KKR Income Opportunities Fund
Q3 2021 Earnings Call Transcript

Published: 10 Nov 2021

[Operator:]

Good day. Welcome to the KIO Q3 Investor Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Aaron Dalrymple at KKR. Please go ahead, sir.

[Aaron Dalrymple:]

Thank you and hello and welcome to the KKR KIO Q3 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 Jeremiah Lane, who is a Partner at KKR and Portfolio Manager across our credit strategies. Jeremiah and I are based in San Francisco with the U.S. leverage credit team. Before beginning today’s call, I have some important disclosures to share. The opinions and forward-looking statements shared in this call are current as of today, November 10, 2021, and are subject to change based on market and other conditions. They do not constitute investment advice or recommendations and are not intended to be a forecast of future events or guarantee of future results. Any performance discussed is past performance. Closed end funds, like all investments, are subject to risk. For more information about the fund, please visit our website at kkrfunds.com. So today I have got Jeremiah with me. He sits with me in San Francisco with the U.S. Leverage Credit team and similar to past calls we will start, I will start with the market update, just reflect a little bit on things that happened in Q3. And then we’ll start a dialogue with Jeremiah just to talk about performance, outlook, and some other macro concerns or macro events that have occurred in the market. So in Q3, the credits continue to positive, Q3 credit markets continues to positive run with bank loans and high yield in the U.S. both positive despite a number of short bouts of volatility, get peers of topping the U.S. debt ceiling and then you also have the evergreen debt crisis in China. We also saw continued pressure on global supply chain and labor wages which we’ll talk about amidst an increasingly real but stationary backdrop. Both high yield bonds and loans are positive during Q3. High yields bonds were up 94 basis points and loans were up a little over 1%. And on a year-to-date basis, the credit markets continue to have a pretty strong year and high yield market is up 4.7% year-to-date and loans are up just under 4.5% year-to-date. You also saw in Q3 continued strong loan issuance and currently on pace to break historical issuance records. A good deal of the surgeon activity within the loan market this year can be attributed to the high volume of primary CLO issuance, which set a new record year-to-date as of September 2021. In fact, every quarter in and 2021 we saw a new CLO issuance record. As far as flows, high yield mutual fund flows were finally net positive in Q3. We’ve seen some volatility in high yield flows this year. The loans have been pretty consistent. Loan saw 10 consecutive month of inflow and September, bringing in total inflows for the year till a little over 7 billion. Just at a high level and at KKR, we continue to see pretty strong demand for thirst for yield as heightened activity levels across our platform. Overall, it’s been an incredibly strong quarter globally for the credit markets. We continue to have strong conviction across the current landscape, albeit without elevating awareness of external factors such as the macro economic landscape, and its real time and evolving policy changes in addition to what we believe will be long term ripple effects catalyzed by the pandemic. So maybe we’ll focus on turn to Jeremiah and focus a little bit about on performance for Q3. If you look at KIO’s performance in Q3 based on NAV is basically flat, just slightly negative down 35 bips. On a year-to-date basis KIO we look at the NAV is up 4.91%.

[A - Jeremiah Lane:]

Sure. Third quarter where there’s a little bit of underperformance overall in the market, and then it was driven by, there is some COVID worries actually that rippled through a lot of the some of the portfolio during that quarter and we’re talking already about going into fourth quarter, and that a lot of that stuff is already in the rearview mirror. And a lot of the worries that were around Delta variant have subsided significantly and we’ve seen a lot of these leisure names, cruise ship names, for example, recovering quite significantly now going into the final quarter here of the year. So there was some choppiness that happened in Q3. But, but overall, I think a lot of those issues that people worried about has been resolved now. Now we’re on to looking at markets from the lens of supply chain and labor issues and inflation.

[Aaron Dalrymple:]

Yes. it’s interesting because the cruise ship that was obviously a theme of the leisure theme that we leaned in to the market during COVID and as you look out the window over the last couple weeks, I think we’ve started to see cruise ships docking for the first time. So it seems to be some of those later stage recovery trades are playing out.

