going to score worse, they will have ultimately worst credit fundamentals and are going to be tougher investments. And so, we do see that when from our standpoint is pricing in those risks, when we look and try to assess a credit and we think that trend is only going to increase, and we see that more and more now as investors have demanded it.
We have started to look and broadly speaking, look and value companies in that method. We see it at the boardrooms of companies, right, where companies are trying to understand their business and making investment decisions or capital expenditure decisions or decisions on how to run their teams and employees and in a manner that is more sustainable. So, I do think it is almost a necessity to think through when you’re thinking about investing right now.
Oscar Pulido: It definitely sounds like it’s a core part of your decision-making process. Jimmy, you’ve shared a lot of great insights, I wrote down a number of things, but the one that I underlined was when you said, “Science will win.” I think people are in need of some optimism from here on out. So, thanks so much for your insights and thanks for joining us on The Bid today.
Jimmy Keenan: Thanks for having me.
This post originally appeared on BlackRock.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.