Author Archive

Economic Outlook

Hello, my name is Davis Vaitkunas, and this is the June 2024 edition of Bond Capital TV. Over time we see economic cycles of roughly 5 to 8 good years only to be followed by 2 to 3 bad years. Due to central bank intervention interest rates normally mimic this pattern by cresting in better times and then troughing in worse times. The down change in direction is often the result of an economic crisis such as the recent Covid-19 pandemic in 2020, the Global Financial Crisis of 2007 – 2008 and the dot-com bubble burst in 2000. And the up often being inflation.

As of June 2024, central banks around the world are currently leaning towards lowering interest rates. Central banks in smaller economies have already cut rates, including in Canada, Sweden, Switzerland, Hungary and Czechia. The Bank of Canada announced a 25-bps interest rate cut last week as did the European Central Bank. Today the Fed announced no change to its current benchmark level of 5.25% to 5.5%. Japan is the outlier today raising rates to combat inflation after years of below-zero rates and low inflation.

Specific to North America there can be divergence between the BOC and the FED however Canada’s rates tend to stay near the US to avoid currency devaluation and the import of unwanted inflation. Canada with 5-year mortgages and its exposure to commodities is more interest rate sensitive than the US with its 30-year mortgages and technology sector contribution.

I have noticed several recent reports using the words “record high interest rates”. I think we should dispute that language. The 30-year US mortgage rate averaged 7.73% from 1971 until 2024. Since the year 2000, the US has ranged from 3% to 5.5% with Canada seeing 4% to 6% averages for its prime interest rates.

If you are taking on debt and can get a rate under 5%, I think you have done very well. If it’s just over five percent or in that range close to five percent perhaps you may want to take a shorter-term mortgage and hope for a better rate down the road. If you are a business your concern is more likely availability and not cost.

With today’s North American prime rates in the 7% to 8% range I think a prudent person should stress test future debt service costs prior to accepting a loan by using a 10% to 11% rate. Across multiple cycles and for over 20 years, Bond Capital has advised on interest rates and advanced secured investment quality business loans to middle market companies throughout North America.

This has been another edition of Bond Capital TV. Thank you for watching.

Continue Reading

Risk-Adjusted Returns

Over the last several decades investors have diversified their asset allocation and in doing so incurred additional risk in order to maintain returns. Inflation risk has risen and so investors are increasingly considering real returns in their portfolio construction. Institutional demand for real returns has driven demand for private credit as an asset class to generate risk-adjusted real returns. Non-institutional investors should take note and consider allocating to private credit.

The complexity and risk required to achieve the same level of return has increased over the years. According to Callan, in 1993, to achieve a 7% nominal return over the next 10 years, an investor could have had 97% of their portfolio in bonds and 3% in large-cap US equities. In 2023, the same investor would need to have 33% in bonds, 25% in large-cap US equities and the remainder in a combination of higher-risk assets such as small-cap US equities, non-US equities, and alternative assets. Alternative assets most commonly including private capital, and real estate. Unfortunately, the risks taken on by investors, measured in volatility, of this portfolio have gone from 6.2% in 1993 to 11.8% in 2023, almost doubling and certainly troubling the modern investor. Institutional asset allocations now reflect this drive to diversify into alternatives.

Source: Callan, Bond Capital; each square represents 1% allocation

Given the current inflationary environment, it is useful to think about real (inflation-adjusted) returns. In 1993, using inflation expectations of 4% for the next 10 years, an investor could have achieved a 5% real return with 8.8% portfolio volatility. In 2023, using inflation expectations of 2.5% for the next 10 years, to achieve the same 5% real return an investor’s portfolio volatility would be 14.9%. 30 years ago a 5% real return could have been achieved with public bonds and equities, today’s portfolio needs to include alternative asset classes to do the same. Current trends in alternative asset allocations are seeing increased allocations to private credit to reduce risk, mitigate inflation, and skirt current structural challenges in both real estate and private equity that are the legacy of our recent zero interest rate policies (ZIRP). One might argue private credit be moved out of the alternative asset category and into the fixed income category as a “private bond”.

