Warren Buffett said that he and the late Charlie Munger, “prefer a lumpy 15 percent to a smooth 12 percent return.” But not every investor is, or can be, a Buffett.
On the contrary, many retail — and many institutional — investors are highly sensitive to above-average volatility and try to avoid it by allocating to funds whose objective is to dampen short-term changes in valuations. Instead of viewing market ups and downs as an opportunity for alpha generation, the mainstream investment industry defines volatility, or standard deviation, as risk.
I beg to differ. I would argue the inherent dynamism, (an elegant euphemism for volatility), of public credits being marked to market — essentially repriced all the time — provides plenty of advantages over private markets: Investors can often buy securities at a discount during times of stress and get the opportunity to earn higher returns over the long term.
Institutional and high-net-worth investors not only tolerate “lumpy” returns, but accept them as a feature, not a bug. Both mark-to-model (private debt), and mark-to-market (public debt) strategies play a crucial role in diversifying alternative credit markets. However, unlike private credits, investing in the debt of public companies offers several advantages, especially today, as economic, political, geopolitical, and policy events generate uncertainty and spur rising market volatility. For example, geopolitical risks, once confined to specific regions, now affect multiple countries simultaneously. Political discontent is rising in both developed and developing nations. Name your issue: ballooning government debt; technology innovation such as artificial intelligence and the contrasting views of whether it is a potential net benefit or detriment to society; rapid climate change. These tectonic-like changes, seemingly happening all at once, must be factored into investment strategy decisions as never before.
Remember, when market shifts occur, they often happen very swiftly and with significant magnitude as investors are forced to rapidly adjust their positions.
In public markets, credit spreads serve as a premium offered to investors to offset the risks associated with bankruptcy. Tight spreads are reflective of investors’ complacency over the health of company balance sheets, shrinking margins, or the likelihood of increased funding costs. Currently, credit spreads are narrow and in the upper quartile of historical averages. Over the next three-to-five years, companies that relied on cheap borrowing during the period of quantitative easing by central banks, may need to refinance their debt at higher levels. Barring a “Black Swan” type of event, there are already several notable trends that could trigger spread widening: U.S. commercial real estate foreclosures are rising as are delinquency rates on consumer credit cards, and the U.S. personal savings rate, which rose during the pandemic, has been on a sharp decline since 2021.
In my view, volatility offers an opportunity to invest and compound capital over the right time horizon, thus potentially offering excess returns relative to private credit. Investors can use mark-to-market securities to quickly respond to market changes and exploit dynamic conditions. In contrast, valuations of private strategies are often slow to respond to changed markets. In exchange for potentially higher price volatility, the secondary public credit markets offer investors other positive attributes, including price transparency, liquidity, visibility on governance and performance, and the potential for attractive returns relative to equities with compelling yield-to-maturity and with robust margins-of-safety.
In every market cycle, there are attractive opportunities if you know where to look. Why focus on the debt of publicly traded small-to-mid-size companies? I believe this sector presents an attractive opportunity set—in nearly all seasons—for several reasons. First is capital scarcity. By avoiding the big index names, funds can be deployed to pockets of capital scarcity when small-to-mid-size companies experience stress or distress. For an investor, this is an enviable starting point. Purchasing these securities at a fraction of their face value provides a meaningful margin-of-safety and the potential for substantial returns when the bonds regain value. Spreads in stressed assets can exceed 6 percent and spreads in distressed assets can surpass 10 percent.
Large credit whales cannot swim among the minnows because they cannot take sizeable positions without distorting the market. This means that investing in smaller companies presents less competition from other capital providers and grants the ability to engage in proactive credit management with prospective companies. Smaller companies with straightforward capital structures may present significant yield potential and catalysts for growth. Also, unlike equity investors who are the bottom of the food chain, holders of debt have a legal claim on the issuer’s assets and cash flows. This gives them leverage in negotiations with the possibility of demanding more favorable terms during a restructuring, thus tilting the probability of a successful outcome.
Further, because credit spreads in this sector are driven more by the idiosyncratic characteristics of the companies themselves, as opposed to broader market conditions, the strategy is beneficial for diversification and risk management. It can generate non-market beta, equity-like returns. I believe, on a case-by-case basis, there will always be attractive investment opportunities in every market and economic cycle. Unique situations where an industry falls out of favor — current candidates include healthcare, biotech, EVs and cannabis — or a company faces obstacles in refinancing, can create opportunities that do not neatly fit into the consensus of a market cycle. Buying good businesses with bad balance sheets requires deep, fundamental research. With a thorough understanding of a business or sector, it is then possible to use volatility on the upside and exploit opportunities well ahead of the herd.
This is not a “set it and forget it” investment strategy. It is a hands-on, highly differentiated approach where each credit must fight for its place in the portfolio.
Portfolio managers specializing in stressed and distressed companies will necessarily interact with a wide array of stakeholders such as legal and accounting professionals, credit agencies, company management and others. Being nimble and able to adapt to sometimes rapidly changing market conditions and multiple stakeholders is table stakes for us.
To quote Howard Marks, co-founder and co-chairman of Oaktree Capital Management, a global leader in alternative investments, “If you seek superior investment results, you have to invest in things that others haven’t flocked to and caused to be fully valued. In other words, you have to do something different.”
As the world, and concomitantly the capital markets, become ever more volatile and unpredictable, building financial resiliency will necessarily require a greater allocation to alternative assets including public credit strategies which offer the potential for competitive returns to private credits but with much greater liquidity, transparency in valuation, performance and governance, and, yes, volatility. Time horizon matters as volatility only works for those who make it through the investing experience. For those investors who can take a few lumps, the potential for meaningful outperformance in mark-to-market strategies remains very appealing in the coming years.
Parul Garg is portfolio manager of the Pender Credit Opportunities Fund.
