KKR Income Opportunities Fund (NYSE:KIO) Q3 2020 Earnings Conference Call November 16, 2020 7:00 PM ET
Aaron Dalrymple – Director KKR’s Client and Partner Group
Jeremiah Lane – Portfolio Manager and Co-Head of Research
John Reed – Portfolio Manager and Head of Global Trading
Conference Call Participants
Good day, and welcome to the KKR KIO Quarterly Investor Conference Call. Today’s conference is being recorded. At this time I’d like to turn the conference over to Aaron Dalrymple. Please go ahead, sir.
Thanks. Hello and welcome to the KKR KIO Q3 update call. My name is Aaron Dalrymple and I’m a Director in KKR’s Client and Partner Group. I’m hosting the call along with Jeremiah Lane, who is a Portfolio Manager and Co-Head of Research. And John Reed, who’s also a Portfolio Manager and Head of Global Trading. We’re all based in San Francisco with the U.S. leverage credit team.
Before beginning today’s call, I have some important disclosures to share. The opinions and forward-looking statements shared in this call are current as of today, November 16, 2020, and are subject to change based on market and other conditions. They do not constitute investment advice or recommendation and are not intended to be a forecast of future events or guarantee of future results.
Any performance discussed this past performance, past performance is no guarantee of future results. Close in funds, like all investments are subject to risk. For more information about the fund, please visit our website at kkrfunds.com.
Thanks again for joining us today. What I would do is provide a quick market update a summary of Q3, and then we’ll go into the Q&A with our portfolio managers, John Reed and Jeremiah Lane.
So as we look back on the third quarter, we saw the market continue to inch upward and onward as the feds historic intervention continued to seek to the markets pipes and corporate issuance continued to surge. The S&P 500 returned just under 9% in Q3, IO bonds were up 4.7% and bank loans were up over 4%. And a stunning reversal bank loans experienced a robust rally and were almost flat for the year as the end of September, as returned 24% since the March 23 lows.
KIO was also flat year-to-date through September, bouncing up over 25% since the March 23 trough. The bank loan market fully emerged from its winter hibernation in the last six weeks of the quarter, as the asset class outperformed high yield in the month of August and September. The loan market welcome back CLO issuance as demand for AAA increased and spreads tightened, creating a more compelling CLO arbitrage. This created a nice tailwind for the loan market.
On the other side of the risk spectrum high yield issuers placed over $120 billion of debt in Q3, which is the highest quarter on record. With funding rates at record lows and capital markets wide open for business, we continue to see borrowers transitioning from bridging their COVID-19 liquidity gaps to extending their maturities at attractive costs.
KIO had a strong Q3 and our quarterly performance reflects choices we started to make during the March volatility, when we embraced dispersion that are shying away from it. We lean into this location and utilized our fundamental credit toolbox to assess credits that we believe were overly punished. We identified market themes and disparities as they were forming and also move with agility as the Fed stepped in recognizing nothing was impossible. So maybe that’s a good segue to the first question, Jeremiah. Would you mind discussing some of the portfolio changes we made since the start of the pandemic?
Sure, Aaron. I think this market environment since COVID really kicked off in March has really played our strengths and our ability to invest across asset classes and across risks. So in the earliest period of the COVID sell off, we identified the fact that the opportunity was in the highest quality names. The BB names have been really punished alongside the riskier CCC names and more impacted sectors, and there wasn’t a significant amount of differentiation taking place in the market. So we felt the name of the game was to go for the highest quality.
As the market started to recover and those higher quality names very quickly rebounded, we pivoted into more COVID impacted names. These were names that were coming to market, not because they wanted to, but because they needed to. And because they were coming and they needed the money, they were willing to pay high rates and agreed to stronger structural protections that often exists in those types of financings, call protection, better security things along those lines.
As the recovery from the original kind of COVID panic continued, we then rotated into what we characterize as just our spread compression trade, which was buying a broad portfolio of high yield bonds, and taking advantage of the fact that high yield is the class is just trading very wide relative to history, and that, as far as we could tell, the spreads would continue to compress.
