Reassessing Opportunities In The Evolving Bond Market

[Historical changes in the bank regulatory landscape have transformed the bond market, introducing new dynamics and opportunities that remain underexplored by many investors and bond indices. With banks no longer the primary lenders to large segments of the American economy, other lenders have emerged to fill this void. This transformation introduced significant complexity, prompting the need for enhanced due diligence and security selection criteria.

To delve deeper into these less familiar aspects of the evolving bond market and to navigate their complexities effectively, we consulted Institute members Nolan Anderson and Thomas Carney of Omaha, Nebraska-based Weitz Investment Management and co-Portfolio Managers of the Weitz Core Plus Income Fund and the Short Duration Income Fund. Insights from their years of investment experience shed light on effective strategies for approaching the bond market with a broader perspective and a sharper risk/reward lens.]

Hortz: How has the securitized bond market evolved over the past 10-20 years? How has it grown?

Anderson: When you talk about the securitized bond market, many people think of agency mortgages. They are the backbone of the asset-backed securities (ABS) market, where the securitization industry began in terms of bundling loans together and structuring their cash flows in ways that provided different time horizons, payment schedules, or tranches with varying risk profiles. Now, this securitization process is happening across almost every sector of the economy.

Loan financing done through the securitization market has grown significantly, providing alternative sources of financing and financing structures. The largest pools of capital being put together today are in private credit and middle-market sectors, representing billions of dollars of financing that historically would have been funded by banks. Notably, these types of investments are not represented in traditional fixed-income indices such as the Agg (Bloomberg Aggregate Bond Index).

Carney: The pivotal moment in this evolution arguably came with the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Following the turmoil of the Global Financial Crisis, banks were compelled to shift assets off their balance sheets. This legislative move effectively transferred risk away from banks and toward entities like ours. It marked a watershed, catalyzing a profound shift akin to a financial Big Bang, which has since continued to evolve with revolutionary fervor over the past decade.

Since then, the securitization market has grown significantly, attracting increased scrutiny and more investors. This expansion has been good for investors, allowing them to pick and choose which parts of the economy to invest in.

Regulatory dynamics continue to favor non-bank entities, particularly after the failure of Silicon Valley Bank. Ongoing negotiations on further regulatory measures are poised to heighten capital requirements for certain bank lending activities, potentially redirecting more small- and middle-market lending toward non-bank channels.

As Nolan highlighted, it is important to emphasize that these expanding investment opportunities are not represented in the Agg, which many people view as representative of the broader bond market. In order to participate in these markets, investors will need to partner with active investment managers who have in-depth knowledge and experience with this evolving market.

Hortz: In addition to the sectors represented by the Agg, could you elaborate on why you adopt a broader perspective, exploring sectors beyond its scope that might be unfamiliar to many investors and advisors?

Anderson: Sure, it’s a simple answer. About 50% of the investable bond market now extends beyond the index. Restricting yourself to a subset of investment opportunities overlooks potentially high-quality options available elsewhere.

Carney: I would also add that these areas often represent significant value. They receive less attention than sectors tied to the Agg but offer comparable credit quality. So, as Nolan said, we see no reason to limit our opportunity set.

Hortz: What do advisors need to know about the firms involved in the growing securitized debt and private credit market?

Anderson: Many of the firms in this growing marketplace now are household names – Blackstone, Aries, KKR, and Apollo. These firms are subject to public scrutiny and have substantial histories that reflect deep expertise and adaptive capabilities within the evolving debt landscape. But, as with any investment, it is necessary to analyze the sponsoring firm, the underlying assets, the credit quality, and do extensive due diligence.

Carney: The term “private lending” often carries misconceptions that can scare off potential investors. The fact is that many of the players in this space have been around for over 20 years, having successfully navigated major market events like the Global Financial Crisis and the challenges of 2020.

And these firms operate holistically. They do not simply make loans and walk away. They are fully equipped to manage any difficulties that may arise with the loans they originate. They are not merely investment advisors sitting at a Bloomberg terminal investing in leveraged loans, with their only recourse in troubled times being to sell the loan. Instead, they possess the wherewithal, expertise, and resources to deploy specialized teams to mitigate losses when needed and otherwise work with investments over the long term.

Hortz: Can you further explain your investment selection process and how it aligns with your relative value and risk management philosophy?

Carney: Our investment selection process is rooted in bottom-up, fundamental analysis focused on understanding the underlying business and its people. We delve into aspects such as unit economics, competitive dynamics of the industry and how the company is positioned within it, historical performance through economic cycles, cash flow assessments, asset valuation, and durability. We then apply an overlay of understanding the structural dynamics of each securitization, assessing factors like sponsor commitment and capital at risk. Then, we apply that lens to all corporate bonds and other parts of the market.

We visualize this process like a dashboard, looking at the opportunities across the broad bond market, assessing the risks and return potential, and then allocating capital accordingly. It is through this framework that we apply a consistent underwriting process across all sectors to compare the risks and return opportunities. Our flexible approach allows us to hunt for the best ideas wherever we can find them and to cast a wider net, which we feel is a durable competitive advantage.

