BLACKROCK FUTURE FORUM

Investing for income

Lindy Freeman, Head of BlackRock Alternative Specialists for North America, moderated a discussion with Bill McDonough, Vice President of Investments at Sammons Financial Group; Edward Ng, BlackRock’s Head of Americas Endowments and Foundations, Client Portfolio Solutions; and Tim O’Hara, Global Co-Head of Credit, BlackRock Alternative Investors, about where they see opportunities to generate income in a lower-for-longer rate environment.

Highlights include:

  • Why the pendulum has swung back in favor of investors in direct lending
  • Where the panelists see opportunities in high yield, structured credit and emerging markets
  • The importance of engaging trusted partners when investing in private markets
  • Lindy Freeman:  Hello, everyone.  It’s a pleasure to be before you today and my name is Lindy Freeman and I work at BlackRock’s Alternatives business.  We started today hearing from Rick Rieder, who leads our fixed income investing, and we’re wrapping up with this session, titled Investing for Income.  With so many investment portfolios needing income to meet a range of liabilities, the role of income-producing assets has possibly never been more important.  At the same time, yields from traditional public market income-generating assets are unlikely to meet investors’ long-term needs, as we also heard from Rick today.

    We’ve gathered a group of investors to help us explore the many levers we have at our disposal to optimize portfolios and focus on income generation.  It’s my pleasure to be joined by some incredible investors today.  First, Bill McDonough, Vice President of Investments at Sammons Financial Group; Tim O’Hara, Global Co-Head of Credit within BlackRock Alternative Investors; and Edward Ng, who works in Client Portfolio Solutions for BlackRock.

    We may have time for questions later in our session and if you’d like to submit a question, you can do so by submitting them through the Ask a Question box on the bottom of your screen.  We also encourage you to respond to a couple polling questions that will appear on screen during the course of this discussion.

    So, with that, we’re going to talk about why income and we’re going to start with Edward.  Your – you work with clients to rebuild strategic asset allocations to improve portfolio objectives.  How do you approach income investing when that is a key objective for your client?

    Edward Ng:  No, absolutely.  Thank you, Lindy.  So, the starting point for most of our investors is agreeing on those long-term returns, which in today’s environment might feel like 5% to 8% on a nominal basis.  If we look to the slide and look at BlackRock’s Investment Institute’s capital market assumptions, what you’ll see in pink are return streams for equities and to earn that 5% to 8%, you’d have to really concentrate in those asset classes.  However, we think to build a more resilient portfolio given the market environment, we need to have cash flow or income-oriented assets.

    If we look at the next slide, just to try to highlight the importance of income, what you see in red is really the price return over the last 25 years of fixed income and equities on the right.  In pink, you’ll see the benefits of compounding those cash flows or income streams through time and those become an important component of long-term return that investors are seeking, but important provide the flexibility just and support your spending needs through time. 

    The last slide will kind of show you and really highlights post-global financial crisis how much more difficult it’s gotten in that 4% yield in fixed income markets, that only about 25% of the market yields above 4%.  Back to you, Lindy.

    Lindy Freeman:  Well, that really is dramatic.  Bill, insurance company immediately come to mind in terms of organizations that are most impacted by these low interest rates.  How has Sammons evolved its business model in recent years to cope with lower rates and are you finding private market investments more appealing today?

    Bill McDonough:  Yeah.  Thank you, Lindy.  Hopefully the audio comes through just well, just fine.  So, it’s a pleasure to be with you today.  Yeah.  So, here.  So, as an insurance company, you know, we’re in the risk business and, you know, given the current state we’re all in and we’re all facing this much lower for longer current state, you know, the – it’s, you know, we’ve had to evolve our business model, right, to scrutinize and evaluate some of the – some – the merit of some of the guarantees that we’ll make to our policyholders in the insurance space.  What we’ll do is we’ll match against the stickiness of that liability to assets that are more private, more structured, that have a uncorrelated cash flow stream to other traditional asset classes and look to add yield and income using that approach.