And then I say more recently, we’ve been shopping in the lower rated part of the loan market, and that’s been particularly attractive because the loan market is dominated by CLOs. CLOs are unnatural holders of CCC risk. And so, as the agencies got aggressive in downgrading companies to CCC, the CLO holders became sellers, just to the point where there were relatively few buyers because none of the other CLOs could buy those CCC assets.
So we saw continued price weakness in that lower end of the rating spectrum for a period of time, and had pretty aggressively pursued that. I think, where we stand today is we’re reassessing a little bit. There’s been a strong rally after the most recent announcements. And so I think it’s a good point to pause and reassess where the best relative value opportunities exist today.
A – Aaron Dalrymple
Great. Thanks, Jeremiah. And we’re just going back to a press release, we had released early November. Take your announced reduction in KIOs monthly distribution rate. So I’m sure it’s a question that investors want to get a little more color on. So John or Jeremiah, would you mind discussing the factors that led to this decision?
Sure. Hey, Aaron, it’s John. A number of factors led to the recommendation to reduce the dividend including the Fund’s current and expected earnings, the overall market environment and KKR credit advisors LOCs current economic and market outlook. KIOs coupon dropped roughly 50 basis points year-over-year, from 7.82% to 7.3%. The market has experienced tightening since last September. Also LIBOR has been reduced from 2% to 22 basis points within the last year.
We feel comfortable with our current leverage ratio in this market, given the potential for continued volatility, reducing the dividend gave us some cushion while still maintaining an attractive distribution rate.
Thanks, John. And then maybe we’ll kind of shift to go back towards talk about the market a little bit. Jeremiah, you’d mentioned that the markets rallied really over the last month, particularly the last couple days since the announcement. Just curious what our thoughts or KKR’s thoughts on the implications of election results on the credit markets?
Sure. I’ll take this one too, Aaron, its John. The potential rates it has been pretty much decided. There obviously the bigger uncertainty is the composition of the Senate. This still looks like we may not know for sure who has controlled the Senate until January. However, the market appears to be getting comfortable with a split government. We meant that, no blue wave means likely no immediate tax hikes on the rate market is behaving currently, no disorderly rise in bond yields possibly QE of a trillion in Q4 and Q1, but they’ll lead into a supportive credit environment.
And what implications does the less stimulus have on defaulting credit spreads? And do we expect less stimulus given the most recent election outcomes?
Sure. So in regards to defaults, we had a wave of defaults to some of the largest structures earlier in the year like household names like Intelsat or Frontier in the leveraged credit markets, but these were kind of companies with weaker balance sheet companies teetering a lot of these other companies have defaulted. Or who you could truly imagine like energy, retail, et cetera.
Now, however, it seems to me the far down defaults are slowing, given large structures defaulted already, but company defaults are increasing to me at a steeper rate. And that speaks to what we’re seeing possible headwinds in smaller companies could be facing the stimulus to net delayed. So, to answer your question, the stimulus or lack of stimulus on the comp could start affecting smaller companies.
And the ripple effects of the feds corporate credit facilities continue to permeate through the market. Do we think the Fed will continue to support the corporate credit markets? And how does Biden’s potential win in a split senate impact the potential for more stimulus?
Sure, I’ll take that, Aaron. I think that what we’ve seen is that the Fed really directly participated in a significant way, in the corporate credit market at the moment of peak uncertainty, peak panic, that was when the Fed really very quickly announced its programs and start to move on its program. As the market has healed and spreads have come in and the prices have recovered, we’ve seen really a dramatic decline really, almost to nothing in terms of Fed direct action in the corporate credit market.
And so, I think that that is likely the posture that the Fed will continue to adopt and use is that, to the extent that they’re seeing panic, to the extent that they’re seeing a market breakdown. People selling risk, not because they feel like they’re getting inappropriate price for the risk that they own, but because there’s a panic in the market that they need to offset, I think they’ll more aggressively lean into support.
I do think that the process of lower fiscal stimulus will keep the Fed needing to be very accommodative. I think the Fed has been fairly vocal that an appropriate incremental response from here would be additional fiscal stimulus. I think the headlines have indicated that, whereas, before the election, Pelosi and Trump were discussing a high $1 trillion, low $2 trillion type of fiscal stimulus, following gains in the house or for the republicans and what appears to be likely holding on to control the Senate, McConnell is now talking about a dramatically smaller fiscal stimulus as the next move.
