KKR Income Opportunities Fund
Q1 2021 Earnings Call Transcript

Published: 17 May 2021

[Operator:]

Good day, and welcome to the KIO Quarterly Investor Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Aaron Dalrymple. Please go ahead.

[Aaron Dalrymple:]

Thank you. Hello, and welcome to the KKR Income Opportunities Fund Q1 2021 update call. My name is Aaron Dalrymple and I'm the Director in KKR's Client and Partner Group. I'm hosting the call along with Terry Ing, who is a Managing Director at KKR and a Portfolio Manager across our traded credit strategies. Terry and I are based in San Francisco with the U.S. leverage credit team. And for those of you who joined the call, last quarter, Jeremiah Lane was on the call and he CO-Heads Research with Terry on our Leveraged Credit platform. And we've got four senior people on our Leveraged Credit platform, and our plan is just to rotate these people on these calls. So I think Chris Sheldon has done the first couple of calls, Jeremiah Lane did the last call, Terry Ing is doing this call. So every month we'll try to add a new person, so you get more familiar with our senior team.

[Terry Ing:]

Sure. Thanks for that intro Aaron. And some of the themes in the first quarter that drove our performance were the COVID recovery theme that we continue to have an overlay in. And those are, particularly in the leisure sector, some travel and consumer. We tend to see recovery across all those credits. And the outlook continues to be strong. We've also been doing a number of reverse inquiries, which has helped our portfolio in terms of allocations and sizing where we're able to go in early to specific credits that we have a favorable opinion on and help generate a new issuer refinancing opportunity for credits in our portfolio. So that remains strong. The yield as well, if you look at the overall yield and the portfolio, where we continue to collect the coupon, which is a good income component for this fund. And it's higher than the index as well, which has been helping in terms of the first quarter. There's also been a number of idiosyncratic and more positive credit events that occurred in the first quarter. And that we believe that continues throughout the second half here as well. So net-net, it's been, again, COVID recovery themes and some reverse inquiries and income for the portfolio.

[Aaron Dalrymple:]

Great, thanks. And as you look up over the events over the last year, what are some of the biggest impacts of COVID that you're seeing in the credit markets today?

[Terry Ing:]

Yes, today versus last year, what a big change in the market, and as well as in COVID across the world. What we're seeing now in the credit market, and the COVID impact is, it's kind of more into more of what is the recovery theme? Are there -- is there still enough yield left in some of these credits that have recovered what's been priced in for a full recovery or not? There are some -- now some worries on supply chain shortages and inflation worries that have also come into the market, which is a symptom of COVID as well, as we recover on the other side. And so that we're seeing some of that also come into the market as well. But I think for this year, the focus is going to be around, again, .supply chain, inflation worries, and also what happens on the rate side. Overall, the credits and the fundamentals from COVID, we continue to see strong kind of recovery across all sectors from a fundamental perspective.

[Aaron Dalrymple:]

And just curious as far as kind of earnings, you expect more volatility across earnings announcements or do you think there's going to be more dispersion in the market going forward or is it going to be primarily just kind of a rising tide lifts all boats?

[Terry Ing:]

Yes, it's going to be a combination of both. And so what we're seeing is that, look at the rising tide has floated all boats, especially from all the monetary and fiscal help that we've seen. And you're starting to see a lot of companies that weren't able to refinance historically, able to refinance. And so the liquidity profiles of many of these companies remain strong. However, I think you'll see some dispersion, which is typically good for this fund, and potential earnings volatility in companies that will not be able to handle some of this inflation pass-through, or pricing increases, or there'll be needed to pass-through to their customers, and maybe some potential surprises on the restarting of their businesses, working capital needs, that may be unforeseen. And so you might see some of that kind of flow through. But so far, what we've seen in our portfolio companies is that the inflation worries have been contained and the ability to pass-through these price increases has been relatively easy and strong.

[Aaron Dalrymple:]

Great, thanks. And then, we touched on one of the big themes earlier in the introduction was kind of the continuous yield for credit. Obviously, rates are at historic lows. I think a question a lot of investors have is kind of given the strong rally in credit, where are we seeing opportunities in credit, is now still a good time to invest in credit?