    For us as an insurance company, Lindy, it kind of boils down to, you know, there’s, for us there’s really three instrumental ways to add income or yield into the portfolio.  We can either do it through duration, we can do it through credit, or we can do it through liquidity or structured and private markets, if you will.  So, currently what we’re doing is opting for a strategy that continues to focus on that illiquidity pickup in premium that exists in the private markets.

    Lindy Freeman:  So, how do you think about constructing income streams across asset classes?  You know, do you think about single strategies versus multi-strategy approaches?  You know, what are those levers that you’re pulling on given your liabilities?

    Bill McDonough:  Yeah, for sure.  So, you know, in this vein of private markets, you know, we like things like infrastructure, you know, that, you know, you get paid when the wind blows, irrespective of what market’s doing, what the Fed happens to do.  Direct lending, gosh, probably couldn’t think of a time where, you know, the pendulum has swung back in the favor of lenders or investors to creditors in that space with the ability to have tightened up covenants and other limits, constraints and limitations that you can place upon borrowers and get collateral to support yourself.  So, that’s another area that we certainly favor significantly.

    And as well as, you know, other things.  I know Edward touched on emerging markets.  You know, you think in a hard currency situation like that we continue to favor that asset class.  We think there’s favorable demographics to that asset class.

    Some of the things we’ve been underweight, we’re somewhat benchmark agnostic.  We’re bench – we’re really held really to the benchmark of our liability.  And so, if we can pass cash flow testing, if we can pass ALM matching requirements who have – that we have of ourself and that a regulator places upon ourselves as an insurance company, if we can pass all those by virtue of adopting more allocations to private markets, we sure do so.

    So, things that we’ve been un-favoring or probably allocating away from are just your traditional asset classes, like investment grade corporate bonds, just very little, you know, asset-backed securities and particularly in mortgage-backed securities and some CMBS and even US high yield.  Just the relative yield and the relative value pickup there for us just doesn’t seem to move the income needle for us at this point in time.

    Lindy Freeman:  Well, Bill, you mentioned a couple of private asset classes there.  So, direct lending, infrastructure are often, you know, more accessible through private markets.  So, how do you think about the tradeoffs of those asset classes, you know, the liquidity, potentially less transparency, smaller issuers, all of that?

    Bill McDonough:  Sure.  Fantastic question.  So, you know, what we look for is a strategy that, you know, we – that will have obviously some optionality to it.  We’ll model that optionality into our cash flows, in our income stream to see if we can satisfy our liabilities.

    And what we’ve been finding is that this is an asset class that provided that you can tap and grow a relationship with a trusted partner who has a very long-term track record and a skilled team in this area, that you can actually do quite well.  And again, back to repeat and reiterate, you know, we think now is a great time to form those and go further into those relationships with trusted partners that, you know, that specialize in this asset class.  And of course, you know, your firm is one of them. 

    You know, we – it is important, because, you know, you can find a lot of – two men or two women in a truck that can do this type of work.  But it is, you know, it’s important really to form those partnerships with really time-tested and trusted partners.

    Lindy Freeman:  Well, thank you so much.  We really appreciate that.  I think we’re waiting for our polling results to come in here.  So, maybe I will go ahead and turn to Tim.  Tim, you’ve spent your career focused on income investing.  Prior to COVID, what were the sweet spots in the income markets and how has the market move since March changed the picture for you?

    Tim O’Hara:  Well, thanks, Lindy.  The sweet spots in income-oriented credit investing have probably not changed that much since pre-COVID.  But, the pricing on them has changed pretty significantly and there are a few that we’d probably knock off the list in the COVID and energy shock recession.  We think those sweet spots today, similar to Bill’s comments, are in direct lending, probably at the top of the list.  But we also think that high yield in many respects is attractive and we also think there are a few of the more idiosyncratic niches of securitized credit that are attractive as well.

    So, I’ll review each of these briefly and then comment on how the market moves since March have changed that picture.  I think, first, to direct lending, and Bill covered it well, what we’re beginning to see is a return of the deal flow that had taken a pause in March has now begun to resume in June and July.  If we were to draw a comparison with some of the pre-COVID terms that we were seeing in direct lending, we’ve essentially reset from what were really late cycle conditions with some degradation of covenants, leverage getting somewhat peaky and pricing in many cases getting a bit more aggressive.  We’ve seen an improvement to better conditions in virtually every one of those features for most of the deals that we see in the market. 