[Jeremiah Lane:]

Yes, that’s right. I think, especially this past week, the news of the Pfizer pill that you can take that lowers hospitalization rates significantly really rallied the entire leisure and cruise ship sector. And so you’re definitely seeing that. I think one area that we are watching closely is Europe and there are still some cases that are increasing, for example, in Germany and other parts of Europe. But overall the rest of the globe seems to be handling it well, and hospitalization rates and death rates seem to be at reasonable levels. And so I think we continue to see a lot of these leisure names, for example, continue to recover well.

[Aaron Dalrymple:]

Great. And then as far as kind of other high level themes, in the fun, anything else, we’re kind of looking in other areas that we were finding particularly attractive in this market.

[Jeremiah Lane:]

Yes. There’s a number of them. I mean, when you think about this mandate, obviously, it’s the flexible mandate that has kind of, we can shift asset allocation when needed, depending on market on the market move. And last year, during COVID, there is a lot of what we call a theme of dislocation. We saw high quality names tradeoffs initially, and then recover the fastest. And we saw a lot of disruption in certain sectors that we took advantage of opportunistically. This year we’re still seeing dislocation market. And, but we’re also given where yields are and where spreads are there is somewhat tighter versus historical levels. But there are definitely a lot of opportunities that present themselves for example on a proprietary sourcing side where we’re able to use our long term relationships here on for example, on the sponsor side or we can anchor deals, and we’ll be one of the three or four counts that are allocated a large secondly, for example, we’ve been very active in the software sector and now aerospace and defense where we are taking kind of proprietary source type of positions that have some yield on them, and are good credits from our perspective. So we’re seeing opportunity there. The second opportunity, I think, is what we’re seeing in terms of the inflation supply chain labor issue worries and obviously, it’s been communicated in the market for a very long time. Today the CPI came out at 30 year highs. So it’s on top of everyone’s mind, and you’re seeing in the rates movement today. But we’re also seeing lot opportunities in the earnings sessions right now that many companies are coming through, going through right now. And for the most part, earnings have been, I would say, beating expectations. Despite a lot of these supply chain issues, and headwinds and labor issues most companies are handling it very well in passing through price increases and many ways or labor costs are only increasing anywhere from 2% to 8% depending on the second credit, so somewhat manageable. And most of those companies think they are transitory in nature, but when a company does miss and has an earning problem, or a margin issue due to these supply chain issues, we are seeing bonds tradeoffs three to five points. And that presents an opportunity for us to lean in if on credits that we favor and believe have pricing power over time and we believe that some of these are short term in nature. So those are some of the opportunities we’re seeing right now and we think we’ll continue to year end.

[Aaron Dalrymple:]

And you mentioned kind of the flexible nature of the strategy. I mean, maybe you can talk a lot about some of the market dynamics you’re seeing, particularly in the loan market, where you have some of these structural inefficiencies, particularly because of CLO market. I mean, they make up, represent over 60% of buyers in the market. So there is different I guess, I call them structural inefficiencies in the market that we can take advantage of whether it be kind of rating or by sector, but maybe just talk a little about how this fund can take advantage of that, and how kind of how we see that market.

[Jeremiah Lane:]

Sure, yes. Good thing about CLOs and the way they’re structured, a lot of them have certain caps on the face triple Cs. And they can only take on a certain amount of Triple C exposure, for example. And we saw this opportunity sometime of last year in 2020, where some of these CLO funds hit their caps, and they had to optimize their CLO and thus, you saw some for selling a lot of names that we thought are downgraded because of COVID. But were significant were good credits, when COVID dissipated, and these companies were recovering. And so we took advantage of the dislocation and leaned in on some of these. Again, there are some leisure names and travel names that were hit pretty hard and were downgraded to triple C status, and now are being upgraded. And so that’s just an example of some of the dislocation in that particular market that we sometimes see. I think if you look at that goes to the point of upgrades and downgrades. And what we’re seeing also on the rating side is that what we saw during COVID last year was the upgrade, well, we call it upgrade downgrade ratio, the number of upgrades divided by the downgrades were all time lows and 2020 was below one. And now we’re seeing that upgraded downgrade ratio at all time highs over two. And so we can see a complete reversal of kind of the ratings trajectory in the market right now, and seeing an improvement overall on overall credit profiles and ratings agencies are kind of correcting a lot of the downgrades that happened a year ago. So we’re seeing that kind.

