Podcast: Enabled by East Los Capital with Monica Erickson, Head of Investment Grade Credit & Portfolio Manager at DoubleLine Capital

In this episode of our podcast series “Enabled”, by East Los Capital, Co-managing Partner Anthony Valencia interviews Monica Erickson, Head of Investment Grade Credit & Portfolio Manager at DoubleLine Capital, about her views on inflation and Federal Reserve rate hikes, the investment grade bond market, and potential signals for recession. Monica gives an in-depth discussion of what she is seeing in the volatile 2022 markets from the perspective of the investment grade credit market.

DoubleLine is an independent, employee-owned money management firm with over $107 billion in combined assets under management invested across a wide array of investment strategies.

This episode is also available on Spotify and Apple Podcasts at “Enabled by East Los Capital”.

Podcast Overview

01:20 – Monica discusses with Anthony where the investment grade market and greater fixed income market is currently relative to the beginning of 2022 and Wall St. expectations

03:16 – Monica talks about the reasons for the surprising outperformance of the high yield bond market vs. investment grade

05:26 – In context of earnings season, Monica discusses with Anthony the kinds of market signals she looks for as an investment grade investor during an era of Federal Reserve rate hikes

10:24 – Monica talks about the difference between banks and non-financial companies in light of some banks halting share buybacks and the implications for the broader equity markets

14:17 – Monica delineates the insights one can draw considering Treasury rates and changing spreads relative to recession risks and explains the impact of increased volatility in Treasuries on stand alone credit markets

19:25 – Monica discussed how high spreads got in March of 2020 and gives her thoughts on potential Fed action if a similar situation were to occur

22:06 – Monica discusses the health of investment grade credits relative to current leverage and interest coverage ratios

26:04 – Monica talks about her work with The Bloomberg Women’s Buyside Network, an organization focused on increasing diversity and raising the profile of women working on the buyside as analysts, portfolio managers, traders or other similar roles

[Extended Transcript] 

[Sally Gao, 00:00]

• This is Sally Gao, introducing another episode of Enabled, by East Los Capital, where we speak with institutional investors and corporate Founders.
• Today we are excited to be chatting with Monica Erickson, who is the Head of Investment Grade Corporate Credit at DoubleLine Capital.
• I’ll now turn the call over to East Los Capital Partner, Anthony Valencia.

[Anthony Valencia, hereafter AV, 00:27]

• Thank you Sally. So I am very pleased to be chatting with my friend and former colleague, Monica Erickson, at DoubleLine Capital. Thanks for joining us today, Monica.

[Monica Erickson, hereafter ME, 00:38]

• Great, thanks for having me, I’m excited to do this.

[AV, 00:42]

• Maybe we start with just some high-level thoughts on the investment grade market. Maybe you could give us an update, year-to-date, what were you thinking or what was the consensus thinking in the IG (Investment Grade) market towards the beginning of the year? Obviously we’ve had a lot of volatility, a tumultuous year in the stock market – where are we now from what you thought was happening at the beginning of the year?
• Let’s set the stage from there, and dig down into the more topical issues like inflation and recession and so on and so forth.

[ME, 01:20]

• This year has been one of the worst years. Deutsche Bank did a study going back to the 1800s, and this year [2022] is one of the worst years for the bond market overall in terms of returns.
• The investment grade market is down a little bit over 13% YTD, so not really what investors look for in what should be a fairly stable market. Really what’s been going on, is that treasury yields have been rising at a very rapid pace, we’ve had a Fed that has had to put on the brakes because of the flood of money that had gone into the system, creating what we now have: massive inflationary problem.
• Frankly, it is something that we as a firm have been talking about for some time, one of the problems with the investment grade corporate market is that it has very long duration, meaning that it has very high sensitivity to any kind of movements in rates or spreads. That negative 13% return that I was talking about, 80% of that has come because of the move in the treasury market.

• Not only has the investment grade market, but frankly all of fixed income has had a very tough year in terms of returns.

[AV, 02:55]

• Got it. It is interesting because year-to-date, the high yield market has actually outperformed the investment grade market, which to some would be kind of counterintuitive because generally we think of high yield as more risky than investment grade.
• Can you talk through that quickly in context of duration and interest rate risk?

[ME, 03:16]

• It really goes back to that duration and interest rates. Looking at returns, high yield had been outperforming. High yield now is just ever so slightly outperforming. What’s been going on in the two markets is that the high yield market spreads have actually widened more, than the investment grade market, which you would expect in this type of environment where there are more risks out there.
• But the returns have really been driven by the duration part, by sensitivity to the moves of interest rates and spreads. What we were talking about at the start of this conversation, that the IG market has been so impacted by the move in treasury rates because of its long duration, and that is why the market has been underperforming compared to the high yield market. And the HY market in this environment has actually been able to outperform-really back to the duration numbers.
• You and I were speaking about this before, to give listeners a sense, as to how sensitive each market is to shifts in spreads and Treasury rates. The high yield market has a duration of about four years, meaning that every 100 basis point move one way or the other in terms of spreads or rates, is about a 4% move. Whereas the investment grade market has a duration of about seven and a half years, so that is almost double the move per movement in spreads or rates.
• This is what we are dealing with: a super long duration asset class that is getting whipsawed around by what is going on in the treasury market.

