Harvest Rock Advisors, LLC

Earthrise - 01/04/2019

I hope everyone had a satisfying holiday season. A client said it well: “I had a great holiday and now I’m exhausted” – that’s my sentiment these first few days of 2019.

On Christmas Eve, I was in the office tying up loose ends before the holiday. I found myself staring at the PC screen as the US stock market had another really rough trading day, sliding down despite low trading volumes, closing early and bereft of any financial news, good or bad. The only plausible explanation was the Grinch was shorting the market, right?

I fortunately got distracted by a feel-good story: Christmas Eve marked the fiftieth anniversary of NASA’s Apollo 8 mission, the first-time humans orbited the Earth and the celebration of arguably the most famous picture ever taken.

On December 21, 1968, the Apollo 8 spacecraft made a hurried takeoff on its quest to deliver the first humans to the moon and back. The space race against the Soviets was real and rumors were the Soviets were about to launch a similar lunar orbit mission. Accordingly, the Apollo 8 mission, originally scheduled for 1969, was moved forward to the consternation of many in NASA who feared the spaceship was not yet duly tested. 

Luckily, the spaceship worked as designed, circling the moon ten times and successfully returning to Earth six days later. Reportedly one-third of the world population watched or listened to the Apollo 8 mission! 

A few days after splashdown, NASA released the iconic photo now referred to as “Earthrise” – and the story on how it was captured is gold. 

On Christmas Eve, during the fourth orbit of the moon, the three astronauts were stunned to see a stark image of the blue marble planet rising over the moon’s horizon 240,000 miles away. 

Astronaut Bill Anders was in charge of the mission’s camera and only had a limited inventory of film earmarked for scientific photographs, not tourist pics. 

Stunned by the image, the astronauts said the hell with film protocol and scrambled to change out the black-and-white camera film with their color stock. They had to float over to a different window and narrowly captured the picture before the Earth left their view. 

Now, Earthrise is considered the most famous photograph ever taken and has been credited with kick-starting the environmental movement.

Anders is still alive and last month quipped: “Fifty years to the day we set out to explore the moon and instead discovered the Earth." Talk about the right stuff.

Look for our 2019 investment outlook in two weeks and review our last blog for commentary on the market’s antics last quarter. In this note I want to focus attention on the behavior of a single investment sector, corporate senior secured credit.

What a difference a quarter makes. Through September, traditional asset classes were having a blah year, but senior secured credit was having a solid one. In fact it was one of the best performing asset classes in a diversified portfolio.

Then, on October 3rd, Fed Reserve Chairman Jay Powell gave a speech about the Fed’s intention to stick to an assertive tightening schedule of US money policy, hell or high water, and global capital markets immediately recoiled. None more so than senior secured credit sector, which has truly wigged out over the past three months.

Per Citibank, about 70% of senior secured credit instruments were trading at or above par in September. By December, the figure had dropped to nearly zero and the entire sector is now trading at discount to its loan par value. Ouch.

Per a recent Eaton Vance investor note, the fourth quarter sell-off in the senior secured corporate sector was emotion-driven and not based on credit fundamentals or asset quality. 

Based on their research, bank loans have violently re-priced downward to where the expected collective loan default rate is now an astounding 27%. For perspective, the actual default rate of all senior secured loans during the great recession was 15%! 

Note that “senior” means the lender is first in line to get paid in a bankruptcy event and “secured” means the loan is collateralized. This is a vastly superior capital position than a high yield bond, which is an unsecured debt obligation. Investment recovery in bankruptcy for high yield bonds is often low.

Heading into 2019, the credit default rate is running at 1.6% and the level of distressed senior secured credits is just 0.4%, so it’s not signaling future trouble either. And, importantly, the US economy remains in very good shape.

The sector’s ugly 4Q18 is due to change in investor psychology, specifically a torrent of spooked retail investors who had poured into floating rate bank loan sector over the past couple years, chasing yield and higher short-term interest rates. The outflow of retail investor money from bank loan funds since October has been meaningful.

Now, all is not peaches and cream in the senior credit sector. Much of the large volume of recently issued corporate bank credit is “covenant-light”, which means the loan terms are too accommodative to the borrower and can spell trouble for the lender if the loan goes bad.

This suggests effective investing in the senior credit space requires smart active management, hiring professionals who sift through loan deals to select the better credits with adequate collateral and good loan documents.

Over time, fundamentals lead to logical investment outcomes, good or bad and so now is not a good time to bail on this asset class due to fear-based selling. Senior secured credit has been a good, if not frustrating, portfolio diversifier and its short-term outlook is the opposite of dire. In the past, this sector has often seen quick V-shaped rebounds due to their preferred position in the capital stack, their short average life and the “pull to par” reversion dynamics.

Longer term, senior secured credit will be tested again once a US recession materializes, but we don’t see one looking out our spacecraft window, at least for 2019.

Until next time, Happy New Year and be well…..Tim


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