Bryan Krug – High Yield Credit Investing - [Invest Like the Best, EP.114]

I know firsthand how complex the tech stack is for asset managers, and seemingly every new tool and data source makes the problem even worse, adding more complexity, more headcount, and more risk. Ridgeline offers a better way forward, one unified platform that automates away all that complexity across portfolio accounting, reconciliation, reporting, trading, compliance, and more, all at scale. Ridgeline is revolutionizing investment management, helping ambitious firms scale faster, operate smarter, and stay ahead of the curve. See what Ridgeline can unlock for your firm. Schedule a demo at ridgelineapps.com. Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast. My guest today is Brian Krug, who manages the Artisan Partners credit team and oversees more than $3 billion in high-yield credit investments for the firm. This was my first conversation on high yield, so I took it as an opportunity to get an overview on the investment universe and hone in on the tools used for analysis and security selection. As an equity investor, I think one of the most fruitful areas of research is into ways that companies fail or go wrong, and credit investors focus almost entirely on this potential for impairment. My guess is that all equity investors will learn something useful from this conversation, so please enjoy.

had any conversation with anyone specifically about the high yield universe and really about fixed income in any level of detail, to be honest, much more of an equity guy. So maybe highlight what that universe of high yield looks like, how it's defined. And from that definition, we'll kind of get into some of the more particulars. So let's talk a little bit about the evolution of the markets. And I think that we kind of give some very good context as to how things have been in the past and how they're going in the future. So if you look historically, If you go back 20 to 30 years, the high yield market was a subordinate credit solution for companies that the banks wouldn't lend to. So in the past, banks used to lend and they would lend to typically, let's just depend on the business between three to four times debt to EBITDA. And then when companies wanted incremental leverage, the banks wouldn't take that risk. So a public market solution occurred, which was basically the high yield market. And the high yield market really started in the early 80s. And it's grown pretty significantly through probably the growth of alternatives. So if you think of alternatives, private equity, as an example, private equity uses high yield to basically leverage equity returns. And it's also grown through companies that have incurred capital to build out CapEx. So examples would be MGM or Wynn. Those casinos were built with high yield capital. Sprint used high yields capital to build its network out. So those are examples of businesses that actually have tangible needs for it. So that's how it started out. The banks used to lend, and then high yield was the more junior capital solution for the fixed income side. Then structured credit happened probably about 15 years ago. It became much more universally accepted. And the loan market moved from a bank-owned market to a syndicated public market. Structured credit made it cheaper for syndicated structures such as CLOs to essentially give risk to companies cheaper than banks could do it. And you also had regulatory changes where it was more expensive for banks to hold that capital from a risk way to capital perspective. So banks moved from an origination model where they used to originate and retain the risk to a syndication model. And the syndication model essentially evolved to where investors such as ourselves, CLOs, and other managers essentially

take that risk and a more senior part of the market. And so that started 15 years ago. And that market essentially went from nothing to a trillion dollar market in the last 15 years, give or take. So that's been a significant growth on the loan side. The way that the public high yield and the public loan markets work is typically the loan market is your more senior tranche. It's often floating rate. Its characteristics are that it has limited call protection. which is important because if there's a lot of demand for loans, the spreads will compress. And it's similar to like a mortgage where if you have a rate of 5%, if market rates are in a 4% for your mortgage, you'll essentially refinance it. So it's capital that issuers have the ability to reprice. High yield market is typically seven to eight year maturity on average. It is typically non-call for approximately the first. three to four years. And there's a call premium of four to five points at that time. And so if the company wants to address the maturity earlier, there's breakage that the issuer must pay to move on. So that's actually a big benefit to owning a high yield piece of paper. Maybe you could talk a little bit about the... idea for investors of why to allocate to this specific asset class relative to investment grade bonds and maybe also compared to equity. So if you think about those two, plus maybe cash as big primary asset classes, what are the behavior points that distinguish this asset class? And what are the primary motivations you find for, let's say, your customers for investing in this group to begin with? So if you look at the return characteristics and risks of high yield and leveraged loan investment. It's a little bit of a hybrid between the two. And at different points of the cycle, they have different characteristics. So there is clearly more economic sensitivity to a credit investment relative, a high yield or loan investment relative to a investment grade investment. That's very obvious. In exchange for that, investors get incremental spread. So that is one factor. Relative to equities, credit does not experience

