KKR Income Opportunities Fund (KIO) 2021-08-17 Earnings Call Transcript

Good day. And welcome to the KAO -- KIO Quarterly Investor Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Aaron Dalrymple. Please go ahead, sir.

Thanks. Hello. And welcome to the KKR Income Opportunities Fund Q2 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 just have a couple important disclosures to share. The opinions and forward-looking statements shared in this call are current as of today, August 17, 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, past performance is no guarantee of future results. Closed end funds, like all investments, are subject to risk and for more information about the fund, please visit our website at kkrfunds.com. So thanks for joining us today afternoon. This is the Q2 update. It’s a similar to the previous update calls. I am just going to give a couple ball points on what happened in Q2 across the credit markets and then I will do some Q&A with Jeremiah. Just specifically talk about KIO’s and opportunities we are seeing in the market and Q2 performance. If you look at Q2, the market continue to bounce back with sustain appetite for risk assets and momentum with the reopening of the U.S. economy. There is strong quarter for credit market with yields basically ending at pre-financial crisis types and spreads continue to growing tighter. We have seen some more recent, I will talk about vitality primarily driven by the spread of the Delta variant. And if you look at high yields bonds and loans over Q2. High yield bonds are up around 3% and loans are up about 1.5%. If you look at the first half of the year, credit obviously -- has obviously had a really strong year, the high yield markets up 3.7% and loans are up 3.3% on a year-to-date basis. In Q2, we saw -- I mentioned a couple themes we saw them in the credit markets, obviously continue to have a continuous thirst for yield across the market. You saw heavy primary issuance in both high yield bonds and loans. You’ve seen obviously lower rates have led to greater patient pay downs, which have pushed market yields lower, ultimately increasing reinvestment risk. And you’ve seen some heightened volatility within markets amid reflationary current trends as the Fed gets closer to tapering. With that backdrop, we still saw really strong performance in the lower credit quality parts of the market. triple C, risk outperform, higher credit quality risks in Q2. High yield bonds are up a little over 4% in Q2 and triple C loans were up 3.4%. And if you look on a year-to-date basis, that trend was exhibited in Q1 and Q2 with little risk outperforming, triple C bond and loans were up both around 10% on a year-to-date basis. So maybe as kind of a follow up on performance we will shift a little bit to KIO. KIO had a strong quarter in Q2, if you look at on a market value basis, up around 5%. Bring the year-to-date performance up over 15%, the $14.43 at year, if you look at year end up to $16.68 as of 6/30.

Sure. Thanks, Aaron. Really, I think, of Q2 is, as a continuation of the trend that we’ve been seeing since Q2 of last year. If you go all the way back to Q2 of last year, April 1 that was just about a week, April 1 of last year, that was about a week off the bottom of the market and -- from the COVID panic. And over Q2 through Q4 last year, and then continuing Q1 and Q2 this year, we’ve seen a steady broadening of the markets acceptance of credits that it is looked askance at the bottom. So in Q2 of last year, that meant the market was newly opening back up to double B credits, fallen angels, things like that. As you move later into the year, last year in Q3 and to some degree in Q4 B3s were, sorry, single B credits all the way down to B3s, were reaccepted by the market. Starting in Q4 of last year, we saw the market start to open up to the triple C names, the direct strike COVID names, names in the leisure space and the live events space. And we saw the market start to reopen to those names and that’s really just continued to grow. And so as we think about what drove performance in Q2 and what’s been driving performance more broadly this year, it’s really been -- it’s been a lot about leisure names, the leisure names were obviously in that direct strike category. They’ve been really re-embraced by the market overall and that’s been facilitating both some refinancing activity and continued extension, continued new financings to extend those companies right away. So that -- those -- that’s been, probably, the strongest theme that we’ve seen driving performance in terms of what we’ve been doing. We’ve continued to look closely at those names. We still see value in those names. We’ve also been doing a lot of reverse inquiry, calling into banks, calling into sponsors, identifying companies that we think were more positive on then the market and trying to drive catalysts, trying to drive new primary coming to the market. And then, finally, I’d say that the portfolio performed well, just because we have a higher yield than the market overall. We skew a little bit lower on credit quality spectrum and so we’re able to get a bit more coupon than the market overall and as the market has become more open to those names lower on the quality spectrum, that’s just continued to drive performance.