[Terry Ing:]

Yes, in markets like these, where the fundamentals remain very strong, I think default rates will continue to trend lower for the overall high yield market. But the -- when you look at yields or spread, people will -- markets will say, hey, look, it's a little bit on the tighter end from a historical standpoint. However, what we're also seeing is a lot of idiosyncratic reverse opportunities that we are seeing in some of these COVID recovery names that continue to be out there, or we still see spread compression as a viable option throughout the end of the year. Many of these companies are looking to refinance. Some of them are everywhere in the consumer retail sector, all the way, again, out to the travel sector. We continue to see robust recoveries across those segments and those idiosyncratic reverse opportunities remain. There are also opportunities where, we saw in March, where there was a decent sell off in I would say, higher quality, lower coupon, longer duration credits, given a lot of the rate tiers that were in the market. There continue to be a number of those opportunities in the market. And I think you'll continue to see that kind of ebb and flow with rate concerns and inflation concerns throughout the year. So the ability to pivot and buy those will also be important. So I would say in those two categories right now are some of the most attractive opportunities we're seeing.

[Aaron Dalrymple:]

And that may be good dovetail to the next question. You mentioned rates, I think the big story in Q1 -- I think if we look back to Q4, Q3 and Q4, I think, the economic number that most credit investors were looking for were energy prices, price of oil, fast forward to Q1 and into April into Q2, the big story has been the rate move. So obviously rates -- you saw the rate move in Q1, that's really affected kind of longer duration credit. I'm curious kind of what KKR’s view on rates is? And how you think this will impact the credit markets going forward?

[Terry Ing:]

Yes, it's a good topical question. It's on people's minds and when we at KKR are working with our macro team here, we did not see rates getting unglued at the long end of the curve. We do expect faster growth and more government spending and complications from the supply chain that I mentioned before. But it does -- all that take into account, we are taking a more conservative approach to rates this year. Our macro team recently increased our per 10-year interest rate forecast for '21 up -- we took the 10-year up to 1.75%, it was at 1.5%. And when we look at 2022 we are moving the forecast to 2.25% from 2%. So it is moving up, but at the same time our macro team does not see interest rates as being, to clearly shield, per se that derail the entire recovery. We do expect again, I mentioned before, more volatility and some increased dispersion across the high yield and loan space. But I think that definitely plays into our favor given that KIO is a flexible mandate, and we can pivot high yield to loans and shorten duration if needed, and we have been. So I think it's kind of testament to the flexible nature of this fund. I think on -- I think your next question was -- Aaron was on kind of how it impacts our portfolio and so forth?

[Aaron Dalrymple:]

Yes, yes. You said me this -- I think this is a topical, as well as like how does this play into our kind of portfolio construction? And what do we think about the moving rates and how does this impact kind of portfolio in a rising rate environment?

[Terry Ing:]

Yes, it's an important question. And historically, when you look at KIO and how we’ve run the portfolio, we’ve always run it -- we've always had lower duration, it's always been lower duration type of portfolio, and that's the way we've historically run it. We do have the flexibility. If you look at our funds, approximately over 50% is still in kind of floating rate bonds and loans, and we have -- so that helps in terms of keeping duration relatively short. And when we do that, we're still able to generate the returns needed with a lot of these short-term kind of catalysts that we have on these shorter dated type of bonds, or even on the loan side which helps. And so, we constantly are seeing that opportunity to pivot to loans that are trading at discounts that have potential takeout opportunities, as well as shorter duration bonds that have a near-term catalyst for whether it's an upgrade or refinancing opportunity.

[Aaron Dalrymple:]

Great, thanks. And then, you’ve mentioned rates, you've mentioned inflation. I mean, do you see these as the two biggest risks as a credit investor or there some other risks that you would highlight?

[Terry Ing:]

Yes, again, I think those unforeseen potentially events that could be an issue. We've looked at labor, wage inflation across our credit. And we've been looking and staying away from credits that have that large wage inflation component in it. There was a large service company that came to the market recently, and we decided to not reallocate to it based on some of these concerns, and their ability to kind of pass through that. It'll be credit by credit in terms of figuring out what -- which credits will have the ability to pass through and which don't. For example, building product segment, you know there's a lot of lumber inflation in those -- in their business model. However, it's interesting, we've done a lot of due diligence in this area and so far management teams and some of our calls have come out rather positive on the end consumer and their ability to absorb the price increases. Once we see that change, we will obviously make some adjustments, but so far yes, that those are some of the bigger risks as a credit investor. We can talk about some other risks. I'm more concerned about potential policy risk that could occur, the Fed kind of misjudging the potential inflation in the market and rates or misinterpretation of the stimulus programs and how much we are feeding the consumer and their end demand and how it impacts certain business models. So they're definitely seeing that benefit roll through in certain business models. What we call COVID beneficiary, companies that have seen a spike in their earnings because of COVID and stimulus program and just being aware of those risks and how it normalizes over time, is what we've been monitoring. So it's a combination of all that. I think it's again, inflation top of mind, fiscal policy, monetary policy risk, and then being able to watch these idiosyncratic credit moves, and making sure that we're flexible and pivoting towards the companies that have more risk -- have that ability to pass-through the pricing versus others.