    Pricing is better.  A lot more floors have become a requirement in most of the deals.  The covenants are stronger, and leverage is more reasonable.  And we’d also say that working in a virtual environment what we’ve also found is the ability to perform proper due diligence, in some cases with visits, but often with a lot of intensive remote working, is also very much there. 

    In high yield, as most on the call are probably aware, March was maybe the most dramatic decline we’ve ever had in the market as measured by both the speed and the magnitude of the spread moves.  And equally impressive has been the strength of the recovery that we’ve had in the market on the back of all of the central bank and fiscal help and also the inflows to the asset class that occurred really starting in early April.

    It’s popular to say that the dislocation trade from that March episode has passed and we’d agree with that.  But, we shouldn’t miss the point that spread levels in this market, as compared with where we were pre-COVID, are still 60% to 75% wider than where they started the year and are at levels that are generally in the widest quartile of spreads for the last decade.  So, we think that it’s not only a good source of income, but we think there’ll be some total return that’ll be above the stated coupons that’ll probably occur from some of the spread tightening we’re likely to see as we eventually start to recover from the COVID stress.  And while with record levels of issuance in the high yield market, it means that the higher quality companies have been able to raise the liquidity they need to get through the COVID recession and we think that the credit quality from the middle and the upper quality end of the market is still quite good, despite the fact that we’re seeing signs of increases in distress broadly speaking in that market and in the loan market. 

    Dispersion has also picked up significantly in the high yield market, so it’s become a bit of a stock pickers’ market, which as active managers in the businesses that I'm attached to, we find attractive.  And then, I guess just to address it briefly, I mentioned there were three categories where the third is maybe a bit more idiosyncratic.  We would say in the securitized credit space we think that there are some interesting values to be found in the middle of the capital stack and CLOs, some in the primary.  But certainly, in the secondary market, it’s again a bit of a stock pickers’ market given some of the differences in CLO manager performance.  It’s really a name by name kind of trade.  And then, we’ve also seen some attractive opportunities in asset-based lending in non-traditional assets as well.

    So, that’s what we’re currently seeing.  Lindy, back to you.

    Lindy Freeman:  Great.  Well, you know, one of the things that we talked about earlier in this conference was the likelihood of lasting impact from COVID-19.  So, how are you approaching underwriting new investments with any reasonable degree of certainty?

    Tim O’Hara:  Well, it’s certainly a much more uncertain environment than it’s been.  And if you think about what historically, what banks and fund investors tend to do in looking at downside case models, I think there’s often a somewhat formulaic approach in many cases to what downside cases look like.  And I think that the approach to what a downside case is will probably be forever changed by what we’ve seen here with really a, probably a much more in the weeds assessment of what are some of the bigger macro shocks that can happen to a business and what the differential outcomes and different business models might be.

    I guess though in substance, our approach to underwriting new loans, new financings has really not changed.  I think like most leading credit investors, ours is an industry-led, fundamentally driven, bottoms-up, individual name-oriented approach to investing in the space.  We start with a view on what sectors we like based on the fundamentals, some of the secular trends in certain sectors.  And then, we also think about what are the risks in each sector that we cover?  We then apply a rigorous approach to assessing, in some cases creating the right structure for the level of risk that we perceive in each of those borrowers.

    What we’ve found so far, and we recognize we’re only four months into the post-COVID crisis period or the onset of the COVID crisis and we think that this is something that will probably play out for at least a year and more likely longer than that, is that business in certain sectors is holding up well, mostly in places where the models are business to business.  So, a lot of business services, places like telecom, software, some of media, much of healthcare but not all, and a lot of different financial services businesses are holding up well, though even within these we see exceptions where concentrations with certain customer types or regions can create some challenges.

    We also see that consumer businesses that are driven by some of the more stay at home driven activities, which might be things like even home maintenance and in-home non-digital entertainment.  We have a business that we support that is in the business of selling musical instruments is actually seeing constraint in the COVID crisis we think because people are looking for more at-home entertainment.  So, we’re seeing in places like that business holding up well or even in some cases growing, recognizing that a lot of consumer-oriented businesses in retail and restaurants and things like that are having a tough time.