Great. Thanks, Jeremiah. You mentioned reverse inquiries, maybe what’s the mortgage generally, broadly understands that term. But what’s the advantage of KKR approach in a company to do a reverse inquiry?

Yeah. I think, really we think about it in a couple of ways, the biggest advantage is that, you can secure an allocation. So when the market is strong, as it’s been over the last quarter and half, at times, it gets more difficult to secure the amount of paper that you want, it creates a stronger relationship with both the bankers that are ultimately going to issue the paper, as well as the sponsors whose deals you might be supporting. And then, frequently, we’re doing this for companies that were already invested in and we see a credit positive associated with them, coming to the market and raising new capital, sometimes that credit positive is going to be the new capital is going to, partially pay down an existing financing that we’re invested in. Sometimes, as an example, in the leisure space this year, sometimes that new capital has been dedicated to extending the amount of time, the business can successfully operate in a COVID disrupted world. The reality has been that people started to think that COVID was maybe behind us and then with the resurgence of Delta turns out is not behind us. And so we’ve seen companies want to extend their runway and we’ve encouraged companies to do that, because having a longer runway just bolsters confidence that the businesses will get to the other side, if investors are more confident that the business will get to other side, they’re willing to accept a lower spread, that should be accretive to our existing investments in those companies. So it’s multifaceted. It allows us to get paper. It further develops our relationships. It’s often a credit positive for the names that were invested in these. This is all a part of something that we call our new active approach. Traditionally, investors have talked about just active versus passive, are you trying to replicate an index or are you actively going in and out and we’re obviously active -- actively going in and out of names. With new active, we really think about going beyond just harvesting gains and trimming positions that we’ve lost conviction in and we think about it as creating this -- creating our own catalysts and that’s really what we’re doing with this reverse inquiry activity.

Thanks, Jeremiah. And when we talked about KIO and the more opportunistic credit strategy, how this approach is maybe different some -- than some other competitors out there, how does that flexible strategy play out kind of with the current market dynamics. I mean, you talked about reverse inquiries, but other things that this more flexible strategy provides investors advantages to?

Yeah. I think it’s a huge advantage. And I think that, you can really see the degree of the advantage, not so much in just a single quarter’s results, like the quarter that just passed, but in a little bit of a longer term look at the market. And so, when we go back to the second quarter of last year, we were pivoting into some of the highest quality things that we’ve ever bought, because you could get incredibly strong returns buying double B loans and bonds. In general, double B’s don’t offer the type of return that we’re looking to deliver to our investors in KIO and so in most time periods, that’s not a big part of our portfolio. And so we pivoted into high quality. There was a lot of uncertainty around what the ramifications of COVID were going to be and that was a way for us to deliver -- still deliver high returns to our investors, but do it in a risk mitigated way. And then as the year progressed, we saw a big opportunity in high yield bonds. There’s a lot of new issuer -- a lot of issuers last year were in COVID impacted sectors and they were willing to issue at high spreads. And they were willing to accept the terms of the high yield bond market which typically have several yearlong non-call period. So you’re locking in the spreads for typically at least three years. And so we found that very attractive. And then later in the year, the place that we saw, the value remaining was in lower rated loans, where we hadn’t been as active in the middle part of the year. And we saw that area is attractive because CLOs, which comprise a large portion of the loan market, overall, were very, very sensitive to holding triple C loans. And given the number of loans that were downgraded at the onset of the pandemic, there were -- there was a large just quantum of triple C rated loans and CLOs were regular sellers of those and so the prices stay depressed for a long period of time, well past when we had seen more recovery in the high yield market. And so there was an attractive opportunity to pivot into lower rated triple C loans. Today we’re doing things more like the reverse inquiry that I talked, which can be in loans and bonds. We’re participating in CLO tranches, which we think are attractive. There have been some structural enhancements to those since the -- before the pandemic and you’re still getting pretty attractive spreads and some -- and we’re also seeing some opportunity in some second-lien loans that are coming to the market where we’re using our proprietary sourcing network, our large private credit team, the relationships that that team has to financial sponsors to get us access to some of these really high quality second-lien loans. So I think, more than just focusing on the individual quarter, if you look at the, take a broader look at the last year and a half, you can really see the value of the flexibility in this product. And the way in which we’ve taken advantage of that flexibility to pivot into successive areas of value, as maybe we targeted an opportunity and the opportunity played out and there wasn’t more opportunity there and then we went ahead and pivoted to the next the next area.

