KKR Income Opportunities Fund (KIO) 2021-02-16 Earnings Call Transcript

Good day, and welcome to the KIO Q4 Investor 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 KIO Q4 2020 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 with KKR and Portfolio Manager across credit strategies. Jeremiah and I will based in San Francisco with the US leverage credit team. Before beginning today's call, I have some important disclosures to make. The opinions and forward-looking statements shared in this call are current as of today, February 16, 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. For more information about the fund, please visit our Web site at kkrfunds.com. So thanks for joining us this afternoon and on the East Coast this morning on the West Coast. So much of the previous formats, I'm going to go through and give a quick market update of Q4 and 2020 and then we'll start with some Q&A with Jeremiah Lane. This is a review of 2020. We started the year at almost record types and spreads widen out to distress levels in March with high yield and loan spread reaching over 1,000 basis points during the depth of volatility in March. The credit markets ultimately ended up the 2020 on a strong note. In Q4, strong market momentum across risk assets was driven by the search for yield, a constructive backdrop of an accommodative fed, stabilizing rates, solid earnings and increasing vaccination rates. The bank loan market benefited from strong demand driven by the resurgence of the CLO issuance. In Q4, the high yield market was up 4.5% with CCCs outperforming up nearly 8%, loans were up nearly 4% with CCCs returning over 9%. CCC assets experienced one of the strongest performing quarters in Q4. At year end, high yield spreads tightened back to 386 basis points and loan spreads to 452 bps. 2020 felt like we'd pack a full economic cycle into one year. The interesting thing is that high yield essentially returned its coupon, which is a little over 6% and was nearly unchanged on a price return basis despite all the volatility. Bank loans ended the year down on a price return basis but was up 4.5% on a total return basis. We look back at KIO performance in Q4, the fund had a really strong quarter. The fund’s price went from $13.53 to $14.43, which is about a 7% increase over three months. So maybe Jeremiah, we can talk a little about what's driven the fund’s recent strong performance.

Yeah, sure. Thank you, Aaron. I think the number one thing is just really what you were talking about with respect to CCC outperformance in the fourth quarter. As folks who have been investors with us for a while will know this fund and the strategy that we pursue with this fund has little bit higher concentration in CCCs. We pride ourselves on finding differentiated risk return across all of the credit markets and specifically often a portion of that, a significant portion of that is in the CCC part of the market. And I think one of the key drivers of the good performance that we had in the fourth quarter was just some of those credits that we have identified that we felt were out of favor or babies that were thrown out with the bathwater, were big participants in that broader market phenomenon that you alluded to of CCCs outperforming so substantially. I would also just say that I think some of them, many of the names that we think have more gas in the tank, I don't think that the CCC outperformance story is at all done yet, because we see the CCC part of the market as little bit cleaner than it has been in prior years. It's less concentrated with energy E&Ps than it wasn't in prior period, those businesses have had a tendency to have a lot of volatility and disproportionate probability to default. And so we see a lot of the CCC market is just being kind of traditional corporate credit, maybe a little bit higher levered, maybe coming through a period of dislocation or in their industry or with their specific business. But with the strong backdrop in the market, we continue to see market participants become more open to investing in those types of names. And that's leading to the continued acceptance of those names and further compression of the GAAP between B and CCC, which is what's driving CCC outperformance.

Thanks, Jeremiah. And with that, we'll end this quarter's call. We appreciate everyone spending time with us today and hope you found this call informative. We appreciate your support. And just to let you know the replay of this call will be posted similar to previous quarters on the KIO Web site in the next few days. Again, thank you for listening to the call and have a good day.

This concludes today's call. Thank you for your participation. You may now disconnect. End of Q&A:

And I think one of the questions investors probably have top of mind just given the recent strong rally in credit and risk assets in general, particularly in Q4 and even into Q1. You mentioned you alluded to the fact that we saw some gas and tank in some of our CCC names. What else are you seeing opportunities in credit across the full spectrum?