nearly the same amount of volatility as equities do. If you look at the high yield market in aggregate, leverage as you define debt to EBITDA is around four and a quarter times in the market. If you look at the S&P mid-cap example, as an example, the EBITDA is around 12 times, which is very comparable. So you're not taking the same amount of valuation risk. broadly across the market, obviously realizing within various companies are going to be different leverage points. But if you just look broadly out there, the risk is not nearly that of equities into the volatility is generally less with the exception of when you have the 08 example, it's kind of a little different example. We can get into that later if you'd like, where there was a lot of leverage that was unwound at that time period. So generally, if you look at returns, the high yield has had three negative return years in the last 35 years, which is actually very benign. And if you look at returns going forward and invest, we're under right between 6% and 8% IRRs today, depending on the risk across the portfolio. You mentioned before we started recording that when you began in the industry, you thought maybe you'd be in the equity world, but that the nature of evaluation or analysis and your skillset just lent itself better to this world, kind of a more fundamental view on what's the ability of this company to repay its loans. So maybe talk about From that perspective, the primary differences that you think of as like the work itself of an equity analyst looking at a given company, there was an example that you sent J.Crew at one point versus a debt analyst. What are the primary gaps between the things that they care about and how they think about those things? A lot of the investments that are made in the high yield and loan market are actually to privately held companies. So we don't have, there is some similarities, there are some differences. The J.Crew example is actually private equity owned asset. that we gave as an example. Some of the differences are we are much more fundamental. We are looking for basic core, as we look at the business, what is the defensibility of the business? What's the cash flow stream? What's the ability of the company to deliver its balance sheet? That is the primary metric that we look at is...

the company's ability to basically delever the business. And that's a little different than equity, where I think there's a little more expectations in terms of growth rates. How will the company do relative to street expectations? Will there be earnings revision positive or negative? We're a little more fundamental, like, is this a good business? Is this business going to delever? And then what are the priorities for that cash flow? And what is the credit? How do we think the credit will evolve? Talk more specifically about that ability to deleverage. My view is if you keep asking why, usually you get down to specific data sets or specific spreadsheets. The units of work themselves that determine these ideas. So when you talk about the ability to deleverage, what are the primary factors that you would think about to determine that? We tend to look at business quality first. So we tend to look for businesses with high recurring revenues, low capital intensity, generally higher margin profiles. And those companies generally have strong free cash flow to debt. And examples of areas that we have significant overweights that zip those financial characteristics are insurance brokers. They're software businesses where they have low 90s retention rate before the sales force does anything, after the sales force is able to grow organically low single to double digits, a predictable cost structure. And those characteristics generally support strong enterprise values. which also gives us downside protection. How do you think about your own individual advantages versus other high-yield credit investors? So I always like to ask, what is it that you do that others either can't or won't do? And how is that something that's sustainable? So how does an advantage persist through time? There's a couple of things that we feel like that we do differently from some of our peers. One is we are cash flow lenders at par. We tend to look at asset value in a more stressed scenario. A lot of our peers will tell you that they look at assets to protect them. Asset value can evaporate pretty quickly as fundamentals change. And so best example of that would have been the energy market. So the energy market is very asset heavy. You have oil and its acreage is worth X per acre. However, that math changes dramatically as the price of oil goes from 100 to 30. And the average E&P, as an example, which was perceived to be high quality, dropped.

roughly 55, 60 points from par to roughly 35 to 40 cents on the dollar in Q1 of 16. And so that asset value at par basically didn't help you. And I think a lot of our peers will say that that's how they think first. We tend to think of cash flow and the ability to deliver the business. So that's one big differentiator. From a research perspective, I think we believe. in the man in the machine. And so as part of our process, we spend a lot of time looking more at data and analytics, which we think gives us a little bit of an advantage. So we'll use outside data sources to reinforce some of our views. So we'll look at credit card data as an example to essentially be able to get confirmation on trajectories of Everything from cable TV spending to retail spending to consumer spending. And we feel like that gives us a real-time edge on a weekly basis, which I think a lot of people don't look at. And then the other thing that we do is we're very disciplined. We don't, it's just hard to quantify, but we believe enterprise value is. I think a lot of investors will stretch for yield. And when they stretch for yield, that can be very, very expensive. And so what we will try to do is we basically, we don't want to sacrifice enterprise value coverage and try to avoid permanent. impairment. If you look at what credit investing is doing, there's an asymmetric risk profile, bonds are issued at par, and we want to avoid mistakes. And that's something we've been able to do at my time at Artisan. It sounds like there's a mixture of quantitative and qualitative elements to the analysis. Since I'm such a biased quant, I'm always curious to know what the key factors are quantitatively, maybe like the table stakes, if you will, for you to consider something like, is there a minimum? level of criteria before you even begin to look at something? And if so, what's kind of the spirit of those criteria? As you look at credit investing, there's a broad suite of industries. I would say that there's a little more of a focus in the market on old line businesses. So if you look at some of the areas, like for example, energy is roughly 25% of the entire market, a little under 25% if you include E&P, MLP, and oil field service.

