(Bloomberg) - It’s too soon in the cycle to look for bargains in the credit market, according to Mark Okada, CEO and co-founder of Sycamore Tree Capital Partners.
The firm, which manages over $1 billion in assets, is instead looking for assets that will perform decently as economic growth weakens and defaults rise, Okada said. He spoke to Bloomberg’s Gowri Gurumurthy in a series of interviews ended July 19. Comments have been edited and condensed.
Where are we in the credit cycle now?
I have seen many kinds of credit cycles. The market is very different this time. Credit spreads are being driven by fundamentals as opposed to the risk-on/risk-off cycles driven by liquidity that we had been seeing before. The last cycle driven by fundamentals was 1998-2002 and there are a lot of similarities between that cycle and this one. This could last three to four years.
What makes this cycle different?
There is not enough leverage in the system to jeopardize the banking industry. And there is no evidence of stress in the money market as in the past cycles. But what really differentiates this cycle is the credit dispersion across ratings and sector. That kind of dispersion was not seen in the earlier cycles.
The gap between BB and B spreads was about 246 bps at Friday’s close and between B and CCC spreads was around 436 bps, almost double. The dispersion is more pronounced in the lower quality credit because there is no Fed put here and there is no liquidity propping up the market. This shows market players are reluctant to own high-risk credit.
That credit dispersion creates a lot of opportunities. There are winners and losers in the high yield market. Investors are able swap one bond or loan for another and get paid enough for taking risk. This kind of situation hasn’t really been seen in the last 20 years, if we take the Global Financial Crisis off the table.
So what looks attractive now?
If this is the beginning of a multi-year cycle, it’s early to look for value at this stage. There is margin pressure building in many companies and overall interest coverage and leverage numbers are deteriorating.
Instead we’re stress testing for recessionary protection and defaults. We’re looking for higher-quality cheap credit on the margins.
We like AA and AAA CLOs. We prefer that to AA investment-grade. There is no credit risk and no rate risk there. They offer attractive returns. The CLO market has been held back because banks dominate the AAA world. AAA CLOs are held by banks, who aren’t active buyers now. On top of that, some managers are selling the securities to create liquidity. So it has gotten cheap.
In high yield, BBs offer opportunities when the Fed takes pressure off the rates market. It is a little early to do that now. We are not playing in the high-yield market at the moment. Up-in-quality has to be the broad perspective.
In bank loans, the market has been down after big outflows in May and June. Loans are still outperforming the high-yield market though after adjusting for ratings. We like secured debt. BB rated bank loans are cheaper than BB rated high-yield bonds. We are playing in the BB market and are not looking at B or CCC loans.
What sectors do you avoid?
Some names in the construction, food and consumer sectors and building products are getting hit hard because they have difficulty passing on cost increases and are seeing margin erosion.
Alpha comes from not owning them rather than buying them. We are punting on names that don’t have the pricing power that they thought they have. We’re focusing on defensive sectors like healthcare and energy.
Durable performance in this bear market will depend on how a manager deals with the losers in the portfolio.
By Gowri Gurumurthy
