Oaktree Capital Management is warning credit investors to brace for unpleasant surprises in the fourth quarter, as U.S. elections loom amid the persisting pandemic.
“More than ever, it is important to be wary of market exuberance and to avoid chasing risky investment opportunities to tighter levels or weaker legal protections,” Oaktree said in its third-quarter credit report, released this month. “September’s turbulence interrupted what had been a resounding recovery from the depths of the selloff in the spring, and markets now look to have entered a sideways period.”
The alternative investment firm, co-founded by Howard Marks, cited its concerns over the rising cases of Covid-19, the U.S. elections, and Brexit. Industries are under stress as business activities fall off in the pandemic, while companies are shouldering heavier debt loads, the firm said.
“The economic strain produced by Covid-19 will be felt for several more quarters, if not years,” Oaktree said in the report. “We remain focused on protecting the downside in our investments.”
Defaults have been on the rise.
The rolling 12-month default rate for U.S. high-yield bonds was 4.5 percent at the end of September, up from 2.4 percent a year earlier, the Oaktree report showed. For U.S. senior loans, the default rate rose to 4.2 percent from 1.4 percent over the same period.
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“With the U.S. election and Brexit ahead, market volatility is all but guaranteed,” Oaktree said.
UBS Group reminded investors in a research note Monday how far off polling had been before the 2016 presidential election, and how “wrong-footed” the stock market’s initial reaction was in selling off once it became clear President Donald Trump had won. “So it is important to take first reactions with a grain of salt,” Solita Marcelli, UBS’s chief investment officer for the Americas, said in the note.
“In a blue wave, small and medium-sized firms should fare better on the back of expected fiscal easing,” Marcelli said. “Treasuries will likely sell-off in a clearer Democratic victory, and we believe the dollar will rally if Republicans are winning.”
Uncertainty surrounding “the severity of the next bout of turbulence” demands disciplined credit research, according to Oaktree.
The firm saw “very low” interest rates — as opposed to a fundamentally stronger economy and market — encouraging risk-taking among investors and driving the recent rally in risky assets, according to its report. Oaktree pointed to “lofty” equity valuations in the third quarter, particularly in the technology sector, as well as “yield spreads” for junk bonds and senior loans that continued narrowing from the wide levels seen in March.
High-yield bonds gained 4.9 percent in the third quarter, even after prices tumbled in September on the renewed wave of Covid-19 cases, a U.S. standstill on fiscal stimulus, and a glut in supply, according to the firm’s report. U.S. senior loans returned 4.1 percent in the third quarter as “lower-quality” credits rallied the most, the report showed.
Oaktree expects elevated unemployment will persist along with “muted” economic growth globally. The firm is skewing its portfolio toward more stable sectors in the pandemic, finding “interesting opportunities in the convertible bonds of life sciences and technology companies” that cater to the stay-at-home economy, according to the report.
“We are approaching the fourth quarter defensively,” Oaktree said.