And if you look at those businesses, they're okay businesses. However, if you look at their ability to incur leverage, I would say that's very different than a software business. It's very different than insurance brokerage business because you don't have that same degree of cyclicality. So as we look at, and you look back at the high yield market historically, the biggest sector in 05 and 06 was autos. Tremendous amount of cyclicality. And if you were to take a quant approach and just say, I'm going to look at leverage, debt to EBITDA, and then look at spreads and determine what the spread pattern of leverage is as a quant metric. That would have been a very painful experience because you would have underpriced the cyclicality in that piece. And when you had massive swings in profitability, leverage spiked and there was significant impairment in those sectors. debt to leverage, which is probably the key metric that most people look at. So I think there's an art to it, as well as a science to it. I think you need to have both, in my opinion. And so that's just partly because of the nature of the businesses. Interestingly enough, in the credit space, there is some inefficiency. And one thing Artisan is attracted by the space is the ability for act to manage to provide value. And this is one of the few spaces. where active managers actually beat their passive peers, which actually I think is a very interesting dynamic that occurs out there. And that's partly because of the inefficiency that happens from the analysis perspective. Maybe you could talk more about the driver of that. So in the equity market, you've got cap-weighted indexes. Maybe begin by talking about what the benchmarks are in high yield and what the largest structural flaws of those benchmarks are. So there's a little different dynamic. Fixed income versus equity. So let's start out. If you have a benchmark that is tied to market cap, or in this situation, be total debt. If you have, there's a little bit of a different incentive system. On equity, having a big market cap is actually a very positive dynamic. If you have a lot of debt, that's obviously not a very good outcome, potentially. And so having the most amount of debt and being overweight debt,

can make you more susceptible to default risk, all else being equal. So that's one dynamic. Two, but if you look at the ETFs, interestingly enough, the way they're constructed, they try to avoid some of those areas and they'll try going a little more high quality, but it doesn't always work out that way. And the other components I would say is if you look at ETFs, they have In the space in general, they've underperformed for a few reasons. One is that the fee differential is not as big. Two is transaction costs are much higher for fixed income investing versus equity where it's almost free to trade. And three is there is some inefficiency. There's 1,600 issuers in the high yield market. And so through credit analysis, we can basically find opportunities out there and take meaningful stakes and have the meaningful effect our... our returns as active managers in general. You mentioned this idea that I really like about lending against cash flows versus asset-backed lending. And you already mentioned software. So obviously, really great cash flow businesses. I'm curious how that translates into your own thoughts on portfolio construction. So if the benchmark is kind of peculiarly constructed due to what you just described, what groupings do you think about in portfolio construction? different takes on this market, on the loan and high yield markets within the portfolio? And how do you think about allocating to those different groups, assuming that this cash flow idea might be one group? So everything we invest is corporate. So we don't do any structured product. So we tend to look at the underlying businesses. And so as we look at the businesses, cash flow lending is obviously something that, it sounds very simple, but it's like if you've got the cash flow that serves the debt, that reduces our risk. We internally tend to bucket in three criteria. We look at core, which think of as a stable, predictable business. An example of that would be like a charter communications. We don't love the cable business, but we really love the broadband business, which does well regardless of the over-the-top threat. Can you just talk about the difference there and why that preference? So if we look at the cable TV business, the cable business is basically a commodity type product. So you're basically repackaging various channels.

We personally believe there is some advantage that the companies do have in terms of lower content costs relative to YouTube or Hulu just because they purchase more of it. However, they tend to have skinnier bundles and younger viewers particularly don't really want as much. They don't need 150 channels. So there is definitely a loss incrementally of basic TV subscribers. However, in order to access the YouTubes, The Hulus of the world, you need a broadband connection. In the broadband connection, the cable solution is by far the most robust solution versus DSL. And so we think there's continued pricing power that those businesses have. And the margin structure is such that you really have very limited cost. Your margins on high-speed data, they're not broken out, but we believe they're close to 70% EBITDA margins, which are very high. And the cable pay TV margins are actually materially lower because you have to pay ESPN and the content providers for all the product out there. Sure, sure. So that would be the example of a core name. Spread tightening is an example where we're trying to find a cyclical out of favor company. So it could have been energy when oil was down. And we're basically, we have a view that the business can sustain itself through the downturn. And if there's a macro recovery or company specific initiative. we believe it will have material spread tightening. And depending on the risk, it could be high single to 30% IRRs or underwriting depending on what the market environment is. So it can be equity plus returns for taking fixed income risk. Another example would be some of our insurance brokers and our software assets where the leverage point starts out high today. But as you look forward through cash flow, they have the ability to deliver meaningfully because of their strong cash generation ability. So the spread tightening and the core, those are the two kind of primary? Those are the two primary. And then a smaller component would be we have an opportunistic sleeve. The market has been not very volatile, and so we tend to take advantage of opportunities across cap structure. So we'll take advantage of...

