Neuberger Berman’s Norman Milner on Why Credit Could Lead Us Into Recovery

Introduction
Neuberger Berman’s Norman Milner on Why Credit Could Lead Us Into Recovery

Powerful data is beginning to emerge to help us create opinions and perspectives on how to move forward from the first phase of COVID-19. As we look toward recovery, through expert analysis we can uncover new investment opportunities that will take advantage of the unique landscape we’ll find ourselves in over the next year.

Purpose Financial founder and CEO, Som Seif, talks with Norman Milner, Managing Director, Neuberger Berman, about:

  • Why the Fed’s response bodes well for a sustainable rally in investment grade credit
  • How to avoid confusing yield spread with total return potential
  • The major credit market difference between today and 2008 that bodes well for the future
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Read the transcript:

SOM
Hi everyone. This is Som, founder and CEO of Purpose Financial and Purpose Investments.

We’re all enjoying better weather these days. Hopefully, our mental health and some of the mental struggles and anxieties we’ve experienced are starting to release a little bit. I hope everyone’s feeling better, and what makes me feel a lot better is that we’re now in a really interesting time where the critical data is starting to formulate to help us make decisions.

We’re also seeing a lot of the stimulus and monetary policies start to play their way through the markets and see the effects of that.

All of this data is really powerful to help us create opinions and perspectives on how the paths forward will come together. It allows us to make better decisions, and that gives me a lot of hope and relieves a lot of the stress that I’ve been feeling personally. I hope everyone’s feeling that way.

I do like a lot of the trends we’re seeing on the data-side of health care, trends for the most part in terms of flattening the curve are very positive. At the same time, I’m also, as always, really interested in the trends and growth changes we’ll see out of this. I read a recent Globe and Mail article with a lot of curiosity as it laid out the major trends around how we’ll be living our lives differently after this.

As I’ve said before, I don’t think the trends we’ll see coming out of this weren’t already beginning to happen before, we’ll just see an acceleration of them. There will be some social habits and changes, but I am somewhat cynical to think that 12 to 16 months from now our lives will be lived very differently than they are today.

I think there will be lots of change by virtue of the acceleration of trends that we were already seeing, but I don’t see us all living in a socially-distanced world for the next three to five years. It can be hard when you’re at the bottom of the pit to look out and think of when things will be normal again, but I do think for the most part we will be normal.

Whenever I think about big opportunities and how the world could potentially change I love to get the perspectives of industry experts. One of those experts who I love talking to is my good friend Norman Milner. He’s one of the really deep thinkers in the credit markets and what’s happening around the world, and luckily he’s my guest today.

Norman, I love talking to you about everything that’s going on and I wanted to have your insights and learn about the opportunities you’re seeing today but also where the challenges lie. Norman is a managing director at Neuberger Berman where he runs multi-sector fixed income strategies, he’s also one of our core partners at Purpose Investments and runs a number of our core bond mandates, and he’s also a wonderful friend.

Norman, welcome to the chat today.

NORMAN
Som, thanks for inviting me and for your kind words. It’s always great to sit down to flesh out ideas with you. You bring a perspective that’s unique to your clients, and to us, and we really enjoy sharing our ideas with you.

I’d start by echoing the points you made around an increased level of clarity, and an increased level of understanding of the ramifications of this terrible disease.

As one begins to look through the data, we’re beginning to see a framework within we can make decisions — from a risk perspective, from a capital allocation perspective. Much of that decision making in our thought processes is framed along a couple of key points.

Number one, there’s been a fiscal response, a monetary response and a healthcare response. The monetary response, we’re very encouraged. The fiscal response, we’ve obviously seen a massive fiscal stimulus globally, whether in Canada or the U.S. or Europe.

In the first few months, particularly March and April, we saw an incredible liquidity squeeze globally and that was responded to by central banks, particularly the Federal Reserve cutting rates to zero and moving into a very aggressive bond-buying program. Later it expanded in a truly unprecedented step to buying U.S. investment-grade corporates along the lines of the ECB.

So we saw this fantastic monetary protection put into place to allow the capital markets to begin a healing process, that was then buttressed and reinforced by a massive fiscal response from the U.S. government and coupled with that, as you correctly alluded to, is a turn in the data as we began to flatten curves during the pandemic.

