How to invest now? | FinancialTimes


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Hello. Stocks were boring yesterday. Less annoying were the Spacs, several of which were hit hard. BuzzFeed lost over 40% after its lockout period ended. The riskier end of the risk spectrum remains a tough place to live.

Today, our first section asks readers to do scenario analysis and build a portfolio. We sincerely hope that you will share your views with us: [email protected] and [email protected]

Place your bets on the US economy

When markets are particularly uncertain, as they are now, it helps to have a good framework. Here’s an interesting one, suggested by Unhedged rates guru, Ed Al-Hussainy of Columbia Threadneedle. He came up with a simple but neat two-by-two matrix, condensed below. Each cell shows an economic outcome that could develop over the next 12 months:

It is, of course, too neat. Results that fall between or outside the cells are possible. But the four scenarios together capture a wide range of likely outcomes and can help us plan ahead.

What do you think is the probability distribution from A to D? (The only wrong answer is 25/25/25/25.) And which of the following asset classes should outperform in each scenario? You can be long or short:

  • Growth stocks, value stocks or defensive stocks

  • Short end, long end and belly of the treasure curve

  • Business, investment grade, or junk credit

  • Emerging market debt, in local currency or in dollars

  • Immovable

  • Gold

  • American dollars

  • Paradise currencies (yen, Swiss franc)

  • Commodities — energy, food, industrial metals

We would love to hear your review via email. We’ll report on what readers are saying — and provide our own thoughts — later in the week. (Ethan Wu)

BDC: a public window on private debt

As the economic cycle turns, there are concerns about private debt markets. There’s been a deluge of capital in the space, competition for assets between managers has been fierce, and it all seems a bit toppy. Here is Ruchir Sharma of Rockefeller Capital writing in the Financial Times a few weeks ago:

After 2008, as regulators tightened the screws on public debt markets, many investors turned to these private chains, which have since quadrupled in size to nearly $1.2 billion. A significant portion of this amount is direct lending from private investors to often risky private borrowers, many of whom are in this market precisely because it is unregulated.

Sharma implies that high-growth, low-regulation areas such as private equity are ripe for a market “crash”. But it’s tricky to assess demand like this, because private markets are private. You might get information, for example, from the reports of publicly traded private equity firms or from the debt statements of individual borrowers. Overall, however, information on the private debt sector is not easy to find, nor very detailed nor very uniform.

But we have a clear – albeit small – window to that world, in the form of publicly traded business development companies.

BDCs are a species of closed-end investment fund that primarily hold the debt of small and medium-sized private companies, often those owned by private equity firms (a private equity firm may enter into a buyout agreement, grant part of the debt to partners, keep part of it for himself and park part of it in a BDC). Sometimes BDCs also own leveraged bank loans, small equity tranches, or other elements of the capital structure.

BDCs pay out most of the income from their investments in the form of dividends. The debt they hold tends to be floating rate, making it an attractive way to gain exposure to high yielding debt in a rising rate environment. They increase their returns by taking themselves into debt, which is usually around half of their total assets. Importantly for investors, BDCs also pay fees to the management companies (often private equity firms) that control them, equivalent to a few percentage points of assets per year (a few BDCs are self-managed).

By looking at BDC stocks, we can get an idea of ​​how the market is pricing private debt risk. Here are some of the financial metrics of five of the largest BDCs. All amounts are in millions, except stock prices:

The fact that many BDCs are trading at significant discounts to net asset value suggests some concern about credit quality in portfolios. The same is true for dividend yields north of 8%.

Here’s how stocks have performed, excluding dividends, since just before the coronavirus pandemic (the dark brown line is a broad exchange-traded fund covering much of the industry):

Line chart of BDC stock performance showing a developing story

The sector’s high dividends, or of course, are a game changer. Ares, the top performer of the bunch – with a good reputation as a risk manager and a reasonable fee structure – trailed the S&P’s 33% total return over the period by only a few percentage points. Owl Rock, on the other hand, returned -3% over the period.

The concern with BDCs is that credit quality is somewhat difficult to monitor, as managers have little incentive to reduce debt valuations until portfolio companies fall behind in payments. At this point, things are already very bad and will get worse quickly. How much should we care about as the cycle turns?

I asked Jefferies analyst John Hecht, and he argued that you need to look at each company’s record:

We’ve always called it an industry of haves and have-nots. [Our ratings of the stocks] relate almost exclusively to our view of the ability of managers to manage credit risk, and that comes from history. The reason the group trades where it does is because half of the market participants aren’t doing very well.

But there are some – for example Ares – that have been very good at managing credit risk, especially in troubled environments. And there are others like Apollo who don’t have this historic performance.

(Note, above, that Ares trades at a premium to NAV and Apollo at a 22% discount.) Chelsea Richardson, who covers BDCs for Fitch Ratings, pointed out to me that one of the reasons One comfort is that in the bad early days of the pandemic, many PE sponsors provided funding to portfolio companies that were having cash flow issues, thereby protecting lenders. But she also had two worries.

First, rising rates will increase the debt burden of portfolio companies. Second and most importantly, as the BDC industry has grown, competition for assets has become fierce, especially from huge unlisted BDCs such as Blackstone’s Bcred fund, which now has $38 billion in assets. Competition has made middle market debt transactions very expensive, leaving lenders with little room for trouble.

It makes sense that if there are problems in the world of private credit, the weakest players in the BDC industry – the leveraged buyers of venture corporate debt – could be where the problems begin. Unhedged will be watching closely.

A good read

Tiger Global – or, as FT Alphaville’s Robin Wigglesworth calls it, the Yolo hedge fund – has made a huge bet on the technology. Boy, did he not blown away.

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