technicals in either the loan or the bond market, or we have an event-driven trade, we're all a potential covenant violation due to market conditions. It's been very limited. It's a very small part of the portfolio. However, it's added value throughout the cycle. You've referenced spreads quite a number of times. So maybe define what is interesting about spreads, which ones you look at, why they matter, and what they tell you about what's going on. So if you look at spreads, spreads... If we look at simplistically, what are spreads and what do they mean? Spreads are what investors are being compensated for taking the credit risk. And so it's return in excess of the treasury rate. And if you have a high yield bond, as an example, with a seven-year maturity, and for simplicity, let's say that the treasury is roughly 3.25%. It's a little higher than it is today. And if you're getting 7.25% return, you gain 400 basis points of incremental spread. for that risk you're taking. And if you look at the market aggregate, if you assume spreads are roughly 350 basis points, you're getting 3.5% over the treasury market yield for taking that risk. Defaults are your biggest cost of that. And if you assume the market has a 2% default rate, which is actually higher than it is today and higher than expected where it will be in 19 and 20. And if you assume a 60% loss in defaults, you should be getting paid 120 basis points for just pure default risk. And so spreads are a discounting mechanism for expected future defaults and what you're getting paid for that. And there's also a liquidity component because investors should be paid an incremental value for not having treasury type risk. So depending on the market conditions, they deviate. Right now, spreads are at historically, are closer to the tighter end of the range. And part of it is for good reason because the fundamentals are constructive today. Defaults are benign and expected to remain benign. And that's kind of where we are in today's market. Talk a bit about the ratings of these different issuers or the individual issues and how that, maybe what efficiencies lie in that process, whether or not you think rating agencies do a good job or not, and whether or not that's a source of advantage.

So as we look at the agencies, we think they're terrible. I mean, just to be totally blunt about it, across the board, there's been a lot of validation to that argument over time. You can go back and look at 10 years ago, AIG was AAA risk months before it essentially needed to get bailed out and going bankrupt. And AAA risk is supposed to be as good as it gets a fortress. The structured credit market, all the AAA debt, that essentially went to zero through CDOs and CDOs squared. I mean, that just gives you an example of areas where they've been off. Even within credit, which they're arguably better than structured credit, there are some inefficiencies. So there have been companies, for example, in the energy space that we had that were actually underrated, in our opinion, because of a couple of characteristics that they focused on, such as like length the business has been around, which we think has nothing to do with the asset quality. Let's just look at like within a sector. So if you'll get energy as an example, they overrated diversified companies at scale and they underappreciated cost structure, which if you're in a commodity business, cost structure is your primary driver if you're going to remain solvent. And so companies that were in low cost basins, there were... only in those low-cost basins, had shorter operating history, such as the Permian, were underrated. And we were able to identify companies that were actually upgraded when oil went from 100 to 30, which is kind of ironic. Well, they were downgrading assets such as like Chesapeake that were very diverse, and those bonds ended up going down 90%, but they were a double B. So it's like you have a lot, which presents an opportunity for us as credit pickers because we're able to identify companies where they're just off. How much of the opportunity arises because of a change in rating? So if you look, I think there's a lot of topical things we can talk about on that. So there's about $5 trillion of BBB debt. And where the biggest opportunity is, is typically when issuers drop from investment grade to high yield. Because typically what you have is investment grade holders that are essentially

Required. Required to either outright sell or materially reduce their exposure. Because if you're an insurance company, you can only have so much capital that's double B or below. And so in that situation, you have forced selling and you have opportunities to take advantage of that. If you look broadly, what you're seeing is triple B issuance has absolutely exploded over the last five years as issuers have taken advantage of low rates. to either return capital shareholders, do M&A that's debt financed. And if you have a cycle or a cycle within a cycle, like you had an energy in 2016, you can expect some pre-material downgrades in those sectors or broadly across the board. And so that could create a strong buying opportunity. And where there's probably the most vulnerability is in the longer duration part of the market. Because if you look at the investment grade market, the investment grade market tends to be a longer duration market with the average duration of nine. I'd contrast that the high yield market that's give or take three to four years. And so there's an unnatural home for a lot of that paper, 20 to 30 year maturity paper in the event of downgrades. Maybe you could give a recent example. I always think these processes are best illustrated through an actual company, an actual issuer. A recent example of something that you came across that you found interesting, maybe the source of what you view as the mispricing. So what we're all trying to do as active managers is identify mispriced securities. So the source of the mispricing, maybe like the high-level work done to verify that it might be interesting, and then how you thought about actually getting involved. A good example of something that we identified. So there's been some weakness. in cyclical type industries as rates have moved up over the last, I don't know, nine months, give or take. And one of the areas that has underperformed has been housing related bonds. And there's a company called Beacon Roofing. Beacon Roofing is a roofing distributor. Most of their business is actually not new construction related. It's predominantly repair and remodel where it's your roof leaks.