And so I think if you do have a dramatically smaller fiscal stimulus that will put the onus on the Fed to continue to be accommodated and just very, very slow to remove the accommodative measures that they’ve already provided.
Thanks, Jeremiah. And one question we get a lot is just kind of regarding the liquidity of the credit markets. So John or Jeremiah, how would you evaluate the liquidity of the credit markets over the last few weeks? And how has this impacted our trading strategy?
Sure, I’ll take it. So liquidity in our leverage credit markets has been quite poor in the last few weeks. Market got very defensive heading into the election, in conjunction with being in the middle of earnings and obviously with cases and then pandemic striking the network. So it was the dealer community had no inventory and we’re not sure money managers were either hedge are running high cash balances. And everyone was waiting for the news cycle to play out. So volumes were quite low.
And so when we saw Biden win and the possibility to split senate a few days later, and use of a compound with the news on vaccine, the market which was structurally short supply exacerbating the liquidity the market caps higher and it was stable liquid. So the market was kind of stayed, but very illiquid. And then after the election, you kind of gap north and continue to be very illiquid. The short supply was naturally offset by new issue and opportunistic sellers, but some other liquidity in the market remains very poor, pretty historic standards.
In regarding to our trading and deployment strategy in KKR, we usually spend October and November, prepping to trade as least as possible into year-end after earnings, and do as much trading as possible pre-Thanksgiving because the markets historically are quite illiquid in December in the holiday season.
That being said, because the market historically is structurally short supply, there is a typically a notable performance in the back half December and first-half of January. High yield bonds provided a positive returns 86% of the time since 1999, in the final 15 days of December, with an average return 84 basis points. And this compares to positive returns of 77% of the time in the first 15 days of January, with an average return of slightly over 100 basis points.
Of course, there’s exceptions, December 15, January 16 was horrible. Today, we are kind of in a new frontier, but typically we positioned portfolios to take advantage of the illiquid nature of the Santa Claus rally or the December effect through a fall, which we’ve done this year.
Thanks, John. At a high level, the market seems to look like a one-way market. I think you got to significantly tighten credit spreads this year, particularly since the pandemic. But when you look beneath the surface, you see significant dispersion, particularly at the sub sector level. John or Jeremiah, could you mind talking about the dispersion that we’re seeing in the market and whether it creates opportunities for credit investors?
Yes, I’ll take that, Aaron. I think, we absolutely see a lot of opportunity from the dispersion that’s continuing to linger in the market. And a lot of the types of opportunities that we’re looking to are things we’re taking advantage or just kind of structural challenges in the market, that limit normalization. I was talking earlier about how CCC loans are difficult for CLOs to hold. And so as a result, in some of those lower rated names, especially names that have relatively near-term maturities, we’ve seen the agencies keep those ratings particularly low. And we’ve seen the market reluctance to bid up on those loans to what we would view as appropriate total yield profile.
And so I think there’s an opportunity for us to then go to sponsors and reverse inquiry on try to create catalysts to take out existing positions, as well as to create positions and new attractively structured loans and bonds. And I think that there’s just a lot of examples along those lines.
So, if you think about our credit platform overall, in the U.S., we’re covering about 450 names. In Europe, we’re covering an incremental 250 or so names. So we have an incredible breadth of research coverage in the market. And to successfully pursue the concentrating high conviction strategy that we use in hire, we only really need to find a handful of names that have the catalysts that we’re looking for, and the total return profile that we’re looking for. And so I think that dispersion just continues to play to our strengths. Absolutely.
And, Jeremiah, just to follow-up on that, earlier, you mentioned rotating and some of the kind of the COVID impacted sectors, leisure earlier in the year. Are we still seeing opportunities in those sectors? Or are we seeing kind of a new wave of opportunities, given kind of work six months post-COVID?
Yes, I think that it’s just becoming a little bit more to your prior question, it’s a little bit more just about dispersion, maybe it’s not that every name in leisure meets our threshold. To invest in leisure, we developed a framework around amount of time that the businesses we were investing and could survive in a zero-revenue environment. So if a Casino in Las Vegas was just shuttered, how many months, quarters, years could they survive in that environment or a theme park or a ski resort.