    I guess what I'd also say is that being structure-oriented, we are seeing and tracking closely a willingness by asset owners in some industries, not in those categories that we tend to lean into, to give pricing and protections in the form of covenants and, most importantly, security, that can provide enough downside protection to make for an attractive loan, even in industries with significant COVID-specific challenges.  So, we’re sifting carefully through a broader set of industries for these opportunities as well across a variety of industries.  Thanks for that, Lindy.

    Lindy Freeman:  Oh, no.  Thank you.  And one more question for you here.  What’s your view on potential recovery rates for this cycle, you know, looking across direct lending versus, you know, the syndicated bank loan market, versus high yield and thinking about also do you expect any meaningful differences in those recovery rates now versus what we saw 2008, the last cycle?

    Tim O’Hara:  Well, really good question.  It’s in some sense recovery is hard to gauge recently, because if you take a backward looking view over the last year or two or over the last decade, we’ve had a period for an extended time now of pretty low default levels.  So, you haven’t had a lot of data points and the data points that you’ve had have been pretty concentrated in a pretty short list of industries.

    But the data points are about to increase.  That's all about to change.  If you look into the high yield market last month and this month, we’ve had more than or I should say by the end of this month we expect that each of these two months will be more than $21 billion of defaults in the high yield market each of June and July.  That's eight to ten times what have been the monthly average for the last eight or nine quarters prior to the last couple of months.

    The loan market in June also hit a ten year high for defaults.  It was still a relatively low number compared to recession episodes in the fours, where those recession episodes are up closer to 10% or higher.  So, we’re about to see a lot more data points.

    I think our view for some time, though, has been that some of the leverage and structural trends, which are generally higher leverage and more sharing of what was traditionally the domain of the loan market and of loan instruments, that the security and the capital structure has been more broadly shared with first lanes and second lanes and the leverage levels for those have been pushed up.  Our general view has been that we would see lower recoveries in the next recession and the early evidence in the COVID recession, again on still relatively a low number of data points, is trending this way.

    If you want to put some numbers around it, we’ve seen in June recovery levels drop to 31% in high yield.  That's much lower than they were in 2019, but again against relatively few data points, but still above where we were at some of the depths of ’08 and ’09 where those numbers were in the low 20s.  And then, in the loan market recovery rates, because of some of those trends I was talking about at the beginning of growth in second lanes and just growth of absolute leverage in the loan market, which coming into this episode is actually higher than it was in 2007, have begun to get close to some of the ’08-’09 lows, which were right around 40%.  We see those as trending toward the low to mid 40s right now. 

    And what’s probably interesting there is that there’s a relatively broad base to what we’re seeing in terms of the industries represented in those numbers.  Certainly, retail stands out and over the last couple of years energy’s been a big contributor to those.  But, the broadness of that base starts to give us some views that that’s probably where recovery is trending and that’s meaningfully below where it was in the last crisis.

    Lindy Freeman:  Crisis, yes.  Oh, well, I guess it’s a lot of wait and see there with default and recoveries.  But, better to be thinking about it and preparing now.  So, let’s think about right now, current positioning.  I want to come back to you, Bill, and, you know, talked a little bit about what you’re thinking about positioning today.  But maybe you can expand a little bit more on where you're underweight relative to your historical allocations, as well as, you know, where you’re adding to on new allocations.

    Bill McDonough:  Yeah, sure.  So we, I guess I would say what we do is we look out, Lindy, anywhere from five to seven years, which is about the weighted average life of our liability, and we try to project as best we can, you know, maybe looking backwards and then looking forwards as to what asset class in the mix of their respective cash flows and income streams and return profiles can satisfy those liabilities and also give us the required, you know, return on equity that we require for putting our capital to work.

    So, where we currently see our portfolio allocation in recent investment activity relative to historical norms has been, you know, I think we’d all have to admit that there was a lot of attractive investment grade corporates that came to the market in the, you know, to Tim’s point, you know, post-COVID-induced recession and market dislocation.  You know, the Fed providing liquidity did, you know, foment a significant resurrection, if you will, of investment grade corporate issuers.