To achieve the same returns as in years past, institutional investors are looking to private credit for high-quality, real yields. An allocation to investment-quality private credit can help boost returns while reducing risk. Private credit’s “principal” component provides a safe contracted value store with the “interest rate” component bringing reliable cash flows and an illiquidity premium over public bonds. Together the principal and interest offer greater diversification through a lower correlation with public market equities and traditional bonds. These features help reduce portfolio risk without compromising on returns, allowing investors to achieve the goal of better overall risk-adjusted returns. Private credit outperforms in rising rate environments due to the floating rate structure prevalent in direct lending transactions. Alternatively, if interest rates are falling due to lower inflation, real returns are locked in. However, an experienced direct lender will structure transactions with an interest rate floor, so real returns would increase as interest rates drop. For these reasons, we believe the empirical evidence shows why investors should consider reallocating a portion of their current public bond, real estate, and private equity holds into private credit.

Source: Bond Capital

As a maturing asset class, there is now a robust private credit data set from multiple sources. This data informs us that private direct lending loans underwritten by experienced managers able to negotiate stronger protection result in lower loan losses when compared to other credit classes such as leveraged loans and high-yield bonds.

Returns in High Interest Rate Environments

Source: Morgan Stanley, Bond Capital
* Return data for the period from Q1’08 to Q2’22. Calculated as annualized average returns divided by volatility. Volatility is measured using standard deviation.
* High interest rate environment defined as 6 time periods (1Q’09-2Q’09, 4Q’10-1Q’11, 4Q’12-4Q’13, 3Q’16-4Q’16, 3Q’20-1Q’21, and 3Q’21-2Q’22) when rates increased by 75bps+.

Private credit generated higher returns and lower loan losses. The size of the private credit market was $875 billion in 2020, $1.4 trillion in 2023, and is expected to reach $2.3 trillion by 2027. Global equity market values were estimated at $124 trillion for 2021 versus $10 trillion for private markets, according to SIFMA and McKinsey. There is ample room for growth in alternative assets if investors transition a fraction of their equity assets into alternatives. Good investors regularly rebalance to go where the growth is.

Loan Losses

Source: Morgan Stanley, Bond Capital
* Loss rates represented by period (Q1’20 to Q2’22). Default and Recovery rates are sourced from Moody’s.

We are living in an uncertain economic environment and times of relative calm are often followed by periods of volatility. With inflation proving to be stickier than expected, investors need to position their portfolios to provide the best risk-adjusted returns in all weather. Private credit can help decrease portfolio volatility, increase returns, amplify capital preservation, and provide a hedge against both rising and falling interest rates. Prudent investors should get off zero and allocate as much as 20% of their portfolio to private credit to lower risk and manage up their returns.

About Bond Capital

Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital secured structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for over 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.

Continue Reading

Safe Money – Private Credit is Modern Fixed Income

Inflation has risen substantially since 2021, and while not at peak levels, it may be stabilizing at a rate higher than that targeted by central banks.  In response, pension funds are turning away from the 60/40 portfolio (60% equities and 40% bonds). For those who want to take advantage of a higher for longer interest rate regime, moving beyond the traditional 60/40 (equities/fixed income) portfolio will be key. The empirical evidence we have seen suggests a 40/30/30 asset allocation is where institutional capital is headed.

Inflation Expectations?

  Source: United States Core Inflation Rates (1957-2023) (usinflationcalculator.com)

Core inflation in the U.S. appears to be leveling off near 4%, double the target of 2% set by the Federal Reserve. This data supports the idea of higher for longer interest rates. Looking back at the 1970s-1980s, inflation initially spiked up over 12% in October 1974. After decreasing to 4.8% in November 1976, it began to increase again hitting a peak of 14.7% in March 1980. It did not drop below 3% until June 1983, almost 9 years later. Even then, it was back above 3% before the end of the year and did not drop below 3% again until March 1986. This was a historic period in time, and we know history does not necessarily repeat, but it often rhymes. Even if we do not face a decade or more of high inflation, chances are it will take longer than many expect to get back to central banks’ 2% target. 