you need to replace your roof. And incrementally, what drives demand is when there's hail damage. So if you have hail damage, you're forced to replace your roof. It's paid for by the insurance companies. And the company performed a transaction about 12 months ago where they bought one of their competitors. It was a debt finance transaction and they used high yield bonds to consummate that transaction. When they came with the transaction, the bonds were Low coupon, four and seven eighths. And that was done in basically October of last year. We actually thought the valuation was very expensive, but we liked the asset. Between a combination of concerns about interest rates and then interest rates slash housing, and then also concerns about storm activity being less robust than last year, which is factual, the bonds dropped basically 14 points. And as we look at that, we identified the name through a screen. And the bonds now are yielding roughly. We actually look, we assume the company takes the bonds out two years before maturity. And it's just under 8% to that date for what we believe is part-type risk. As part of our research process, we obviously did financial modeling. We also talked to management. We also talked to competitors, former employees. as part to really triangulate how the integration was going in the acquisition. And then we also used, we actually did some interesting proprietary work on the data side. So we actually track every storm that's out there and every hail storm and we're able to quantify it by zip code. And then we overlaid every location. And then we looked within a 20 mile radius to see what the activity was. because their footprint is a little different than some of their peers. Try to figure out what the implication was for the storm activity and use that as a proxy to see, to get confirmation in our views. The storm activity will be better than what market expectations are. And that's something we did to really kind of get an edge in terms of that investment. As we look at the business, we think, you know, the bonds are roughly 89 cents on the dollar. And so we think that's a very attractive IRR. We think that probably default is very, very low on the company.

generates meaningful free cash to debt. And the primary focus of the company is to deliver its balance sheet because that will, and we're aligned with the equity because that will help their equity value. So that's an example of something we accumulate a material position in the portfolio as a way. And that's something that we identified. Yeah, really interesting combination of triggers and data confirmation and things like that. If you had to identify in your world, like what the most valuable data sources or data sets tend to be, how would you think about that? So as we look at our process, there's a number of pieces that I'd like to break it down in. First is the ID identification. Unlike the equity world, there's roughly three times the amount of companies in this market relative to the S&P 500. So you have to have a good way to really identify the opportunity set. The good news is that the opportunity to set the return profile is much easier to model because it's mathematical as opposed to psychological where multiples can be whatever they want. In the equity world, we have fixed upside. It's where we identify our opportunity set very quickly through. And we use Tableau, which is a great visualization software that is able to slice and dice the indexes. That's the first piece that we do on the data side. And then everything that we do. from a data source is really more bespoke and so it's it's really more idiosyncratic specific to the company like correct we just gave so it's really trying to track storm data as an example another idiosyncratic area would be like uh theaters where we track literally every weekend the box office then we can track like what the major movies are and then to see like what drove performance so for example in q1 black panther drove the box office in that we can say it was 30 or 40 percent of the box and like you know what's likely to repeat itself and we can use data to really kind of track updates on a weekly basis for us automatically yeah it's interesting advantage if you think about a data edge as being idiosyncratic versus like something cross-sectional that and that's just harder work to scale right so it's someone like me it's

I can't go get like custom data sets for every individual equity and track that. Maybe I could with ridiculous resources, but it's very hard to do. And not every industry has got readily available data out there, but there's a lot of data out there that I don't even think people realize exists. What are some favorite examples? Census data is got... great data for example so one thing we're able to track as an example is very very uh interesting is a vinyl siding data over time you can see how many houses have vinyl siding in like the mix over time you can track it or it's there's like a vinyl siding institute which i guess there's associations for everything where you can where they basically track squares of shipments by year and so you can get some pretty good insight as to like how the the penetration of that product's gone for years. And that's the sort of things that we look for. What is your favorite part of this whole process? My favorite part is always learning new information. You're always evolving and you're always learning about new businesses. I'm a very competitive person. And the other piece is trying to get an edge relative to our peers and kind of pushing ourself. Because if you look at active management, I mean, active management is changing a lot and you have to evolve your process. Because if you don't evolve your process, I mean, it's just getting more and more competitive. And so it's really trying to find those next pieces that I think will continue to give us the edge and the moat. So I'll ask an example from each of those categories. So maybe in the last few years, as you're learning new things, what is the most surprising new learning? Probably the most surprising learning is how companies are very good and bankers are very good at manipulating data. So when you actually go and look at the underlying data, They cherry pick. It's not really surprising, but it's more just reinforcing like how they're able to cherry pick and manipulate charts to make it look different than a broader sample. It's just more just the level of dishonesty. It's probably the more, it's probably the biggest. I mean, obviously, I think that leads into the second, which is like source of edge and evolution. So you mentioned, it sounds like for a long time, you've had this idea of cash flow versus assets. Correct. I'm curious, does the market get wise to that? So if that's a really successful way of thinking about things, and maybe that means you're overweight software, markets are usually pretty good at updating their beliefs. So how is that?