Anderson: Speaking of durable competitive advantage, I think our investment process, and specifically our decision-making process, stands out in its efficiency and decisiveness. We want to avoid getting bogged down in the committee approach, where things can get lost in translation. Opportunities can come up quickly, and it is important to respond quickly. There needs to be a circle of competence and a cohesive team. With more than 13 years working together, Tom and I can make informed decisions quickly, avoiding the delays inherent in bureaucratic committee processes that can potentially dilute alpha opportunities.

Hortz: How do you preserve the liquidity of the portfolio given the illiquidity of the private market?

Anderson: Liquidity is a big consideration for us. We manage it structurally through loan diversification, position sizing, and diversification among managers. We work with over two dozen private credit managers, which helps mitigate risk should there be an exogenous shock to the markets. We are lending to those managers through a daily-valued 40-Act fund that is well diversified in U.S. Treasuries, mortgages, and other security types. It is a good example of how we approach risk and diversification.

Carney: When it comes to preserving liquidity, it is important to note that we are not solely focused on private credit investments. Liquidity challenges are something we carefully manage within our portfolio construction process. For both the Core Plus Income Fund and the Short Duration Income Fund we have generally allocated less than 20% to private credit. Taking advantage of the benefits of private credit and other less liquid investments does not necessarily signify that you are a high-risk, illiquid portfolio. In our view, there is a continuum of liquidity risks that we carefully assess and build into our portfolio construction process. We have different liquidity levers to pull to manage various scenarios, like what we saw in 2020, so we are prepared for whatever comes our way.

Hortz: You often mention how important your key partners are in supporting your private market activities. How exactly do they contribute to your investment decisions?

Anderson: That is probably the most fascinating part of what we do. Many sponsors are private companies, so their information may not be readily accessible. We have to be on the ground, traveling across the country, meeting sponsors at conferences, and sometimes visiting their offices. We genuinely engage with their businesses, seeking insights about market trends. These relationships are strategic—as active management is still a relationship business—and have significantly enhanced our investment strategy over the past decade.

Further, we maintain a robust network across the private credit market. These relationships provide a wealth of information that can be incredibly valuable. Being able to communicate with them and share perspectives regularly is something you do not get with passive investment management. This qualitative aspect, contrasting with the quantitative, is where investing gets challenging but also where tough decisions are made.

Carney: When you are in the middle of a tough market environment, picking up the phone to discuss an investment with a sponsor and understand their market view becomes a crucial part of making a decision on whether to sell, hold, or buy more. It is more impactful than just staring at a Bloomberg screen, which may not reflect current realities. Access to knowledgeable players and being able to ask them questions is integral to our due diligence process and adds significant value for our shareholders.

Hortz: Let us apply your perspective and approach to the recent bond environment. How have you navigated this tight-spread environment and volatile rates through 2023 and 2024 year-to-date?

Carney: In 2023, we saw significant shifts in the regional bank landscape and with the Federal Reserve. The Fed started quantitative tightening and withdrew somewhat from the mortgage-backed markets, second only to U.S. Treasuries. As a result, spreads widened, and nominal rates increased.

It was a rare occurrence, perhaps the first in two decades, that agency mortgage-backed securities offered wider spreads and higher nominal returns compared to so-called investment-grade alternatives like corporate bonds.

So, we seized the opportunity and took advantage of distress in the regional bank environment as they, and the Fed, became less of a buyer. We increased our exposure from nearly zero to nearly 25% in agency mortgage-backed securities as of 3/31/2024, making it a substantial portion of the Core Plus Income Fund. Our flexible strategy allows us to capitalize on opportunities as they arise in the market.

Hortz: Can you give us examples of how you would steer your portfolios through different potential scenarios in the future?

Anderson: Well, the future for interest rates is still quite uncertain. Our portfolios are designed to handle various scenarios, and in most scenarios, a part of the portfolio will benefit.

For instance, if longer-term rates increase or the yield curve steepens – so longer-term rates rise while short-term rates stay steady – our agency mortgages with coupons ranging from 5% to 6.5% could perform well. Higher long-term rates typically mean slower prepayments, which is good for us. On the other hand, if the economy takes a downturn and rates decline precipitously, our holdings in longer-term treasuries would benefit significantly. Then, there are our holdings in floating-rate securities. These are tied to the Fed funds rate, so if the Fed decides not to cut rates as much as expected, they will benefit.

Our portfolio is strategically structured to avoid making big bets on any one outcome. Instead, we have diversified the portfolio across segments that respond differently to interest rate changes. This strategic allocation prepares us for multiple scenarios, as the future of interest rates is unpredictable.

Carney: We believe in staying nimble and responsive to market changes, rather than trying to predict macro shifts and then adjusting our capital allocation accordingly. Take 2020, for instance. Despite an exogenous shock to the markets, we concentrated on our best ideas and quickly shifted capital to its highest and best use. We have the right team that is adept at seizing opportunities. For investors concerned about the direction of interest rates and the bond market, our flexible approach positions them well going forward.