[Aaron Dalrymple:]

So you are seeing kind of a tailwind in this market going into next year in the market and the demand for that?

[Jeremiah Lane:]

Yes. I think there’s obviously a strong CLO demand that continues CLO printed a number of them almost every week. And that remains strong. Retail markets are looking for are worried about inflation, and we’re seeing flows into the loan markets. And we’re also seeing flows in higher market as well. I mean, that’s more recently, so flows kind of remain healthy I think. What we’re also are looking out to keep track of is default rates and recovery rates and when you look at default rates, we’re tracking below 1% which on both the high yield and bond side, which is a significant decrease in a very low number, an absolute basis for default rate and the outlook per se going forward remains to be pretty benign under 1% in 2022 if you look at a survey across many of these sell side firms on default rates and recoveries actually are improving from 2020. If you look at recovery rates on a lot of these bonds and loans that defaulted you’re returning back to kind of normalized averages or average level. We did hit a low in 2020 but the recoveries are also proving which means valuations are there. So overall still remains very healthy. I think what we are watching is in keeping a very close eye on is any supply chain disruption, inflation type of issues and monitoring that very closely.

[Aaron Dalrymple:]

And just as kind of a reminder for the audience KIO, the strategy focus on the U.S. liquid credit markets. So allocates across loans, bonds, and to a lesser extent, structure credit, and we tend to the flexible nature of the strategy allows us to kind of pivot where we see the best value. So more recently, we’ve been pivoting, or favoring kind of floating rate asset class of loans over high yield bonds. You’re not going to see material shifts in short period of times, but it’s definitely something we’re going to lean into loans more than bonds right now.

[Jeremiah Lane:]

Yes, I think just to add to that, I think on the loan side, if you look at the just general spreads or yields versus the high yield bond market loans still are remaining a more attractive meaning you’re getting more spread and that’s kind of remain the case for most a lot of these years and some of that’s due to a lot of the kind of LBO supply that we’re seeing in the market. It’s been a decent amount of loan issuance this year and if you look at the high yield market they’re just, there is always a demand there. But the high yield index tends to be a little bit more I would say higher quality. Last year, given that there’s increasing number of fallen angels, but the spread differential still favors loans. And so we are actively looking at the loan market for convexity and opportunities to buy.

[Aaron Dalrymple:]

And that makes sense given kind of where we expect rates to head and given the inflationary pressures, and rising rate expectations. I mean, the floating rate nature of the asset class offers kind of a value they’re looking ahead. So maybe I’ll shift a little bit and we’ll talk about kind of the macro environment, we’ve mentioned a couple times that I may just going to frame discussion as far as how we’re thinking about rates and how this impact of inflation and the job growth and how this impacts the portfolio KKR and KIO team we have access to our, we have a global macro team that releases research and there is constant dialogue between the investment team and the macro teams. But if you look at kind of the inflation and job growth expectations we’d expect job growth to run pretty hot in the first half of 2022, as supply chains remain constrained, and as economy continue to emerge from the Delta wave. The Fed forecast is suggested that the committee will consider rate hikes once the unemployment rate moves below 4%. We’re still I think closer to 4.6% now. So we think there’s a good chance, these conditions will be met in the second half of next year 2022. So we have kind of forecasted out one to two Fed rate hikes into next year. And then 2023 we think the Fed will likely proceed more slowly in the realm of kind of two hikes a year. So that’s kind of the backdrop of how we think about the market. And kind of where we think rates for, right rates will go. Maybe just talk a little about kind of how we’re thinking about current rates and the impact of portfolio and kind of how we can factor some of these kinds of inflation concerns when we’re underwriting credits.

[Jeremiah Lane:]