edge evolved or changed? And maybe how do you begin to move away from that if it has evolved? It is starting to evolve a little bit. People are getting smarter on it for sure. I guess I would say as I think of like evolution, I'll give you a sense of like how I've evolved as an investor. So we started out, I'm dating myself, but I started out pre-regulation FD. And regulation FD was when the companies could basically tell you whatever they wanted and they had to put press releases out. That changed on 2001. And the edge before used to be having a good relationship with management and being able to kind of anticipate what's going to happen because they would basically tell you before it was like broadly known. The second evolution, it was essentially having greater independence. And so greater independence would be training what's going on through talking to competitors, former employees, suppliers. And so we do around 150 calls a year. with those types of people that really give us an independent view as to what's going on. I think the third leg is essentially using data and analytics to essentially get confirmation in greater context as to what's happening. So I think that's kind of evolution of our process. I think you need to be, I think you need to. We'll see what's coming next, but I think we're still early in the third phase. And I think a lot of investors actually, particularly on the credit side, aren't even at the second phase. I think a lot of those investors are focusing on what management's telling them, what's in the roadshow. And it's a more simplistic type of research process. I'm just always interested in structural stuff. You've already mentioned maybe some issues with the rating agencies, the idea that many investment grade. holders or investors are forced to sell under certain conditions when ratings change. Are there other interesting structural things that drive prices and behavior in this market that you watch closely? Those would be probably the two big factors that I see out there. I guess another way of thinking about this would be, so if active managers are, let's say, the weighted average is they're in step two of that evolution. Not even. Or not even. Not even.

the primary you know i'm always interested like who's on the other side of a trade right like when i'm when i'm buying like who am i buying from and why and sometimes those motivations are pure and they make sense. And sometimes the person's making a mistake. And like, there's only so much investor error to go around. And so I just always want to know like, what are the pools of investor error? You could argue, you know, for selling because of a dumb rating agency, changing a letter is a source of investor error. So I guess the better way to ask the question is like, what are the biggest pools of error and what drives them? That's a good question. So in terms of investor errors, I never heard of the... the letter changing, but that's the way to put it. It's true though. I think part of it is if you look at the high yield side, when assets come from investment rate, it's just, it's pure technical where you have investors basically have to reduce exposure because of a change of downgrade. And there's a structural reason for that because those investors essentially are forced from a capital perspective to only have X number, they have to have X number of reserves depending on the rating criteria. And it just is what it is. In terms of within the high yield side, if you look specifically at what we're doing, debt that is lower rated, some investors preclude themselves from buying low rated papers as a CCC paper, where they have specific limitations that they can only own X percent. And we tend to look at where we believe the trajectory of the credit is going and what we believe the credit metrics will. We expect them to be improving, which is a very different opinion. You have to understand why companies are rated lower quality. I think a lot of investors will say, oh, it's triple C. I don't want to own it. And if I can own triple C, I want to get paid greater yield for that because it looks bad on my fact sheet to have that exposure. We look at it and we say, what's the trajectory of the business? What do we think?

leverage will look like? What do we think the equity value creation is? And are we aligned with the equity from a business strategy perspective? And how we see the business evolving, the balance sheet evolving. And so that's how we tend to think about it, which is a little more nuanced. And so in general, if you look at some of our lower quality paper, the yield is generally less than that of that subsector. But if we look at the trajectory, it's obviously going. forward. And we think that's an arb we're able to capitalize on. I'm always fascinated by industries. And I don't want to talk about software because we've talked about that a little bit. What couple other, maybe two or three other industries, and maybe we'll leave cable and broadband aside as well. So trying just to identify some other different examples. Do you find most interesting for your work right now? It really kind of evolves. We have an opportunistic. been to us. And so it depends where the opportunity has been. So due to the environment, we went from essentially zero energy weighting in the middle of 14 to high teens energy exposure. And so we thought that was actually a really interesting time because you had an environment where the price of the commodity was basically unsustainable where it was from a... reinvestment perspective and we're able to identify names where we could get 20 plus percent IRRs because of that fear of the price of the underlying commodity. And we were also able to extend it different areas, which I thought was actually more interesting. So we were able to extend it into MLPs, which there was concern about the solvency of some of their counterparties and combined with leverage, answering it to buy some investment grid assets between single B and triple C valuations. And then we took it even one step further and went and found another place such as Gardner Denver, which had around half their business exposed to supplying basically components to the energy space that had the drop off with E&Ps essentially reducing their spending. So that was an area that I thought was actually really interesting in the energy space. And it's something that we aggressively added to risk when it was down and we're able to find great opportunities that we got. We have a big cyclical recovery.