    So, we did take advantage of that.  It seems to have kind of run, certainly run its course.  So, what we’ve had to do is just kind of, you know, with a lot of juice being off the table in that asset class that, of course, that gives us a nice duration, nice income stream.  Back to something Tim also mentioned just recently is, you know, we’ve had to turn back into and with the help of our managers have become stock pickers once again, going back into that secondary market and going to try to find either securities, CUSIP by CUSIP or strategy by strategy.

    And so, what we’ve tended to favor is, again, is going back to this concept of, hey, there’s significant relative value pickup in private markets.  Private markets is – you know, it can be very largely defined.  But, you know, again, I’ll reiterate, you know, direct lending.  We are significantly much more allocated today and have been increasing that allocation to bank loans and high yield loans and levered loans, etcetera, than we have been previously.  I would say previously we were set up for some type of reaction in the market.  Of course, I don't think any of us predicted there was going to be a black swan in the form of a global pandemic.  But, nonetheless, we were set up to – just because relative value was just so – and again, some – one of the other fundamentals and technicals that we’ve spoken about were just, you know, it certainly favored issuers in lieu of lenders and investors.  And now, that pendulum has swung back.

    So, we see ourselves allocating a lot to those types of strategies, as well as, again, along this main theme of taking illiquidity risk and getting fairly capitated for it.  And so, our allocation to those more illiquid asset classes, we’ve touched on them already, emerging market debt is another one.  You know, relative to our historical norms, we continue to favor those types of strategies.

    Lindy Freeman:  Great.  Well, coming back our first polling question, we asked which strategies are you currently invested in to generate income?  And coming in at the top at 52% were real assets and infrastructure.  So, two asset classes, you know, Bill, that you’re very familiar with, followed by high yield, which you know, Tim’s talked a little bit about.  And another one, which is dividend yielding equities at 49%.  Edward, do you want to comment for a minute on dividend yielding equities?

    Edward Ng:  Yeah.  Absolutely.  And I think it comes back to, I think, a couple of things that both Bill mentioned around the opportunity set.  And I think, you know, when we think about as an asset allocator over the long horizon, finding that extra durable cash flow through the, you know, extra higher yielding dividends comes both in terms of a sector, as well as an opportunity in terms of getting that running yield, but also the upside.  And I think what we’re seeing more and more investors gravitating to is not only the price returns of those sectors, but more importantly the kind of cash flow stability.

    So, we find of focus, we’ve seen more focus from a asset allocation perspective on thinking about dividend-oriented strategies where the dividend is growing.  So, it’s not just about pursuing the highest dividend equities, but it’s one where the dividend yield’s actually growing.  And I think in the post-COVID environment for some of the things that Tim was talking about, very idiosyncratic, you’ve got to be very focused to be comfortable from an underwriting perspective that those cash flows will be there in the future, because you are paying for them at the point of entry.

    Lindy Freeman:  Definitely.  So, Edward, staying with you for a minute, where are you most focused on finding income in today’s markets?

    Edward Ng:  Yeah.  So, coming back to something that Bill touched on related to the asset liability equation, we work a lot with clients to understand strategically how much illiquidity or what are their cash flow needs over the next six to 24 months.  And with that cash flow match, we tend to find that many investors have more than enough liquidity to satisfy those near-term cash flows.  And then, that enables investors to really turn to the private markets, where there is the complexity or illiquidity pickup to look for more income, whether that’s in direct lending, in real assets. 

    So, we’re finding more and more opportunities there.  Similarly, our client base is also wrestling with should I be index versus active.  And I think that what Tim touched on is potential rising default rates.  If we remember in fixed income, it’s about principal plus the coupon.  So, we need to make sure that we’re both getting both.  And so, that has implications from a manager’s selection or a strategy selection point of view.

    Lindy Freeman:  Well, Edward, you just hit on something that, you know, we do always want to highlight on given our firm’s background in risk management for investments, which is what are the risks of using private assets as a bigger part of an income seeking allocation and how do you think about managing those risks?  Because, you know, we’ve talked a lot about allocating there, but you certainly want to have, you know, a sound framework around that as well.