Yes, I would call out two or three different areas. The first is an area where we've started to see some more activity after period of relative dormancy over the past few years, which is second lien loans, in some cases bonds, but more typically loans, to really high quality businesses that are being [LBOd]. And so this is an area that we participated in for a long time and earlier in the lifecycle of KIO and more broadly, our opportunistic strategy we were actively participating in second lien through these high quality businesses. More recently, the syndicated second lien market has been went through a period of relative quiet and now we're starting to see sponsors access that market more regularly with larger tranche sizes that really allow us to participate and get a position of the scale that we're interested in. So those names are typically going to be paying us LIBOR plus 650 to 750, and we're typically going to be buying with a couple of points of OID and some non call period and then some call protection after the conclusion of the non call period, maybe a one or two call price or a one on one call price. And so that's been an interesting area to reemerge. Those companies typically have a very high equity check coming in underneath us. So we are taking a little bit more leverage than we see in our first lien positions but we feel like it's an acceptable risk to take on given the amount of equity coming in below us. That would be one area. Second area is, we continue to see some opportunity in CLO tranches in the asset back space. Coming out of the COVID disruption, we were very active in this space through all of 2020, as the underlying loans recovered in price, we felt that there was a lag between the recovery that we were seeing in the underlying loans and the recovery that we were seeing in the prices for the tranches. So we were participating in the secondary market. And then as the market continued to recover, we also began playing more actively in the primary market. So new CLOs that were being created buying BBs and in some cases BBBs in those structures. Those structures are benefiting from a little bit better structural credit enhancement than the pre-COVID CLO did. While we see that trend dissipating to some degree in Q1, it's been an area -- it was an area that we were actively mining through Q4. And then the last area that I would say is just the idiosyncratic names that have long been a core part of opportunistic credit strategy and specifically KIO. Just finding the out of favor name, perhaps out of favor, because it previously went through a bankruptcy process or because it was -- the industry transitioned or the company had an operational hiccup. Whatever it might be, we continue to find those one off names in their space that are out of favor and offer substantial incremental yield for what we determine to our processes these acceptable risks. And so we’ve been active in all of those names in Q4 and into Q1.

Thanks. And you know you alluded to some of the opportunities specifically in the bank loan market. If we look at kind of the relative value between the high yield market and the loan market, I mean right now I mean over 70% of the high yield market was trading above call price. Just curious how does KKR think about kind of the allocation and the relative value between loans and bonds?

Yes, I think that recently we’ve been -- there’s little bit more opportunity in loans. Typically, the loan market overall is owned about 60% by CLOs and CLOs by their covenants can only hold so many CCCs. And the agency is, especially in the early period of COVID in April and May, we’re extremely aggressive in proactively downgraded businesses that they expected to be heavily impacted by COVID. And so what we see today is we see many CLOs that are exceeding their threshold levels for holding the CCC and as the market recovers, are interested in moving on from those and working down those exposures. And so in some ways we’ve just seen a more persistent supply of those names [Technical Difficulty] have become active in serving their customers again. And then in a lot of other spaces, you know, I would just say that some of these companies have just been really fully reaccepted by the market. In a lot of cases when these businesses were first borrowing, they were completely shutdown and they had an uncertain path to being open again. I would call out some of the skews to our businesses, which ended their season early last year and obviously were in the offseason. When they were coming to market it was very uncertain what type of season they would be able to have this winter. Fast forward and they've generally been able to have be open and have a season. And so by taking that risk off the table, the markets become a lot more open to them, and just kind of the total risk reward is much smaller than it was, and so is not as attractive opportunity for KIO. So I think that it's really a new phase with respect to how we're specifically targeting the leisure sector. In terms of broader sectors, I think that we're probably just as I was saying with leisure, I think, in most sectors, we're kind of moving back to a place of picking our spots, as high yield has gone inside of its long term spread average. You could imagine that most sectors then by extension are inside of their long term spread average. We do find in those types of market environments, but we do find by finding the idiosyncratic name that still offers substantial returns for risk, as opposed to by making broad brushstroke investments and a high percentage of the names in a given sector.

Yes, I think, there was -- 2020, if you look kind of sub sector level, there's a pretty wide range of dispersion between the top and bottom performing sub sectors. I guess at the sector level that we're not quite as much dispersion. But what's causing these high level levels of dispersion? I mean, is it more kind of cyclical secular impacts across the market and how do you take advantage of this?