[Aaron Dalrymple:]

That’s a great answer. And just curious, any specific sectors that we’re focused on, that we think are going to be a little bit more problematic looking at 6 to 12 months?

[Terry Ing:]

Yes, again, I think it's these COVID beneficiaries that we're watching closely what we call COVID beneficiaries, meaning that these are companies that have, let's say, benefited from the stimulus program, the rapid rise in PP&E, for example, supplies. We saw a company that significantly benefited from that, that probably won't occur in a long-term basis or companies that have been over earning or have expanded margins that eventually will normalize and compounded with the fact that they have leverage on top of it. And so coming through that cycle watching those companies, and making sure we're derisking on that front, before the rest of the market does. There's a consumer company that makes wheel, like consumer wheels for companies, that company we're watching that has been benefiting. But for the most part, we're seeing robust demand across all sectors. In particular, we continue to be overweighing leisure and some travel name. And if you look at where these companies have priced in spreads prior to COVID, many of the spreads have not returned to those levels yet. And so we still see an opportunity there, or that the full recovery has not been priced into those bonds or loans. So we continue to be overweighing some of those names. So hopefully that answers your question, but it's a combination of watching the COVID beneficiaries. And then also taking advantage of these fast recovery companies and recovering companies that have not been fully priced in yet and taking -- and watching that spreads compression and having us continue to benefit from the spread compression that, that offers, those bonds offer.

[Aaron Dalrymple:]

And then as far as the -- you've mentioned this couple of times, the ability of KIO to toggle between loans and bonds. How do we see the kind of relative value between loans and bonds? Understand this is always changing. And what do you see as the key risk in each market?

[Terry Ing:]

So our investment committee is, as always, focused on the relative value between loans, bonds, and CLOs and some structured products. And so we're looking across that entire framework. And our analyst team does that every day, looking at their capital structures, and trying to find the best value between loans and bonds. What we've noticed from a high level is the -- from the first quarter is that on the loan market side, there's been more LBO issuance, more companies raising money on for LBOs, or leveraged buyouts. And that usually comes in the form of loan. And so there's been a little bit more supply pressure, I would say from that end and some of these larger LBOs have been 00 -- that the loan market has been digesting. And so even though we've had robust demand on the CLO creation side, the retail demand hasn't totally come through yet, which has added a little bit -- I won’t say much, but some spread being a little bit more attractive on the loan side versus the high yield bond side, as of now. Now, that's not a big -- it's not a big differential, when we're looking at that. So slightly more attractive right now. So -- but KIO I would say is more balanced again, between loans and bonds, because I think that relative value can pivot pretty quickly. Loans being obviously higher up in the capital structure being more secured typically than the unsecured high yield bonds structures. But, I'd say between loans and bonds, we're still seeing -- it's again, more idiosyncratic risks from a credit side, company by company kind of specific, some companies are loan-only issuers and some companies have a mix of loans and high yield. So we're watching that, and continue to monitor that. I think, the high yield -- on the high yield market, though, there is -- they have been -- there's been a lot more supply in the last year and a half from all these falling angels, which has led to more lower coupon longer duration bonds that are in the high yield index now, which makes it a little bit more, I would say, susceptible to kind of rate sell-off. So when you think about that, obviously, the high yield market is a little bit more rate sensitive than it has been historically. So kind of comparing that with loans, loans being low duration, high up in the capital structure, it does tend to -- at least as of now, loans, I think, in my opinion, are a little bit more attractive at this moment in time, but I think it's still pretty balanced between the two.

[Aaron Dalrymple:]

And you mentioned kind of the high yield bonds had longer duration and loans. I mean, are we seeing similar credit quality across loans and bonds or is it -- I mean I know the high yield markets are -- the yield markets had significant growth over the last couple of years, but how would you set kind of the credit risk in each market?

