Michael Lewis opens his new book, The Undoing Project, with a quote from Voltaire that I think perfectly describes our current posture toward the markets: “Doubt is not a pleasant condition, but certainty is an absurd one.”
While some are compelled to state a definitive view at all times, I will freely admit that I believe we are currently operating in uncharted territory. On this I seem to be in good company, as Federal Reserve Chair Yellen recently said at a press conference, “We’re operating under a cloak of uncertainty at the moment.” We do not know any specifics about the President-elect’s plans and his cabinet does not provide us with a long history of relevant government service on which to base predictions. It’s a bit like watching performance art -- in the absence of a tangible storyline everyone is filling in the blanks as they presume or interpret them to be. Good predictions are based on deep analysis of data and recognition of patterns. Right now, I do not see a lot of meaningful, instructive data or discernible patterns coming out of Washington.
There were some policies voiced during the campaign and historically espoused by the new Republican majority that will drive markets and can have true stimulative effects on the economy. A reduction of taxes, investment in useful infrastructure and streamlining regulations can all benefit a sluggish economy. That said, too much tax reduction can blow a hole in the deficit and streamlining regulations only works if it spurs innovation and investment. Done to excess, it can have long-term deleterious effects on the economy and society. In the short run, the markets will certainly react positively to these actions. As investors, it’s our job to identify the difference between a successful kick start to economic growth and a sugar high.
Beyond the obvious atmospherics around this most unusual transition, we do worry about the potential impacts of the posturing on free and fair flow of goods in international trade. History tells us tariffs and trade wars usually don’t work. There is no precedent for understanding the potential for tweets that could crash markets or be taken as provocative in the world of diplomacy. My instinct is tweets don’t change intrinsic value or market realities, but neither can be ignored.
While I am somewhat surprised by the market’s reaction since the election, I still believe opportunity exists in the credit markets. You just need to know where to look. Last year, we achieved near-record results across most of our strategies. Notably our flagship Multi-Asset Credit Fund was up over 14% net in 2016 and our newest Distressed & Special Situations Fund deployed 30% of its capital and was up over 25% net. We also closed on a groundbreaking permanent capital lending vehicle. What pleased me more was we did this with relatively conservative positioning and asset mixes. Quality of earnings is as important as quantity.
One might logically ask how can funds be up 14% to 25% and not be completely “risk on.” The answer lies in the old Warren Buffett adage, “Be fearful when others are greedy and greedy when others are fearful.”
While our Multi-Asset Credit Fund was up 14% net during the year, it never had 100% exposure and at various points held S&P puts, retail puts, gold calls, HY CDX shorts and cash. We bought protection when volatility was low and sold it when volatility was high. In the liquid space, we are still in a low default environment. The slow, steady growth of the US economy has been good for fixed income and credit. Our newest Distressed & Special Situations Fund invested 75% of their new capital outside the US with 35% in Europe, 22% in Asia and 18% in Australia. We largely purchased assets off of banks’ balance sheets and participated in complex transactions that took months to structure and negotiate. Several of these transactions were ones that we had been tracking for six months or more.
The team showed great patience and discipline leading up to the Brexit vote, while also moving quickly in the subsequent chaos, when we bought over $1 billion par across three heavily-discounted European portfolios. The portfolio purchases we have executed in Ireland, Spain, Italy, Thailand and Australia were all bought well below what we believe is intrinsic value. Their successes or failures should result much more from a plethora of micro factors rather than a more generalized macroeconomic “bet.” Finally banks continue to step back from corporate lending, creating opportunities in private lending, especially senior debt.
So what do you do in times of uncertainty? First and foremost, we must remember that you never have to do anything. We will continue to play our game, protecting capital and making sensible investments when and where we see fit. We do not “put money to work.” We invest it. We are focused on preparation and adaptation, not prediction. As we were last year, we will be nimble with our asset mix and make sure we always have enough cash to move when we see unique and often proprietary opportunities.
What does all this mean for our funds? While equity valuations are in the 90th percentile and bonds are in the high 70s, bank loan spreads are still at the median historical level. Average leverage for new issues has been stable and interest coverage is strong. Across our portfolio, over 70% of our companies are meeting or beating expectations and only 10% are reducing guidance (which isn’t always bad from a debt investor’s perspective). Therefore, in liquid credit we are taking risk off in the rally, skewing toward bank loans in our multi-asset credit strategy, continuing to layer in cheap shorts and holding slightly more cash than normal.
Despite the macro and political uncertainty, the core of our liquid funds comprises solid companies with reasonable spread and leverage levels. Whether or not President-elect Trump builds a wall and who pays for it will not affect things like residential alarm installations, the number of hamburgers consumed or the amount of high-speed data used to stream Netflix. We are watching a few sectors with idiosyncratic exposure in the new administration, namely retail, automotive and healthcare; but the majority of the leveraged credit market depends on the overall health of the US domestic economy not relying on trade in any material way. In fact, our liquid funds are mostly invested in US companies, 90% of our Multi-Asset Credit Fund and 86% in our main Senior Loan Fund. Our core portfolio earns an attractive current yield, and yet our more defensive positioning overall should protect capital in an uncertain market and allow us to quickly take advantage of opportunities if and when volatility materializes.
In the special situations realm, we continue to be patient, looking for idiosyncratic value, maximizing the benefit of our 14 industry teams and global scale. Our global team has a strong pipeline of both portfolios and corporate distressed opportunities, and we expect our investment pace in 2017 to be similar to our pace in 2016.
I always remind the team things are never as bad as they look or as good as they feel. Dispassionate investors should not be caught up in the exuberance of the current equity markets, nor should they run around with the narrative that the sky will fall in irreparable ways. The current state of affairs is far more nuanced than that. Short-term relaxation of regulations might drive the markets but has negative long-term effects for the economy, businesses and society, while short-term actions that expand the deficit may in the long run spur growth that the economy is not seeing right now. Now more than ever we all need to avoid knee jerk reactions or decisions made of emotion or personal ideology.
Part of our success in 2016 was driven not just by our scale, but also our scope. Having teams in the United States, United Kingdom, Ireland, Hong Kong and Australia opened our idea funnel in ways we could only have imagined possible as we embarked on our global expansion more than a decade ago. Currently, 30% of our investment managing directors are outside the United States. Of the four new managing directors we elected this year, two are in Hong Kong, one in Australia and one in Boston.
While the partnership continues to grow, totaling 34 today, one of our old-timers, 17-year veteran Dave McCarthy, has decided to try something new. Dave is currently Head of our Structured Products Group and has decided to move to New York to become Chief Risk Officer of the commercial division of a well-respected, mid-sized bank. He had previously served as our head of risk and is intrigued by the opportunity to take over a 200-person risk group. John Wright, his number two for many years, will take over leadership of the Structured Products Group and Stephanie Walsh, our former European CLO Portfolio Manager and current Co-CLO Portfolio Manager with Dave, will take over as Lead Portfolio Manager on our CLOs. Dave is a dear friend and I wish him all the best in his new career.
Thank you for your continued partnership and support. We look forward to sharing our ideas and market perspectives as the year unfolds.
Jonathan S. Lavine
Co-Managing Partner, Bain Capital
CIO & Founder, Bain Capital Credit