Opinion: Bond Investors Should Double Down on Due Diligence as Yields Rise
Higher Borrowing Costs Can Expose Companies’ Risk
Millennials have a very different take on the American dream than previous generations did.
Owning a home and paying for an aspirational lifestyle by carrying credit card debt was a way of life for many of their parents, until the Great Financial Crisis took their jobs and made it tough for them to find another because they couldn’t sell the family home and move to another city where there were employment opportunities.
Watching their debt-encumbered parents struggle though this malaise led many millennials to vow to avoid the same financial path.
Buy a house? No thanks. In the age of the gig economy, a mortgage is an impediment to career and social mobility. Max out credit cards? No way. While a majority of older Americans have at least one credit card, 67% of millennials don’t have any, according to a recent survey by Bankrate.com. Take out a car loan? Eh, Uber.
New Financial Demographic
Appealing to this new financial demographic is the idea behind such companies as Upstart and Social Finance Inc. (commonly known as SoFi). Since 2013, SoFi has securitized about $9.5 billion in loans, while Upstart last year packaged $338 million of personal loans into two deals.
SoFi targets top college graduates — Harvard lawyers, Yale doctors, Wharton bankers — people whose outstanding student-loan balances match their outstanding career potential. For SoFi, this cohort is a good bet to provide lower-cost loans that allow the buyers to de-lever faster and hopefully return for car loans, mortgages and wealth-management services such as college- and retirement-savings plans. Upstart took the idea a stage further by widening the customer base beyond the Ivy League.
Because so many millennials have such thin credit reports, Upstart and SoFi gauge risk by using algorithms that analyze college grades along with behavioral criteria such as the ability to delay gratification. The result is often a bespoke loan — a longer term, a lower rate than a traditional lender, or payments that rise over time along with income. The algorithms get more efficient with each new data set and loan, making them arguably a better indicator of risk than FICO scores.
So one way to potentially earn sufficient income while avoiding undue risk in a rising-rate environment is to consider asset-backed securities (ABS) from innovative and well-managed businesses.
Following the Federal Reserve’s 25-basis-point increase March 21 — its sixth since December 2015 and first under new Chairman Jerome Powell — yields on 10-year Treasurys are closing on 3% for the first time since Jan. 1, 2014, while the extra premium investors demand to hold corporate bonds of similar maturity stands about 340 basis points, about 90 basis points tighter than the 10-year average.
Since interest rates largely impact the short end of the yield curve, buying longer-dated debt works so long as inflation doesn’t spike. But generating excess returns based on such macro calls is tough — get it wrong and the extra duration risk can wipe out a year’s worth of alpha.
Holding shorter-dated high-yield debt from well-managed issuers that allocate capital wisely, have a clear and defendable competitive moat, and good growth prospects can go a long way to alleviating worries about interest rates and inflation, which the Fed now expects to exceed its 2% target in 2019 and 2020.
In addition to favoring shorter-dated high-yield debt, ABS, whole-business securitizations and commercial and residential mortgages, another way to potentially earn sufficient income without unduly adding to risk is to allocate more capital to bank loans. There are two main advantages to this — loans are secured, placing them above bonds in the capital structure, which lowers risk, and they reset as rates rise.
Houston Rockets owner Tilman Fertitta, the founder of closely held Landry’s Inc., which owns businesses including The Golden Nugget Hotel and Casinos, Rainforest Cafe, Bubba Gump Shrimp Co. and Saltgrass Steak House, works diligently to ensure he never overpays for assets, allocates capital and runs his businesses efficiently, and prioritizes the paying down of debt. Those attributes make for a good term-loan story.
So for many bond investors who are seeking to generate consistent income while avoiding undue interest-rate, inflation and credit risk, stress-testing the business models of innovative and high-quality issuers diminishes the need to reach lower on the credit spectrum or increase allocations to equities, which can fundamentally alter the risk profile of a portfolio.
Used with permission. First published on MarketWatch 03.27.18
Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Alpha compares risk-adjusted performance relative to an index. Positive alpha means outperformance on a risk-adjusted basis.