Yes, I think that it's really just -- I mean, in 2020 it was driven by the way that people were responding, the way the companies were responding to the pandemic. And what we saw was really that some businesses there was a boon for and they actually, while you know supermarkets would be a great example where they put up same store sales unlike they've seen in decades. And then obviously, there were all of the COVID impacted sectors. One of the interesting things last year was that there were a lot of companies that performed differently than people expected them to. So I would call your attention to parts of the retail market where which were sold as though they were worthless. Some individual companies and subsectors were sold to levels as though they were worthless early in the pandemic, only to then have people realize shortly thereafter that they were actually getting a lift in demand. And they were finding ways to stay open or to serve customers out of their brick and mortar locations without allowing the customers to actually come in the door and they ended up being successful. So those types of dynamics really drove a lot of some of that idiosyncratic subsector dispersion. And I think that the way that we try to take advantage of it is just really through our core fundamental underwrites. In the case of leisure, as an example, because we've been talking about that, people were very negative on the space because of the obvious impact of COVID on leisure companies. The approach that we developed in the early stages of the pandemic was underwriting the amount of time businesses could survive in a zero revenue environment. And at that point, we didn't know if these businesses would have a zero revenue environment. But you wanted to validate that if the government force these businesses to be closed for a long period that they could indeed live to fight another day. And using that framework, we were able to identify a set of businesses that we thought could survive multiple years. And then as we got incremental data on what was going on with those companies and the fact that they, in many cases, were actually able to be partially open, which mitigated the amount of cash that they were burning through the peak impacted period, that just meant that they had even more runway. And so that would be the type of situation where it's that core industry, industry focused analysis and just being active, leveraging the advantages that we have as part of KKR, tapping into through wall cross process, tapping into information in the private equity side, tapping into the other parts of the credit business, doing the core fundamental underwrites, to get a deep understanding of what's going on in these businesses. The market was assuming that subsectors were going to be impacted in a certain way. And what we saw again and again last year was that the market wasn't always right. And so to the extent that we could reach that conclusion faster in the market it presented really huge opportunities to outperform.

And then in 2020, I think you'd mentioned this earlier, but rating agencies were particularly aggressive with downgrades. This was very apparent in the loan market. And do you expect agencies to be as aggressive with regards to upgrades and this does present opportunities?

You know, I don't. I don’t expect them to be as aggressive with upgrades. Historically, the agencies are quicker to downgrade and slower to upgrade. A lot of businesses, even though you could look at the most recent quarter of financials and say, it looks as though they have fully recovered from the most difficult COVID impact. If you look on a trailing 12 month basis, which is how the agencies usually operate, they're still heavily impacted. Because they've got one quarter, two quarters, two and a half quarters, maybe starting from sometime in the first quarter through the third quarter, where they were really getting hit. And so it's not going to be until -- certainly, until the second quarter rolls off that you're going to start to see a pretty good look at a 12 month period that is not heavily COVID impacted. And so I think we're really going to be into the back half of the year before we see really aggressive upgrades. And I think that that presents some opportunity. I think that especially things rated CCC, there's so much less demand for things that are rated CCC that if something still has a CCC rating, even if it's performing like a B, there can be there can be a price opportunity there. But for a lot of the market, the thing that's rated B3 that should be B2, or the thing that's rated B1 that should BA3, the market is really moving faster than the agencies and the market is really rerating those things to expected rating faster than the agencies are moving. And so I think in those parts of the market, the opportunity, I'd say, is a little bit smaller.

And maybe I'll kind of shift to a couple higher level questions before closing the call. There's been a lot of press around kind of -- and I mentioned this earlier in the call, the demand for yield that's really driven kind of spreads, the back half of 2020 and 2021. Do you expect this demand to continue and what's driving that? I mean, obviously, low interest rates across the globe. But do you expect this to continue through 2021?