Yeah. And as far as the recovery period, obviously, that’s been a really big driver, positive drive performance this year, like given the resurgence of the new COVID Delta variant. What impact do you see in the market in the broader economy, I mean, how do you -- how does it impact -- have these impacts translating to kind of headwinds or opportunities you’re seeing and actually how could this translate into new investments or rotating out of existing investments?

Sure. I think, ultimately, we’re viewing the Delta variant from a market standpoint as more of a hiccup or a delay in the recovery than fundamental shift our perspective about what’s happening and I think you can really see that in how the market has responded to Delta. I think we do see some market softness in the past weeks or maybe the past month, but it has been pretty muted, certainly, very muted compared to the type of sell-off when we saw COVID initially emerged in the first quarter of last year. So we don’t see -- we see this as a much smaller impact on markets and a much smaller impact on companies. We are seeing some fundamental impacts. There was -- just today there was weaker retail sales reported. Retail sales have been quite positive since reopening got underway last year and that trend had really cooled in the latest month for which we got data. But we see those -- that weakening as relatively modest and it’s not at this point driving a major fundamental repositioning of what we own. I think it’s just adjusting our timeline in terms of how long we think it’ll take the things that we own to play out.

Okay. And given the scale of the fiscal stimulus and the shifting economy, we’ve seen over the last 15 months from COVID, obviously, this really expedited some of the changes that were going to happen across industries, it really just kind of consolidated that the time period of some of these changes happening. But what do you see as some of the net beneficiaries or the companies that have benefit coming out of COVID potentially could lead to increase in EBITDA or better -- be better positioned for the future?

Yeah. I think it’s a great question and it’s one that we’re spending a lot of time on. I mean, I think, that we’re seeing some really clear cyclical beneficiaries of anything related to housing is doing incredibly well right now and that’s both newbuild, remodel and repair. What we see with consumer balance sheets is that, people were locked in their home for six months, 12 months, 15 months, depending on the degree to which you adjusted. How you were interacting with the world. Many people were able to continue to work and get income. Obviously, there was a significant increase in unemployment, but many people were able to work-from-home and those people save a lot of money and now they’re spending it. And they’re spending it on fixing up their home, they’re spending it on durable goods, durable consumer goods, they’re spending it on discretionary items. While delta is causing a little bit of a wrinkle in the recovery and leisure spend. We were seeing really strong indications that they were spending it on leisure, travel and gaming and things like that. And so, we see a lot of cyclical beneficiaries and I think in the tech space, there are some beneficiaries that are more secular in nature that have just gained market share, gained user acceptance as a result of the needs of the pandemic, that will continue to thrive. Well, we’re probably honestly spending more time on is, what are the companies that are getting a short-term benefit or got a short-term benefit last year, that are going to be more challenged when that benefit rolls off or baits? And that’s an area where we’re concerned because there are a lot of new financings being done. There are a lot of new LBOs being done based off of LTM financials and we’re spending a lot of time in our upfront underwrites understanding what was -- what were these businesses doing pre-pandemic. And while many businesses are more profitable today is that because they did no business in Q2 of last year, and so, all of that demand got pushed into the LTM period that we see today. Is it because there was a surge in demand related something around the pandemic. Was it driven by some other factor and really trying to through the underwriting process normalize earnings and have a view of where we think earnings settles. That’s -- from an underwriting standpoint that’s like the most activity -- the most important activity that I see related to COVID right now.

And as you’re doing this underwriting, I mean, in your studies, a lot of the focus is on fundamental bottom of research, but what are the biggest risks you’re seeing as a credit investor and potential risks we’re seeing some kind of unwind data the companies were underwriting?