And I think as we see, on the one hand, the market recovers on the other hand, we see a major COVID resurgence and the implementation of significant new lockdowns, I think, it just goes back to that core analysis. Are these businesses really built to last? And I absolutely think that there are these opportunity in some of these businesses that are really structured to last. And with our framework, we find plenty of businesses that we within the market has gotten wrong, that the market has been up because maybe the latest headline was positive on vaccine data, but they just have a rockier road to recovery.
So I do think that there are continue to be opportunities, but it’s not a matter of waving it all in it, it’s a matter of doing the deep fundamental work to validate durability of cash flow, downside protection, in the case of leisure to validate amount of time that they can survive if COVID persists. And when you find things that meet all those criteria, we absolutely see opportunities there.
Great. And then, could you discuss the potential second and third derivative effects of COVID and dislocation? How this potentially could impact the credit markets?
Sure, it’s John. I think we touched on a little bit. I just think the rate of change will and has been very quick around second and winners and losers and like any credit imagined consumer behavior change. I mean, Jeremiah spoke also. But for instance, like what will be the new normal is reorganization a fundamental shift or a blip or order can be a lasting effect in consumer behavior.
Thankfully, we have a macro that we work lockstep in and that can help us navigate these waters away from fundamental analysis, but from a top down perspective, but we spent a ton of time focusing on future trends using our findings to redirect very gently down, principal protection, as Jeremiah said, first and foremost, and its encouraging there is some themes. So, the rate of change is very quick this year.
Thanks, John. And one of the questions we get a lot is, I think we mentioned this earlier, just discussing kind of default rate. We’ve seen defaults rise pretty steadily in 2020 until recently, you’ve seen a trend down in the last few months. Just curious what your thoughts are on kind of where defaults will head in 2021?
Yes. Sure, I’ll take that, Aaron. I think that for a lot of businesses in the early phases, as John mentioned a couple of the larger capital structures that have been troubled for a long time, and maybe COVID was just the straw that broke the camel’s back, if you will. And then there were some businesses that were experiencing secular challenges, I would call out both retail and energy, where again, the incremental pressure brought to bear by COVID meant that they defaulted.
But as we look at it today, a lot of that activity has been cleaned out. And I think that a lot of the businesses that are remaining, even some businesses that are clearly over levered, and clearly have been heavily impacted by COVID and clearly even with a vaccine have a long road to recovery, a lot of those businesses do have good sponsor support. They have taken the right steps to shore up liquidity. And my own view would be that the incremental hiccup associated with the COVID search that we’re experiencing right now and a potential incremental month or three of local and regional lockdowns, is unlikely to push a large number of issuers over the line into bankruptcy.
I think, for the most part, the businesses that made it through round one, and were able to demonstrate that they were starting to recover, I think sponsors will support those businesses, if they need incremental money in order to get over round two of COVID that we’re experiencing right now.
Great, thanks. We’ve also seen a trend of lower recovery rates in bonds and loans. Do we see this trend continuing?
I do see that trend continuing, Aaron. I think that over several years in the leveraged finance market, there’s been a sustained trend toward asset backed revolvers that segment out certain pieces of collateral accounts receivable in inventory specifically, and leave the remaining assets to secure IP PPP and things of that nature to secure the term loan. I think fundamentally, we see those ABL term loan structures, ABL term loan bond structures, often delivering lower recoveries to loan and bondholders.
We’ve also seen as the arms race in the bankruptcy process continues, and more and more parties get more sophisticated about hiring advisors and lawyers that can advise them through the bankruptcy process. We’ve seen more aggressive use of good facilities that really push economics to a leading steering committee, and away from a broad cross section of issuers.
And then finally, I say, and from our standpoint, one of the things we’re most concerned about, is recently we’ve seen a trend where some lenders are banding together to make structural changes to credit documents, to privilege themselves at the expense of others. And all three of those things, the presence of ABL, the aggressive use of the bankruptcy process by large holders to privilege themselves and then the aggressive use of an amendment to privilege certain holders over others, I think has been a meaningful contributor to lower recoveries.