When it comes to investment grade fixed income, this really for us puts a line in the sand. Our perspective here is that we’ve seen the wides in investment-grade credit for now, and that unless we see an earth-shattering deterioration in healthcare data, we’ve probably seen the wides in that.

Having said that, the opportunities on a go-forward basis, fixed income really doesn’t bring returns on a global basis. The actions of the Fed can’t be underestimated for what it does in buttressing liquidity solvency and the ability for people to take risks. Secondly, spreads are very wide on a historic basis, so even after a tremendous rally you still see investment-grade spreads on or around 175 over, 200 over. If you think about the fact that prior to the pandemic they’d been trading in the range of around 100, what you see is the potential for roughly 75 basis points of tightening in the next 12 to 15 months.

Now, clearly much can go wrong, but if one assumes and begins to think about where investors will want to put capital to work, we have the potential for up to 75 basis points of rally in long-duration credit spreads across the curve.

If you think about duration, and the impact that has on return, and long-duration in particular which is a part of the market we’ve found to be incredibly attractive, you could end up with close to double-digit returns in the next 12 to 15 months in credit.

That is probably one of the most missed opportunities, and that because when people look at spreads they’re confusing the return potential with the spread compression. Our perspective is, frankly speaking, not a very aggressive one, but really much more benign in that we think to position to buy what the Fed is buying and putting ourselves in the position to benefit from those assets which are under the Fed umbrella, and are shielded from the elements, that’s a very attractive place to be.

We feel the ceiling’s been put in place, we’ve had a powerful fiscal and monetary response, the healthcare response for now, and we share the sentiment you alluded to, Som, that creates a decent backdrop for a pretty sustainable rally. It’s important because investors shouldn’t confuse the yield and the spread with the total return potential.

I’ll stop here and throw it back to you to get your sense.

SOM
Thanks, Norman. In mid-March, there was a lot of concern about the seizing of the credit markets and that blew out the spreads. But one of the things that encouraged me is that this year we’ve seen a lot of corporations re-financing longer-term debt and used the proceeds to buy out their short-term paper debt. Which is actually a very positive trend. How are you guys reading that?

NORMAN
We’d agree that we think it’s a very positive development. The ability of companies to turn out their debt is always a great one. This really does draw some very positive parallels versus 2008. In ‘08, some of the overarching concerns were the freezing of the commercial paper market, the inability of financial institutions to respond to that. One of the great benefits this time around is that if you read carefully and listen to the narrative of the Fed, they’ve said that that was their purpose — to prevent this liquidity crisis from moving into a solvency crisis.

They encouraged companies to use the umbrella they provided to access the debt markets to pay down their short-term debt.

The other part that’s a huge positive is that in ‘08 the disease that ravaged the financial markets was the banks themselves, and their inability to respond to the market, their need for liquidity, and the weakness in their balance sheets. This time around it’s, in fact, the opposite — banks, and Canada is an absolute case in point, Europe to a lesser degree but still very robust, banks have robust balance sheets and adequate capital.

If you think back to those dark days as the pandemic began to unfold you saw lots of investment-grade and even higher companies draw down their revolvers to store up the cash on their balance sheets. The fact that they could do that was a healthy sign and it gave the market encouragement.

To just further reinforce what you’re saying, Som, a trend we’ve seen that’s ongoing is companies proactively, defensibly putting cash onto their balance sheets to prepare for what we can all recognize is the oncoming onset of a recession. It’s a powerful and significant juxtaposition to what we had in ‘08, and it bodes well for the long-term recovery, and, frankly, is a reason why we feel so good about some of the decisions we’re making in fixed income markets.

SOM
I’d love to unpack that even further. When you think about cash on a balance sheet that’s great for credit, but does it have an impact on equity and a return on equity and multiples for companies, which of course is always concerning for the equity holders. But I can see why it strengthens the value for the debt.

NORMAN
You’re absolutely correct here and this is one of the things that investors are going to need to think about, is that in a world where you have reduced economic activity, what does that mean in terms of buybacks, dividends and in terms of equity holders being able to receive the kind of returns they’ve come to expect from cash back?