Yeah. I think it’s -- this risk around kind of being a sneaky beneficiary, being a beneficiary without maybe the market or the world really realizing the degree of the benefit. That’s one. I think it’s around where input costs inflation and are you a business that, for example, has relied in the -- for the past decade on the abundant supply of lower wage labor that’s persisted in the U.S.? That seems to be relatively unlikely to persist going forward? And if, yes, if you’re a business that has a large pool of lower wage labor and you’re realistically going to have to pay higher wages going forward? Are you a business that has an ability to pass on costs or are you just going to see your margin squeeze? We’ve seen a pretty long period of steady margin expansion by businesses and I think really understanding whether or not the margins that we’re seeing today are sustainable is critical to our underwrites. So those would be the main things that I would call out input costs, inflation, wage inflation and then this kind of -- these beneficiaries that where the benefit may not persist.

Thanks. And then from a top down perspective, curious how you’re viewing kind of the relative value between loans and bonds? Now, obviously, we’re going to be moving into a rising rate environment. I think you mentioned kind of pivoting across asset class based on the opportunities. But how do you see kind of the differences between those two asset classes?

Yeah. We see it pretty fluid right now. I think a lot of bonds that were issued over the last year are trading at a premium. So some of the upside, if you will, associated with them coming at wider spreads has largely been captured by the market already. And we are worried about rates moving up as the Fed gets underway with a taper, which we’re expecting to kickoff sort of Q3, early Q4 of this year. There’s been -- recently been some news that I think supports that view. And so, but I do see its pretty fluid. I think that, especially if you’re investing in the primary market, we’re seeing the primary market move more than the secondary market. So while saying, well, secondary prices may not be down significantly, we’re seeing opportunities to invest in the primary market at wider levels than we were seeing two weeks ago, four weeks ago. And I think some of that is a little bit of Delta variant fear. I think some of it is also that we’re seeing a big uptick in the amount of LBO activity happening. So there’s a lot of supply coming. And I think that, as a result of that, we’re -- it’s pretty live consideration about whether or not the incremental dollar wants to go into loans or wants to go into bonds. And we’re deciding -- we’re going into both asset classes actively with new dollars spent. I don’t see one side is being particularly poor, one side is being particularly strong. I think that, the part of the high yield market that we’re specifically anxious about would be the higher quality lower spread names, where they just have much less margin for error if treasuries move up significantly, as they did the last time. The Fed tried to taper its asset program back in 2012 and 2013. And so, we are worried about that double B part of the high yield market, but that’s not a place that we’re invested in any kind of significant way, given our focus on higher yielding, higher return opportunities.

Thanks. We’re coming up on 30 minutes. So maybe I got one more question to wrap this up. Obviously, we’ve had a really strong first half of the year and credit spreads have grinded tighter. We’ve had some more recent volatility. But what’s the kind of high level value proposition for accredited investors, particularly as we look into the second half of the year, given where spreads are today, potential opportunities. I know you touched on some of those, but that’s probably something that’s at the top of investors’ minds today, just given kind of the run up in credit?

Yeah. Even at these relatively tight spreads in high yield and loans, it’s still offering the most spread in the traditional fixed income asset classes. So if you’re looking for that consistent return and you’re not willing to accept the incredibly low rates you’re getting in the treasury market, in the muni market, in some areas of real estate finance, we think that loans and bonds are the place to be. And we think that with a strategy that has flexibility, as we -- as our strategy has and a strategy focused on the lower end of the quality spectrum, married with our ability to find value and underwrite credit, we think that’s a really good recipe for consistently outperforming in the market going forward just as we have, historically. So that’s how we see the opportunity and that’s what we plan to continue to deliver for KIO investors and all of our investors.

Thanks, Jeremiah, for your time. And thanks, everyone, for spending time with us today. Hope you found this call informative. We appreciate your support and hope you’re staying safe. I would also let you know that a replay of this call will be posted on the KIO website in next few days. Thank you and have a good day.

This concludes today’s call. Thank you for your participation. You may now disconnect.

So Jeremy maybe talk a little bit about kind of what’s driven the funds recent performance and some of the higher level themes in the portfolio and kind of higher level themes we’re seeing in the market?