What are the larger allocators doing? Pension funds and other large asset managers are increasing their allocation to private credit and infrastructure in response to the current macroeconomic environment. The British Columbia Investment Management Corporation (BCI), the California State Teachers’ Retirement System, the Ohio Public Employees Retirement System, the California Public Employees’ Retirement System, and the New York State Common Retirement System, are just some of the many large asset managers dedicating a larger allocation to the private credit asset class and other yielding asset classes. If the big asset managers are increasing their allocation to private credit right now, this may be something for non-pension fund investors to consider. Pension funds are moving to a 40/30/30 asset allocation model which offers superior risk-adjusted performance in various inflationary scenarios. Even if inflation fades faster than most are expecting, the 40/30/30 portfolio is still expected to be superior to the 60/40 portfolio. 

KKR, a leading asset allocator, believes investors should move to incorporate more private capital right now. Their breakdown for a 40/30/30 portfolio to take advantage of the current higher inflation regime and avoid the higher volatility of public assets in an uncertain macroeconomic environment is seen below. Starting with your traditional 60/40 portfolio, substitute 20% of public equities and 10% of bonds (traditional fixed income) into 30% Private Alternatives with yield (10% Private Real Estate, 10% Private Infrastructure, and 10% Private Credit (modern fixed income)).

 

Source: KKR, Bond Capital

Advantages of an increasing yield allocation

  • Generate income – reallocate into yield-oriented alternative asset classes for ‘predictable and attractive streams of cash flow’ in private debt, as well as the other collateral-based cash flows of private real estate and private infrastructure. 
  • Preserve capital – shift to the low volatility, shallow drawdowns, and reliable inflation hedging characteristics of private credit and private infrastructure.
  • Boost real returns – in the table below, the 40/30/30 shows a higher Sharpe ratio (risk-adjusted return) in all scenarios while providing higher absolute returns in the high inflation and all periods’ scenarios.
  • Hedge Inflation – Private credit is indifferent to inflation, as it is structured with floating interest rates. Private credit delivers a real return regardless of the inflationary backdrop.

When testing the 60/40 against the 40/30/30 portfolio in three different scenarios: low inflation, high inflation, and all periods, private capital outperforms in all scenarios. During a cycle with elevated inflation, the 40/30/30 asset allocation improves risk-adjusted returns by four times. How do you justify a traditional portfolio if it underperforms on a risk-adjusted basis in all scenarios, and substantially underperforms in a high-inflation environment?

  Source: KKR               

With uncertainty ahead, we want to ensure our portfolios are positioned to weather any storm. Increasing allocation to private credit makes sense regardless of whether inflation comes down to target quickly or not. History has shown that the last mile of the inflation fight is always the hardest and tends to last longer than expected. Institutional investors know this and have begun increasing their allocation to private credit. We believe you should too. Even though private credit has been around for decades, it has caught the attention of more investors over the last couple of years. Be sure to put your trust in managers with a strong track record and experience in the asset class.

About Bond Capital

Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital secured structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for over 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.

Continue Reading

2024 Outlook

Welcome to the winter 2024 edition of Bond Capital TV. I’m Davis Vaitkunas, a partner at Bond Capital.   

Happy New Year.  

If your business wants to get more in 2024 you will need to hope for the best and plan for the worst.  We suggest business forecasters model and stress test 11% to 13% cash cost for US interests and 10% to 12% cash cost for Canadian interest. If things continue to behave, this sensitivity should leave funding for CapEx and talent retention needs. 

The current US primary is 8.5% and the next FOMC interest rate meeting is scheduled for January 30th to 31st. The current Canadian prime rate is 7.2% and the next bank Bank of Canada interest rate meeting is scheduled for January 24th.  On these dates, these central banks will determine if they’re going to raise rates, decrease rates, or keep them the same.  We are expecting both of these central banks to keep rates the same with a possible bias, small bias, towards an increase.  

The interest rate risk of 2023 is expected to become credit risk in 2024. This means, now,  that we know the cost. Can your business afford it?  

Bond expects higher for longer rates. We think inflation appears to be improperly defined and higher than presented. I certainly see this in the cost of Pepsi, Doritos, the cost of a steak, as well as the cost of insurance which has probably risen the most. All of these items are high single digits and in some cases like insurance well into the double digits. 