Another example that we saw after that was retail sold off. And it was kind of a continuation of the obvious trends that people see out there, such as online. And then there are a couple of names like J.Crew and Neiman, which have meaningful online exposure between 35% and over 50% of their businesses online. They had company missteps that we believed were going to reverse themselves. That played out in basically 16, 17 time period. I'm sorry, 17, 18 time period. And then recently, it's been really the part of the market that's probably that we thought was the most overpriced is the highest quality part of the market, which is very interesting because investors perceived the higher quality as being more defensible. And it was actually the most vulnerable. And it was the most vulnerable because it had the most rate sensitivity. And so you saw a number of those companies with longer duration sell off the most. And so we actually found that as an opportunity as we were like that area because we saw some of the excesses and we actually moved a lot of our higher quality into more floating rate paper, which was immune to some of those risks. If you were forced to leave the high yield market, what other market do you find kind of next most interesting? If I were forced to leave the high yield market, I probably would just leave the business. That would be... That would, that would, I mean, I love what I do. And is that a reflection of the relative opportunity set? Meaning, you know, you think you've identified a place that has inefficiencies that can be taken advantage of consistently. Am I reading too much into that, that you think? No, no, I wouldn't read that much into it. I mean, I love the high yield business. I think if it was a situation, the way I'm personally wired, I'm all in or I'm out. And so if I'm out, I'd be retired and I would. do something with my, you know, spend time entirely with my family and my kids. And so that's what I would do. So I'm in or I'm out and I'm in and I'm not someone that's going to be like half in. I'm not going to, I found my, my calling. I'm sticking with it. And if I'm out, I'll be on the beach somewhere. You mentioned or referred to a healthy skepticism, I'd say kind of throughout the conversation. I'm curious to what degree you've gotten more skeptical.

of just things in general, companies, you mentioned bankers, rating agencies, et cetera, as your career has progressed? I think it's natural when you start in the business, you have this view that everyone's here to be honest and tell the truth. And then you learn through experience that incentives are not aligned. Issuers want the lowest cost of capital. And so often they'll tell you what they need to tell you to drive that cost of capital down. And so we have bankers on the other side are working for the issuer. They're not working for the investor. We're fully aware of that. And so that's why we think the value of independence is very high. And so that's why we are totally independent. We don't really care what other people perceive. That's why our portfolios look very different than the benchmark and most of our peers. A selfish question as an equity guy and always interested in whether or not we can triangulate other things about a business versus what we would normally look at. Are there factors that you would say portend a very bad future? things happening on the equity side based on work that you do on the credit side. So I'll give you an example just based on talking to you what comes to mind. So maybe if the cost of capital or new issuance in an industry is rising, let's say, maybe that is a negative, all things equal a negative factor for the future returns of the equity. Absolutely. So I'm just curious, things like that, if there are other ideas that you think might be interesting to the equity investors out there. If you look at fixed income and credit in general. If your cost of credit goes up, it's a disaster for equities, broadly speaking. So it's absolutely important. And the implications are across the board. If credit costs are very high, if rates are expensive, it's very challenging for companies to, one, invest to grow. They can't spend capital expenditures like they used to. And so it's actually got a very negative real economy connotation. So when you came out of the financial crisis, And the average high yield bond was yielding 20%. It was uneconomic for any company to incur debt to do any sort of capital project. And so that partially, the flow through the economy is very real in that scenario. If you look at other sectors.

When they lose access to capital, the knockdown effects are very real. And so if you go back to the latest crisis in the energy space, as an example, if E&Ps, if their bonds are in the 40s or 50s, they have no ability to issue new capital. They can't grow production. They're likely shrinking production. And then there's kind of layoffs across. There's layoffs. There's companies that are just trying to repair their balance sheet. And there's no chance of any sort of value being returned to equity holders in the form of dividends, share repurchases. And so the credit side is something you have to be very careful. Credit tends to be early cycle. It tends to lead equities in general. And if you saw in the last downturn, you saw credit underperform pretty dramatically before equities did. And that makes sense because credit is more focused on downside, where equities more of a, you know, looking for what the upside, more focused on upside. So I think those are some pretty interesting. dynamics that happen if you had to sum up a lot of these concepts that we've talked about today you know spreads etc what are they telling you about just kind of the broad picture today what the world looks like today relative to the past so if you look at october as an example when there was a lot of equity volatility credit was off marginally but off about a percent and a half so the implication there was it's not a systemic This is not like another recession. So there wasn't as much concern in the credit market, nearly as much as there was in the equity market. A lot of the equity market though, a lot of the downside was really concentrating some very high multiple growth stocks that massive upside moves in the prior 12 to 24 months. And we just don't have that same dynamic in the credit markets. The credit markets are clearly very robust now and they're strong in it. they're not sensing or pricing in any sort of like economic deterioration. One of the things that I forgot to ask earlier is like the notion of covenants, how much you track, what are the major categories of covenants that you care about? So I'd like to ask that question first. And then my second question would be like, whether or not there's anything that seems scary to you today. So just to give you kind of where we're going, but first on the covenant side, what do you care about? So let's talk about what covenants are, because I think it's probably a good level of point. So covenants are, it's a one-way promise.