[AV, 05:10]

• Thanks for that very thorough explanation. Earnings season started in earnest last week, what are you looking for? From the perspective of an investment grade investor, what would be a satisfactory earnings season for you?

[ME, 05:26]

• We are really listening to companies this earnings season because I think this is a pivotal quarter to see how companies are dealing with what is on everyone’s top of mind – inflation – seeing how companies are able to pass along their higher input costs; also seeing what credit quality is like for the consumer
• So far the large money center banks have reported: Citi, Wells Fargo, J.P. Morgan, Morgan Stanley reported last week. We had Bank of America and Goldman Sachs report today. We also had Synchrony Financial report today which is a credit card issuer.
• And what we’re listening for from the banks is really the credit quality of the consumer. It’s interesting to hear what they are talking about, which is that the consumer, while maybe not as strong as they were six months ago, is still in relatively good shape and better off than they were pre-COVID, pre-2020.
• I think that is going to flow into all other kind of consumer activity. That’s what they’re seeing right now, I think Jamie Dimon from J.P. Morgan has been very vocal out there, talking about that the future is very uncertain and it’s very difficult to predict. Going forward, there is a lot of uncertainty out there and there is a big question whether the Fed is going to be able to deliver on their dual mandate, and not kill the economy and send us into a deep recession while at the same time being able to control this high inflationary environment that we are in
• We definitely have more risk in the market, but I have been surprised more on the upside in terms of the banks’ earnings that have come in are basically in line with what we were expecting. I think the theme with the banks is investment banking is down substantially, the average is about 50%, J.P. Morgan was only down 10% which was better. This is reflective of there not being a lot of new issuances happening, there aren’t a lot of IPOs happening, M&A transactions have slowed down all because there is this risk
• But the banks on the flip side have been able to make up some of that in their net interest margins. Part of how they do business is they lend money at a higher rate than they themselves can borrow money, and make that spread. That has been positive for the banks, and some of their other business lines have made up for the drop in investment banking.
• One other thing that we were discussing prior to doing the Podcast, is the issue of share buybacks and the balance sheet of the banks. J.P. Morgan has halted their share buybacks which, from a credit perspective, is a very positive announcement. I know that it is different from the equity side as they always like to see share buybacks, but what we like to see is companies putting their capital towards strengthening their balance sheet, and that’s exactly what halting share buybacks does.

[AV, 09:30]

• That’s a very interesting point, and obviously the banks are somewhat of an animal unto themselves in that they have certain capital requirements that non-bank, non- financial companies don’t necessarily have.
• Do you think that the announcement about halting buybacks is a harbinger for non-financial companies that could essentially adversely affect equity returns? Because we have seen over the past decade, more or less, that there has been this very high correlation between share buy backs and equity performance.
• So if we are entering a period where corporate treasurers are tightening their belts and reducing the repurchases, what do you think are the implications for the equity markets?

[ME, 10:24]

• I think to your point, the banks really are a different animal than call it…. some industrial companies. The banks are so highly regulated, and their capital ratios have just increased, meaning that the Fed is requiring them to retain more capital because there is more risk in the system.
• I think while halting share buybacks is a negative for equity holders, it really is a positive for credit holders, because it strengthens the balance sheet. It keeps more liquidity on the balance sheet. In addition to halting their share repurchases, they also increase their reserves, meaning that they’re holding back capital to allow them to have more buffers in the event that there are more losses on the loans that they’re making. So from a credit perspective, it’s all very positive.
• Now whether that means that other companies are going to follow suit and also announce that they’re going to be halting share buybacks, because, and I would assume that they would be doing that because they would have some sort of balance sheet constraint. We haven’t seen that, the industrials haven’t started to report earnings yet.
• We do have AT&T and Verizon, which are the two larger telecom companies in our index that are reporting later this week. I know they’ve both been focused on the balance sheet.
• Usually when companies announce those types of initiatives, i.e. not repurchasing shares, it usually has to do with them wanting to shore up their balance sheet, which frankly for credit investors is what we want to see.
• Now the flip side is if it’s really just a horrific quarter and there is something really troubling going on with the business model or they’re not going to be able to weather through this cyclical environment and it’s forced on them to stop share buybacks, and they have, in addition to that, a continuing deteriorating balance sheet, then that’s obviously not good for either class of holder either equity or the credit.