This cuts to the question of durable fixed income and durable yield, and that’s really going to be very important. We believe we’re going to live in a world that’s increasingly yield-starved, and so the ability of companies to have cash, and pay it out, those cashflows are going to trade at a premium multiple. That’s why we feel that where companies are doing well, and have the cash to service their debt, the spreads on the credit of those companies are likely to trade at much higher multiples than what we’ve been accustomed to.

SOM
We’ve seen significant downgrades in the bond market over the last couple of weeks, but we haven’t seen a significant uptick in defaults. What worries you about this? Are we going to continue to see these massive movements in downgrades over the next couple of months as we move into more of the second phase of this economic change?

NORMAN
It’s an incredibly emotional point and there are various arguments around it. Typically, when you look at buying credit you want to buy as defaults have peaked or are on their way down. The difference here is that defaults are going to matter and understanding what you owe and having the resources as an institution to do the work to really understand the risks you’re taking is going to be very important.

A couple of points worth making: Without getting into the very emotional idea of putting a number on what defaults are going to be, we’d imagine that you’ve got two extreme views. Some folks say they’ll be in the high single digits, some say the mid-teens. At the end of the day, we think of it as how to understand the impact of those downgrades on your books and on the market. So clearly defaults are going to pick up year over year, and you’ve already seen this, but in some aspects we’d argue that could be a little bit healthy as some companies have balance sheets that are really unsustainable.

But the markets are pretty good at figuring that out pretty quickly, so you’ll always get surprise credit events, and we’ve unfortunately had some in the travel and leisure space in the last month or so. For the most part, the market is really focused on key sectors.

We feel pretty strongly that we’re going into a market slowdown, we’re going into a recession, but we’re going into it with plenty of notice. We know the sectors that will be adversely affected, we know the stressors that will be on them — travel, leisure, real estate, there will be stress there.

But we’re also positive on the fact that if you do the work in many instances it’s the baby with the bathwater and all companies seem to want to be painted by the market with the same brush. The way we would characterize it is to say that defaults are a concern, downgrades are a concern, there’s a lot of bad news priced into some sectors, but that challenge is also the opportunity. Not all of these types of companies are going to behave the same way. That’s what we’re excited about, that we’re setting up for inventors to be rewarded for picking credits that have durability and that can survive this.

We’re concerned about it but at the same time, it’s an exciting opportunity because if you get it right, you’ll be really well-rewarded for it.

SOM
That’s an important point because I know you’ve been really vocal about the risk/reward opportunity that’s coming out of the credit markets. When you look at the opportunity for an investor today, what do you think are the next 12 to 18 months of opportunity on the credit side?

NORMAN
That’s really where the rubber meets the road and you’re right. If we were to articulate a case for credit on a go-forward basis, we’d say we feel very strongly that a quality portfolio, that is a beneficiary of the monetary and fiscal response, has the ability to really generate very attractive, potentially double-digit returns, over the next 12 to 18 months.

It’s not going to be a smooth path, and our perspective isn’t necessarily popular, but markets reward investors for the unknown and doing the work and understanding what the handicap is around their future. If you go through the math, purely and simply, and you factor out how to avoid mistakes and pitfalls, you could get a 60 to 80 basis point rally in long-duration credit spreads.

We’re not saying it will be instantaneous or a linear path, but in our minds when you think about returns, and most importantly the amount of risk you’ll need to take for that return, credit stacks up particularly given the new monetary and fiscal environment as a really attractive place to be.

One final point, and I think investors genuinely appreciate this, if you go back and look at all the cycles where we’ve had real shocks — coming out of all of them credit led the way. Credit typically bottoms before markets do, and once the market has confidence in the top part of the balance sheets, ie: credit, it eventually filters through to the bottom part, which is equities. We think credit will be what leads us out of this, and our other belief is that durability of fixed income and durability of yield in a world where there will be very low yields for likely a long time, will really entice investors.

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Purpose Investments

Purpose Investments is where thoughtful Canadians invest. An asset management company with more that $9 billion under management, we create meaningful long-term success by focusing on our core values.

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