the issuer makes to the lenders in terms of what they will do in terms of one, what's called a maintenance covenants, which are profitability levels a company must sustain. And then two, there is also incurrence-based covenants, which allows the company to incur debt as long as they meet certain ratios. And there's been a lot of attention about Covenant Lite. And Covenant Lite is tied to the maintenance of certain profitability levels, and that has essentially gone away. And that's in the loan market. It's around 85, 90% of issuers now are covenant light. And I think it goes beyond that. Covenants are essentially power that either the issuer or the investor has in terms of if there is some sort of issue or a covenant problem. Basically, the bondholders or the loan holders essentially have the ability to renegotiate with the issuer. And so issuers have basically tried to take as much flexibility. of that power and it's gone to themselves. And part of it is because of the structural change in the market, which we talked about earlier, where the market used to be a syndicated market. I'm sorry, originated market. Now it's a syndicated market where investors like ourselves own it and we can try to get leverage over the issuer. But it's actually gone one step further. Now issuers have created docs that are even looser and they've got the ability to transfer value. away from creditors in certain circumstances. What would be an example of that? An example of that would be Caesars was an example where they moved collateral. J.Crew moved collateral out of the group. And then if you look at PetSmart, they bought Chewy. They actually used some of the Chewy collateral to try to strip that away from the group and basically move it into a different entity that will allow them to either give that value to equity holders or else capture discounts in their bonds. by allowing subordinate bonds to exchange into that collateral and reduce principal balance. So I think in the next downturn, that will be something that we're very aware of. We never buy an issuer based on covenants, but it can prevent us from buying one. Typically, the higher quality companies have the loosest covenants, which makes sense because they've got availability and probably the museum's less. As we go going forward, we're going to spend, we think there'll be transfer value between.

different credit groups. Another example of where issuers use this is the downturn. Companies would take subordinate capital and exchange it to more senior capital at a discount. So Chesapeake did it as an example. California Resources did it as an example. And unsecured creditors were essentially allowed the opportunity to move up in seniority at oftentimes 50 cents on the dollar. And so it's a pretty clever way for the issuers to capture discount. And if they reduce that debt balance, So let's just say you take a billion dollar of debt and exchange it 50 cents on the dollar. You've essentially reduced 500 million of debt if you're the issuer. So what does, if anything, have you scared or at least hyper aware in high yield markets today? In terms of high yield, we're always looking for what can go wrong. I mean, that's the whole business. What we're looking at right now is, I think the biggest question in the market is what happens on the issuance front? How will we progress through the cycle? And typically you'll have risky issuance, and risky issuance is kind of a precursor to future defaults. And what we're monitoring is basically that leveraged bioactivity. It's been relatively light, especially if you consider the amount of capital that's been raised by private equity firms. It's been raised but not deployed. So there's been about a trillion dollars of PE capital that's raised but not deployed. And if you assume roughly a 30%, 35% equity investment, that's potentially $2 trillion of debt if it all goes in the US, which probably about half of it will go. But we're going to look at the terms, look at covenants, we'll look at the overall issuer quality and try to see how the cycle progresses. And thus far, it's been relatively light. And that's been kind of the big surprise is there's been this lack of private equity, LBO activity. Considering the amount of capital pools that have been raised, I think a lot of it has to do with the economics are challenging for the puppy side to make it work on the buyout side. Well, this has been fascinating. My closing question for everybody is for the kindest thing that anyone's ever done for you. I would say not one particular thing, but I would say in general, I'd give my wife credit. She raises our three kids and it's been really, I think it's been a sacrifice on her part.

to make sure that she is a good influence, raises our kids and allows me to basically work and do what I do. So it's probably been the kindest thing that she's ever done. Wonderful. This has been a whole new area for me. So I appreciate all the, all the learnings, all the insight and all the time. Thank you. Appreciate it. Hey everyone, Patrick here again. To find more episodes of Invest Like the Best, go to InvestorFieldGuide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at InvestorFieldGuide.com forward slash book club. After you sign up, you'll receive a full investor curriculum right away and then three to four suggestions of new books every month. You can also follow me on Twitter at Patrick underscore Oshag, O-S-H-A-G. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.