For the record 370 trillion of total global debt withstanding there is a risk of a central bank debt trap. This coupled with Central Bank concerns for a repeat in policy error, causes us to think there will be a delay into interest rate reduction. 

On the surface, the economy seems okay with energy costs and unemployment statistics both acceptable. However, there is much more concern lurking near the surface than usual. 50% of the world’s population is set to vote in 2024. In addition to conflict expansion, energy transition concerns, and artificial intelligence, whatever that is going to be.  

Good luck I wish you the best with your modeling and your forecasting. I hope our stress test knowledge helps you out.  This has been Davis Vaitkunas of Bond Capital from Bond Capital TV.

Continue Reading

Let the Free Money Zombies Die

Bankruptcies across Canada and the U.S. have started to tick up this year. As we approach the latter innings of this business cycle and credit conditions continue to tighten, things will likely get worse. This is bad news for Zombie corporations which are defined as firms that can pay the interest on their debt to stay in operation but are unable to pay off any principal. This may have been viable over the past 15 years as central banks flooded the market with cash and held interest rates near zero, but this is no longer the case. Interest rates have risen swiftly over the past 18 months and as the debt of these companies comes due, they will have to refinance at much higher rates. This should lead to an increase in bankruptcy filings and a redistribution of assets over the next several years.

Most bankruptcies are voluntary, as a company files for bankruptcy to protect themselves from creditors and seek a more orderly sale and investment solicitation process or liquidation. Bankruptcy can also lead to creditor-approved restructuring where private credit is used to replace tired lenders and or match free cash flow more accurately to debt service with payment-in-kind (PIK) interest. Involuntary bankruptcies are rare and occur when a company’s creditors file for bankruptcy on their behalf. In Canada, business insolvencies, which include bankruptcies and proposals (restructurings), have been increasing since 2021. The trailing 12-month value as of June 2023 is approaching 4,000 and has surpassed 2019 levels of 3680. The last time levels were this high was in 2015 when they were at 4107. The current number is trending in the wrong direction.


Source: Government of Canada

We see similar trends in the U.S. According to S&P Global, U.S. corporate bankruptcies for only the first 5 months of 2023 are higher than any other comparable 12-month period since 2010.


Source: US corporate bankruptcies tick up in May; year-to-date total highest since 2010 | S&P Global Market Intelligence (spglobal.com)

On a positive note, while higher rates have been painful for many businesses that engaged in aggressive financial engineering, they may be leading to a golden age for private credit and asset redistribution. As traditional sources of funding such as banks and private equity pull back in the current economic environment, more businesses are turning to private credit to buy time and or acquire assets. This has allowed the industry to invest at or near the top of the capital structure and maintain robust credit standards while borrowing costs increase. Interest rates are projected to remain higher for longer, which will continue to be a strong tailwind for the asset class. As we can see below, the past 15 years of near-zero interest rates were an anomaly, not the norm. Historically, rates have been much higher. The average prime rate in Canada from 1955 to 2023 was 7.02% compared to 7.2% today.

Source: Canada Prime Rate History (1935 – October 2023) | WOWA.ca

Although it may be painful for some, we think this is a healthy part of capitalism that should be allowed to play out. Not only are zombies inefficient, but they are often bad, low-margin competitors who lower the growth and productivity opportunities of healthy firms. As weak companies are taken over or consolidated, stronger more innovative firms will emerge that are managed more efficiently and therefore better able to adapt for survival in a normalized rate environment. Private credit will benefit from this higher rate environment due to its floating rate structure, and will be ready to support these firms where the opportunity is suitable. For the greater good, it’s time to let the free money zombies die and kiss the unintended consequences of ZIRP goodbye.

About Bond Capital

Bond Capital is an award-winning private credit fund. As a direct lender, Bond Capital provides advice and money across the entire risk curve. Bond Capital secured structured credit financing enables business owners to maintain control ownership in exchange for yield and capital preservation. Across multiple cycles and for over 20 years, Bond Capital has advanced secured investment quality credit to lower middle market companies throughout North America.

Continue Reading