    Edward Ng:  Yeah, no.  I think it comes back to something that Bill as an insurance company practices a lot of, which is that whole asset liability and doing the, some of the testing in terms of the downside scenarios and trying to make sure that you’re not being overly illiquid.  So, obviously you can establish your own internal parameters, but we, in general we tend to find clients have more capacity to invest in illiquids than they currently do.  And those that are at the higher end of any survey results have probably done more sophisticated internal planning to get comfortable with the levels that they’re running at.

    Lindy Freeman:  Great.  Very helpful.  And maybe, Tim, you know, given your role, do you have any additional risks you’d like to add there on those private market assets?

    Tim O’Hara:  Well, I think Edward covered it well.  I do think the risk for most clients is just getting that duration, the liquidity duration mismatch wrong.  But, I think in our working with clients, I think in most cases they’ve built out liquidity models that allow them to really understand what is the duration of the capital that they want to put into income-generating assets.  And I think that plays a very important role in determining what that income-generating asset allocation actually looks like.

    And it’s, I think, common to say that in the private assets that they are illiquid.  But they are both illiquid on the way in, in a sense, and on the way out.  And what I mean by that is deployment also takes typically some time to get to a, whatever a target level of deployment is in private assets.  Since they’re individually originated, it usually takes some time to ramp that up.  So, again, in the private markets it usually requires that there is some sensible duration of that capital.

    I think from a credit standpoint if we look at it, and Bill spoke a little bit about direct lending earlier, as did it, if you look at actually the quality of those assets and we’ve now actually, the industry’s been around long enough now having really originated in the late ‘90s that it’s been through a few cycles.  And what you actually see with the private assets is in general the leverage is lower, the covenant protections are better, the diversification is high, and the recoveries are better, even in moments of distress, so they hold up well.

    Lindy Freeman:  Yeah, exactly.  Exactly what we hope to see again in this cycle.  So, we had our second polling question, which is where do you think the best opportunity to source income will be over the next 12 to 24 months?  And as I look down the results that came through here, we’re a little bit more mixed.  But real assets and infrastructure stays there at the top.  High yield, direct lending, dividend equities, and unconstrained fixed income. 

    So, Bill, I wanted to get your views.  As you think out 12 to 24 months, I know you’re always making new changes in the portfolio.  Which of those resonates most with you in your views?

    Bill McDonough:  Yeah.  I think unconstrained fixed income is something that, you know, it’s now is the point in time where you really want to open up to the wherewithal, the credit skills of a really strong team, strong partnerships that you’ve formed and your managers or manager that’s, you know, that’s in your portfolio and let them do their thing.  So, we couldn’t agree more.

    You know, there’s a saying that we have adopted internally that, you know, it’s better to have an option.  It’s better to have portfolio options than it is to have an option on a portfolio.  So, I think, you know, pick your managers and pick your spots and let your managers sort of skilled in their respective asset classes go to work for you.

    Lindy Freeman:  That is very insightful.  Well, Bill, Tim, Edward, thank you so much for joining us today and sharing your thoughts.  To all of you who joined in and listened to us, thank you.  And before you leave, we have one last question.  And please let us know if you’d like a member of the BlackRock Relationship team to contact you for more information on this topic around income, investing, or any other topics.

    And thank you, again, for spending this time with BlackRock attending our first BlackRock Future Forum.  It’s been a pleasure, an honor to discuss with some of the world’s and our industry’s most important topics with you.  Over the course of the next few days, you’ll hear more about how to stay connected with the Future Forum content, how to continue these conversations well after the Future Forum includes – concludes, and how to stay connected with BlackRock.

    So, we hope to speak with you again very soon.  Thank you again, everyone, for joining us.

    MKTGH0720U-1287978

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Lindy Freeman
Head of BlackRock Alternative Specialists for North America
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Bill McDonough
Vice President of Investments at Sammons Financial Group
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Edward Ng
Head of Americas Endowments and Foundations, Client Portfolio Solutions, BlackRock
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Tim O’Hara
Global Co-Head of Credit, BlackRock Alternative Investors
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BlackRock Future Forum 2020
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