[Terry Ing:]

Yes, I would say when you look at the maturity, bond maturities and loan maturities coming due from a runway -- liquidity runway standpoint. Most companies, all companies in both alone and high yield markets have derisked their short-term maturities significantly, say in 2021 right now, as the amount of debt maturing over the next five years has fallen by $180 billion. And so it's a significant amount of debt that's been moved back. That's both in what we’re seeing both loan and bond communities. And so that leads to, I think, a lower default rate which we are seeing continuously come through quarter by quarter, ever since the kind of COVID volatility we saw last year. And we tend to see that. I think, fundamentally, both sides, loan and bonds continue to be strong. And I think default rates will continue to go down this year. And recovery rates are looking to also improve. We had some lower recoveries on defaults that happened last year. And that, again, was mainly due to a lot of these energy sector names that had really clearly low recoveries, but a lot of that has been cleansed out of the market and out of the -- out of many portfolios. And so we generally see a good fundamental outlook for credit in general. And that's again being both loan and bond.

[Aaron Dalrymple:]

You mentioned kind of the fallen angels and brings up another topic as far as credit downgrades, particularly in the loan market. Do you expect agencies to be aggressive with upgrades as they were with downgrade and is presenting any opportunities for KIO?

[Terry Ing:]

Yes, that's a good question because what we saw was massive downgrades that happened across the board, S&P and Moody's in 2020. And that led -- you know, I was looking at this, let's say for example, high yield LTM downgrade to upgrade ratio. That was over 4.1 times in 2020. And so as the all rating agencies rate to downgrade on COVID worries, and a lot of them did worry about, obviously, there were instances of significant impacts to these COVID business model. But going forward, we've had good dialogue with these rating agencies and we don't necessarily see them upgrading nearly as fast as they downgraded, first of all, but second of all, they are upgrading. And so we are seeing that ratio that I mentioned, the downgrade, high yield downgrade. The upgrade ratio now is, instead of 4.1 on 2020 in the first quarter, we're starting to see that now at 1.6. So, they are upgrading. But it's not going to be at the pace that we saw these downgrades happen. They're not flipping the switch and seeing that. They're actually on some of these later stage, I would say later stage COVID recovery names. For example, convention centers or stadium, the type venue credits, they're taking a wait and see approach to that. And so then these companies need to produce consistent recovery over the next few quarters before you might seeing these later stage upgrades happen. And so that gives KIO a good opportunity, though, because there's a lot of funds that can't buy based on ratings restrictions. And we're seeing an opportunity to lean in on some of these companies that although from a rating standpoint does not look appealing. And sometimes the yields and spreads are reflected in that. But we can take that advantage knowing that through our due diligence and research and comfort around these credits that they'll eventually recover. And then when they do get upgraded, I think we'll bring in new investors, which will continue to drive spreads tighter. So we are seeing some of those opportunities and leaning in when we can.

[Aaron Dalrymple:]

And we're coming up on I think 30 minutes here. So we'll try to wrap this up. Maybe one more question. Do you expect the demand for yield, you can expect that thirst for yield in 2021, you should expect that to slow down?

[Terry Ing:]

Yes, it's a good question. And it's not an easy question to answer. Because what we can see from a relative standpoint versus other asset classes, high yield, and loans continue to be offering higher -- high yield on a relative basis, relative to let's say dividend paying stocks, investment grade or structured -- a structured product. It still offers decent yield. And so when you compare that with our default rate outlooks and what we're seeing from a fundamental standpoint, we continue to see demand across the board for yield. And a lot of that also we're seeing across the board or meeting international demand when you're talking about countries in Europe or Asia that have extremely low interest rates and/or lack of yield products. And so that we continue to see. You continue to see the market absorb very large new issuance volumes, both on high yield and loans. And so that is because, the demand is still there. We are starting to see some outflows here and there in the market, that’s happened. And I think it's also a function of how much can this market really digest in terms of all this new issuance coming through? And so we might see -- through the summer we could see some repricing activities where based on the markets and their yield appetite. But overall, though, still fundamentally see strong fundamentals and the yields being attractive relative across different asset classes.

[Aaron Dalrymple:]

Thanks, Terry. I appreciate your time with us today. And thanks, everyone, for taking the time to listen to the call. We hope you found this call informative. We appreciate your support. And just want to let you know, a replay call -- replay of this call will be posted on the KIO website probably within the next 48 to 72 hours. Again, thank you and have a good day.

[Operator:]

That concludes today's presentation. Thank you for your participation. You may now disconnect.

[End of Q&A:]