Credit Markers and the “Fools Yield” (w/ Dan Rasmussen & Greg Obenshain)
DAN RASMUSSEN: I'm Dan Rasmussen, the founder and CIO of Verdad Advisors. And I'm here hosting a conversation on behalf of "Real Vision." We're talking today with Greg Obenshain, who's Verdad Advisors director of credit. Greg has spent the last few years studying the high yield bond and corporate credit market through a quantitative lens building one of the largest quantitative databases of individual corporate bonds ever built and studying what predicts returns within corporate credit and looking at the market through, I think, a very interesting analytical lens. So, I want to start a thank you for joining us today, Greg. GREG OBENSHAIN: Thank you for having me. DAN RASMUSSEN: Greg, can you start by telling us about-- you've written a lot last year and early in 2020 about what was going on in credit markets. Could you talk about your thesis then? GREG OBENSHAIN: Yeah, sure. So, for the last several years, we've been in what we call internally the fool's yield environment, where there's been a substantial reach for yield. And that can be very difficult to define, because what does reach for yield mean? But for us, we actually think it's reaching down into the bottom parts of the high yield market where you think you're going to get a 7% yield, an 8% yield, and you think that you're a smart analyst so you can get this. But in fact, what you end up earning is a 4% or 3% because your base rate of loss is such that it's very hard to do better than what the BB market or the higher quality, high yield market does. So, for the last 12 months, we've been pretty vocal about this Fool's Yield idea, saying that probably the best you could do was a 4% return. And that what we were seeing in private credit markets, what we were seeing in some of the riskier loan markets was not really sustainable behavior-- and especially pension funds, who started to allocate a lot of money to private credit, and particularly sleeves of private credit that were doing deals with very high leverage, in particular, were really engaging in much riskier behavior than they, perhaps, realized. DAN RASMUSSEN: So, Greg, when you say Fool's Yield, I think what you're arguing is that above a certain point, credit risk doesn't pay off. So, if you lend to someone with a 20% yield, the losses are going to outweigh the returns. And I think a lot of folks intuitively understand this-- that a 30% payday loan probably isn't going to yield 30%. You're not going to get the money back. But tell us how you got to the exact number. How do you locate where on the current market spectrum the Fool's Yield is? What's your process? How did you get to that? What was the research that led you there? GREG OBENSHAIN: One of the hardest things to do in credit is to look at a bond-by-bond level analysis of what's happened in the past, right-- to go back and really dig into that. We have index data, that's what everybody has. But really that's a very crude cut of what's going on. So, what I spent many years building was a bond-by-bond database, basically, where you could go back and say, what happened when we bought bonds that traded like they were in the lower half of high yield, right? That traded with the yields that suggested they had risk-- did they actually return their yield or did they return less? And when we stacked all those up, what we saw was that bonds that were trading as if they were riskier actually had lower returns. So, they didn't realize their yields. Whereas bonds that traded as if they were higher quality in the higher part of the high yield market actually did make their returns, and actually a little bit more. What's surprising, I think would be surprising to most people, is that last year, when we could figure out that dividing point of how far you needed to step down, really, the implied credit rating spectrum, where you started to take more losses than you'd gotten gains from taking on more yield, really happened much sooner than most people think. It happened with that BB to B split. And for those of you not familiar with the high yield market, you have really three parts of it-- the BB part, which is the highest quality, the B part, which is the middle, and the CCC part, which is the lower part. And that Fool's Yield dividing line really happened between BB and B over history. That meant that last year, 4% yield was probably the best you were going to do. And I think that is surprising for especially people who are trying to get out and find a 7 and believe they can find a 7 or an 8. It's actually much, much harder-- it was much, much harder than you'd think.