[AV, 12:58]

• Got it. You mentioned the R word, recession earlier in our conversation, and the bond market has a reputation for being the market that sniffs out problems before the equity market does. But, we’ve already seen this big downturn in the equity market, we officially hit a bear market at one point.
• So for people who aren’t making investment grade bond allocation decisions on a daily basis like you are, maybe you’re a Founder of a company or you are wearing my hat in the private equity world, and you’re trying to really just figure out what the bond market is telling you with respect to the overall economy, what is it inferring right now?
• On one day, the 10 year treasury would be up because there’s inflation expectations and a few days later, it’ll be down because people are talking about the Fed starting QE in 2023 and demand destruction and recession coming.
• So it’s hard to keep up with the daily ups and downs, and what the market story is for the day. So is it too late to glean anything from what the bond market is telling us now? Is the horse out of the barn, or can we still draw some conclusions as of now?

[ME, 14:17]

• It’s interesting that you asked that, because there has been a lot more volatility in the treasury market than there has been in the standalone credit market. What I mean by that is in terms of where spreads have gone. So, just backing up a little bit as an investor in investment grade corporate bonds, you get a total yield and your total yield is made up of the treasury component.
• Then you get some extra spread on top of that for taking credit risk, because the credit quality of an investment grade company is not as high as the faith of the United States government, right? So you get paid for this extra spread.
• Now that extra spread, while it has been out year to date, has not been as volatile as the treasury market. So we see spreads move anywhere between one to three, sometimes not at all, one to three basis points a day, sometimes zero. Whereas we’ve been seeing movements in the treasury markets for 10, 20 basis points a day. So there is a lot more volatility in the treasury market.
• I think that is because it’s just been so much more of a macro call and this concern about being able to address inflation in a way that does not kill the economy. Historically, the Fed has not been able to walk that fine line of being able to squash inflation without killing the economy. So I think that’s why we’re seeing so much more volatility on the treasury side than we are in terms of spreads.
• I think one thing investors do look at is the spread level and then extrapolating from that. So, is the spread level telling me something about where the economy is going? Spreads on the index level right now of 140 basis points, so you could get 1.4% more than you would on the equivalent treasury. Does that fully compensate you for the risk that is in the market? And that really is the question.
• Historically, that spread level when we’re in a recession is closer to 200 basis points over. So if you are of the mind that we’re in a recession, think that a 140 spread is not really compensating you. On the flip side, you could say the 140 spread is accurate and it’s telling you that the economy is not going to go into a recession. So, it’s one or one or the other.
• I would also add that 140 spread on the index, it’s not really indicative of where bonds, the underlying bonds are actually really trading. The underlying bonds, when you actually go and buy and sell a security and there’s a market in it, it seems to be probably 20, 30 basis points wider than that 140 spread. So there are a lot of bonds that don’t trade that are in the benchmark that get traded, or that get priced without an actual trade going through and are reflected in that 140 spread. So the spread is probably closer to about 160.
• However, even at 160, I don’t know, does that fully reflect if we are going into a recession, does that fully reflect the risks? I would say probably not. But it’s also indicating that perhaps we’re not going into a recession now. One other thing that I would add is that we don’t have crystal balls, so it’s very difficult to say whether we are in a recession right now, or are we headed into a recession?
• There are some people that we work with closely, Jim Bianco one of them, who has been talking about this for about two months now. He is fairly adamant that we are currently in a recession. I’m not seeing that yet from what I am hearing from kind of corporate entities, but I think that there’s definitely a much higher risk of us going into a recession given where we are in terms of inflationary picture and what the Fed needs to do.
• Long story short, I’m not sure that spreads fully reflect kind of the risks that are out there.

[AV, 19:05]

• To your point on spreads and the Fed, having to clamp down on inflation and inflation expectations, how high can that spread go before hitting a danger zone where the red lights start flashing?

[ME, 19:25]

• In March of 2020, spreads got close to 400 over and they only lasted for five days, before the Fed stepped in and had their program. So I think 200 over, and I would say this would be an indication that we are either in a ression or expecting a significant slowdown, 200 over would be an appropriate level.
• I also think we’ve seen historically that the Fed really is interested in making sure that the market, at least the investment grade corporate market functions properly. It’s critical for companies to be able to have access, especially larger companies to be able to have access to capital. And so I think if we ever got into a period like we did in March of 2020, where we really had a completely non-functioning market, there would be something that would be done to alleviate that.
• But if we just get into your normal, ordinary kind of slow down and you see unemployment rise, earnings fall, and spreads widen, and there’s still some sort of functioning in the market, then I think 200 over is probably where we would see spreads go.