Yes, we do. We really see the need for the fixed income part of the return from the pension funds and the insurance companies as difficult to fill. And it's really -- you're seeing it from all of the traditional investors and fixed income products are looking for the place that they can invest incremental dollars to achieve the types of yield that they want to achieve. And so I don't see anything that's going to derail it. I think that you could see a shift in which asset class is preferred. High yield has been preferred, I'd say over the last six to nine months, pretty substantially. And with the tenure, I think, now at one and a quarter people feeling pretty optimistic about the path of GDP in the back half of the year. I think that people and the stimulus coming in, at expected to be a really substantial stimulus. I think that there's going to be more pressure on rates to go higher, contrary to what does the fed might prefer. And so I think that that opens up a little risk, some risk for high yield to be less in favor and for people to prefer you know the floating rate structure of the loan market. I think that that's -- personally, I think that that’s still a ways off, but I think that that'll be the driver of potential change in which part of the fixed income market managers are preferring.

And then in your opinion, what were some of the higher level risks that potentially could derail the economic recovery? Is it primarily tied to vaccine distributions, or is there something else that kind of top of mind that KKR is concerned about?

Yes, I think it's primarily tied to COVID. I think I wouldn't say just vaccine distribution. I think that the latest data in excess of 1.5 million shots per day, that's 45 million people getting a shot, a first shot per month, and that number still has been scaling up. So I think that there's room for it to go higher still. That feels pretty well known and understood at this point. I do think the variance are risks that’s out there. I think that their early indications have been that the first variants are at least you get at least a substantial coverage from the vaccine of most of the variants. But we have seen some data that says that it ranges and that I think it was the South African variant that was specifically less responsive to the vaccine. So we to find ourselves in a situation where we successfully distribute the vaccine but then the South African variant begins to rage across the globe, I think, that would be a downside risk. But broadly speaking, we see the setup for the year, I think consistent with how most people see it, is pretty positive picture for GDP, especially as you get into the second half of the year. We see that to be the case really without the stimulus. So to some degree, I think the stimulus just supercharges that positive economic picture that we see developing. And I think that these kind of tail risks around developments with the variants that that are probably the biggest downside risk.

And there's been a lot of discussion about potential risks, interest rate risk, particularly looking ahead. Curious how we think about or KKR things about rate risk and how does that impact portfolio construction, particularly in a rising rate environment?

Yes, I mean, I do think that rates went higher is a risk for the high yield market. I think, when we think about this always if you look overtime, KIO has a substantial portion, typically more than a majority invested in the loan market and that really nicely insulates us. Because the floating rate nature of the loan product means that you're not going to get the sell off in the asset class if you were you to get a big move in the tenure. And so that's the primary way that we mitigate it is through our substantial exposure to loans, that allows us to outperform in periods when the high yield market might be selling off or might deliver particularly weak results as a result of underlying move in rates. I will say that I think that while we're very -- yields are very low. We have had periods of lower spread at the types. And so I think there is -- a little bit of room, not a ton of room, but a little bit of room for spreads -- for rates to go higher, and for that to be taken up by just a tightening of spread between high yield and rates. But we'll have to see. The way the way we try to mitigate it is primarily through the loan exposure.

And then just coming up close up on kind of 35, 40 minutes here, so just a couple more questions. There's been a lot of discussion as far as kind of particularly 2020, as far as the increase in default rates, a lot of this, in particular, in the high yield market was driven by the energy sector. What are your thoughts on kind of default rates going into 2021? And even potentially looking beyond that, do you think kind of the rise or the spikes in defaults has largely ended and do you think this will can continue a downward trend, or do you think there's some other risks that the market has been pricing in?

Yes, we think it's largely ended and it's going to continue the downward trend. I think that if you look at the CCC part of the market, a lot of those companies -- the CCCs are less exposed to energy than they historically been in energy has historically been a disproportionate driver of the overall default rate. So I do think that -- I mean, I think there will always be the individual companies that are either in secular declining sectors or have a transition in their industry or transition with their business that causes them to tip over in default. But the really broad set of defaults that we saw in 2020 we think that'll continue to decline. And usually after you get a period of default spikes, you get a period where you'll go through just the lower defaults, and I think that's our expectation for the next period. Most businesses that have made it, even if they had to take on incremental financing or get incremental money through an equity injection from public shareholders or sponsors, if they've made it this far we generally think that there will be appetite for the incremental injection to make it over the last little hump to get to the other side of COVID. And so we think that there will be fewer businesses facing defaults over the next year or so.