Yes, if you look at the portfolio we remain underweight duration. Most of our, obviously, our heavy exposure took more loans than bonds, helps that. And we continue to think that’s the right positioning for this year and into next year. And so obviously that’s positioned well for more of a kind of rate hike inflationary environment with supply chain issues and so forth. And our house view is that obviously rates continue to go wider here to next year. And undeniably, we’re seeing it in our private equity companies. We’re seeing it in our own portfolio companies. I guess the biggest question is when does this all end? And when is it really transitory and there’s mixed views out there? I think when you look at the sectors that are reporting earnings right now we were pleasantly surprised by a number of these companies, for example concerns around hospitals, given labor, potential labor issues. All the hospitals that were invested in, have actually reported no real issues and on the labor side and margins were maintained and actually increased wages quarter, so that was good, some good earnings on the hospital facility side. We look at leisure for example labor issues are first and foremost top of mind. And we did see some late I know, margin pressure due to labor issues, and many of the hotels and gaming sector. But many of these companies also have pricing power. And they had a lot of margin expansion in the prior quarters. So we think that’s going to normalize over time and we’ll continue to be positioned I think well on the leisure sector. The building products area is another area where we’re closely monitoring. And we’d like to tend to choose building products companies, and distributors that have pricing power and what we’re seeing though whether it’s trying to procure lumber to any building products has been a challenge and to the supply chain. So there’s been a lot of, there’s been temporary margin compression but many of these companies are passing through a lot of these price increases, and we’re going to see that price increase come through in the following quarters. So we remain comfortable with those. And so those also be are still big part of the portfolio as well. And so again, investing in companies that have pricing power, have the ability to pass through these costs. So again, durability of cash flows throughout different cycles and this is just a new kind of derivative of kind of aftermath of COVID that we’re experiencing now and so, again, we’ll monitor it and believe we’re are positioned correctly with duration with some of the sectors.

[Aaron Dalrymple:]

Thanks, in any particular sectors that we’re avoiding, any sectors that we have more concerns about, whether it be energy or other sectors?

[Jeremiah Lane:]

There are a few sectors, I mean, obviously we tend to always stay away from the commodity sectors. And you’re seeing it now in many of these metals and mining companies where they experienced what I would call somewhat of a demand supply issue that led to a lot of the metals prices increasing significantly at the beginning of year and now kind of reversing. And so that kind of volatility in cash flows is typically what we do not underwrite. And we remain opportunistic in some of the energy companies but we’re remaining, that’s an underweight overall for our portfolios, given the commodity kind of nature and the fluctuation of the cash flows that could occur if the client does drop. And so when we do we do we are remaining, I guess avoiding some of the sectors.

[Aaron Dalrymple:]

And then any particular sectors that you’re more bullish on? I mean, it sounds like at one time, we did have a more of a kind of housing kind of bullish theme on that some of those trays may be kind of rotating. But is that still a sector that we like?

[Jeremiah Lane:]

Yes. Building products area is still a sector we like. We’re seeing strong demand across the board. When you look at all the companies that reported demand remain strong. The question again, is still around the margins and supply chain. But demand remains strong. We think that these complementary these companies can, will be able to pass through those prices and maintain good cash flows and leverage metrics. So yes that’s an area that we’re still involved. Other areas are leisure. There’s still a lot of trades out there where the spreads and yields have not returned to pre-COVID levels whether its travel related names to cruise ships. They’re still a lot of spread compression there that could occur over time. And we’re looking at the general theme there is we call looking for collateral. So collateral businesses or bonds that have strong collateral with cash flows and so when we look at some of these names, and you look at our portfolio, a lot of it remains secured. We have security or first lien or second lien security on many of our names in the portfolio, and we still think that’s important and so looking for that collateral, and then the stability of cash flows going forward.

[Aaron Dalrymple:]

And as we’re coming up, kind of on our 30 minutes here, but I may just make a couple of kind of summary comments. And we really appreciate investors support here. This year the funds we have had a really strong 2020, this year, year-to-date numbers, I think they’re still strong relative to the benchmarks. The portfolio continues to generate an attractive yield. I think as Jeremiah pointed out, the defaults are heading in the right direction. And I think we feel like we have a pretty clean portfolio as far as there are a few credit concerns. And we’re also kind of pivoting more into loans as we see kind of the inflationary environment change and the expectation of increasing rates. I don’t know if you have anything else to add before we sign off, but I appreciate everyone’s time here.

[Jeremiah Lane:]

Okay, thank you.

[Aaron Dalrymple:]

Thank you. So thanks for spending time with us today. And hope you found this call informative. We appreciate your support. Hope you’re staying safe. Just want to let you know that a replay of this call will be posted on the KKR Co. website in the next few days. Thank you again. Good bye.

[Operator:]

We’ll conclude today’s conference. Thank you for your participation. You may now disconnect.