Of those I think that the ABL structures, those will continue to persist and continue to drive lower recoveries. I think that the bankruptcy process is what it is and will also likely yield some lower recoveries. I think we’re hopeful that the market regain some discipline around these torrid [ph] bad actor type activities, and hopefully the amendment kind of fall by the wayside. But I do continue to see some pressure on our recoveries going forward.
And then as we kind of finish up this call, I wanted to highlight maybe a few potential opportunities we’re excited today. So I think that’s one question. I think the other question is, our investors that are maybe looking at potentially an entry point for credit. I guess the other question is, have they kind of missed the boat. We’ve seen a significant period of credit spread tightening. So, is the opportunity set still good today? And then what are the most exciting opportunities that you have in mind?
Yes, sure. I’ll kick it off and then Jeremiah please add to that at the end. I think, this year has been like super interesting. Obviously, Jeremiah spoke to a lot of the opportunities that we’ve invested in throughout the year. And sometimes in here, we only have one or two themes that we can invest around. And this year, we’ve had several. I think you’ll see continue to see a lot of these themes play out and we can be able to re-enter them where we address, Mike. We could possibly be see a rate sell off, which could cause high quality to achievement up again, especially in bonds, possibly a magnified version of September.
Like Jeremiah said before, we continue to see reversing career opportunities for companies fortifying their balance sheet, mainly in senior secured short duration high yield, there’s plenty of capital that needs to be deployed by SPAC and private equity, and that will create a debt pipeline that will be quite robust. And there’s going to be capital needs reversing secular winners and misunderstood credits continuously. And there will be also just typical capital needs for currently callable capital structures, which are turnouts.
There will be opportunity to take advantage of waxing and waning of retail flows that we typically see on new slot, new cycles, which we’re inundated by them right now. And I think we’re going to hit a more volatility to take advantages of flat credit curves.
And lastly, the leverage loan in high yield market is expanded a lot this year. So the markets are growing bigger and there’s more opportunities by the natural growing. And in regards to overall like, I personally think that credit spreads still look interesting and could still have room to tighten. I believe that U.S. leverage credit continues to look cheap relative to other asset classes domestically and globally really looks cheap. It was real negative yields of $31 trillion of debt for JP Morgan. So, I think we are going to see a lot of opportunities, I think the asset class looks cheap relative.
I don’t know Jeremiah, do you have anything else?
Yes, I would just add a couple of things. I think the closest comp to the COVID crisis was the sell off and high yield in loans around the collapse in energy at the end of ’15, and the beginning of ’16. And I have just continuously gone back to the recovery from that collapse in energy as a comparable time to the time that we’re experiencing right now, because just in the same way, there was a strong rally off the bottom.
But one of the things that I really take comfort from is back in 2016, we were still finding some of the best trades that we did in 2016, were things that we were still finding at the end of 2016 into 2017, because there’s this phenomenon of things that have fallen so dramatically out of favor, because perhaps they got downgraded, perhaps they had a true near death experience, perhaps a significant amount of paper changed hands from par holders like CLOs and higher mutual funds into more distressed folders, which can be more reluctant to just did the paper backup.
For all of those reasons, some of these names that went through a period of greater stress, they recover more slowly. And I think one of the big opportunities, especially in a really deep fundamental credit shop like ours, where we’re able to do the work on these individual names, is finding these things that are there. They are recovering, they’re well off the lows. But they’re in inning four, inning five, inning six of their price recovery. And it can be a real chance for us to go in and accumulate paper and still capture a very significant return as we ride those names from inning four to inning nine or inning six to inning nine.
In the last cycle, we did that with names like Sequoia [ph], we did it with names like FleetPride. It’ll be a different set of names this time. But I think that last cycle really speaks nicely to how we can find opportunities in environments like this. And that’s one of the things that I’m really excited about looking forward.
Great. Well, I think we’re going to wrap up the call with that. We appreciate you sharing your thoughts, John and Jeremiah. And we thank you all for spending time with us today and hope you found this call informative. We appreciate your support. Hope you’re staying safe during these unprecedented times. Just let to you know also a replay of this call will be posted on the KIO website in the next few days. Thank you and good day.
That will conclude today’s conference. We do thank you for your participation. You may now disconnect.