[AV, 20:51]

• You’ve made comments that in the past, credit quality as of now is not an issue, that leverage ratios are good, and interest coverage ratios are solid. But I remember back in 2008-09 recession when overnight, every equity analyst suddenly became a credit analyst.
• I’m willing to bet that I probably called you or some of your colleagues back then to get your opinion on the large cap media conglomerates that I was covering. Because to a certain extent, when the spreads get wide enough in the investment grade or the high yield market for that matter, it places an upside [cap] on the equity market, because why buy the equities when you can be higher up in the capital structure and maybe you’re 10-20% below par, maybe more if it’s a high yield credit.
• My question is how quickly can things change to where you’re at 3X Debt to EBITDA or 4X Debt to EBITDA and suddenly we hit a deep, deep recession and suddenly you’re at 8X and bumping up against covenants and it’s problematic. That’s a long winded way of asking: how high can the Fed raise rates before it really becomes a problem?

[ME, 22:06]

• I think there are two components to that. There’s the debt level and the serviceability of that debt, so the debt to EBITDA, how much cash flow is the company earning in order to be able to repay that debt over a longer period of time. Then there’s the interest coverage, how much cash flow does a company have every year to be able to pay their interest expense.
• That annual metric of just being able to cover the interest expense is at near historical high levels, just because companies over the last three to four years have done an incredibly good job of coming to market and issuing bonds at incredibly low rates and pushing out their maturities. So we’re not really seeing any kind of concerns in terms of companies having to reissue at higher rates at this point.
• The banks have been fairly active in the new issue market, but they’re also able to pass that along to their end consumer because they’re charging higher rates, so we’re not seeing any issues there.
• In terms of just the absolute debt that’s outstanding, and then that EBITDA and the cash flow number that companies have to pay it off over the long term. Obviously, if you have EBITDA drop by 50%, meaning your cashflow drops by 50%, mathematically that number is going to go up twofold. So, you could see the absolute debt to EBITDA levels increasing fairly significantly if we see a drop-off.
• But I think what we tend to do, is a look at that through the cycle, as opposed to taking the absolute number at the low EBITDA cash flow number, and the rating agencies look at it that way as well. You also have to have comfort in that, this would be a cyclical issue as opposed to some sort of secular issue.
• That is really where deep credit analysis comes in and where we really add value for our clients is that we’ve got this group of analysts that really dig into the numbers and make sure that companies are able to service their debt. Now, in terms of breaching covenants or coming up against covenants, that’s much more of a high yield issue.
• In the investment grade market most bonds, except for REITs, are issued without any covenants. So, the bigger concern is that they push that leverage number up to a point where a rating agency might downgrade them, or that they can’t get the debt down soon enough to right size given their lower kind of cash flow numbers. So that would be the bigger concern in investment grade land.
  

[AV, 25:23]

• Well I think regardless of where you are on the spectrum or whether you think the Fed stayed too low for too long, the one silver lining to your point is that companies were very prudent in extending maturities and stabilizing their balance sheets. So that hopefully some of the problems that we saw in 2008-09 don’t repeat themselves.
• Switching gears a little bit: Monica, you were one of the founders of the California Chapter of The Bloomberg Women’s Buyside Network. Can you tell our audience a little bit about this organization and as you know, I’ve attended a couple of your events and have enjoyed them and have enjoyed listening to you speak at these events.

[ME, 26:04]

• Thank you so much. Yes, we started this with the help of Bloomberg and it’s called The Bloomberg Women’s Buyside Network. We started this last year, and we are the first chapter in the United States. It started in Asia two years ago, and Bloomberg has been trying to build out that effort. We’re trying to do events both in Los Angeles and in San Francisco, and we’re going to start doing some virtual events as well.
• If anyone is interested in joining, please Google The Bloomberg Women’s Buyside Network. If you have a Bloomberg machine, you can find it on Bloomberg as well. There is at the very bottom of the page a place for you to sign up and then you’ll start getting all the newsletters information on events.
• Our goal is to bring more diversity into specifically the buy side, that includes portfolio managers, analysts, traders, anyone that’s working on the buy side, we really encourage you to join the conversation.
• It’s open to both sexes. As Anthony said, he’s come to our events and we really welcome men participating. I think men have a lot of ability to effect change, and we really want to partner with everyone that’s involved in the buy side. It’s super exciting, we’ve got three other founders that are really fantastic. One woman that’s based in San Francisco and the others are based in Los Angeles. I would also add that with Bloomberg’s resources, it’s been really a treat to be able to participate in the organization. So thank you, Anthony, for asking me about that.

[AV, 28:05]

• Sure, sure, they’ve absolutely been first class events. We’re up against the time, unfortunately. I have so many more questions I could ask you Monica, but we really want to thank you for participating in this great and very informative and interesting discussion. We hope that we can do another one of these down the line.

[ME, 28:26]

• Thank you so much for having me.