Featuring:
Robert Hoffman
Managing Director of Credit Wealth Solutions
FS Investments
Interval funds have surged in popularity among investors seeking diversification, access to private securities and alternative assets, and the potential for higher returns. And in recent years, private credit-focused intervals have shown especially strong growth. In this first CEF Insights Podcast episode on intervals, FS Investments Managing Director of Credit Wealth Solutions Robert Hoffman offers insight into the current interval fund environment, the benefits of a private credit strategy, and more.
Read or listen to the episode below and learn more about interval funds with CEFA resources including interval fund data, education, and news.
About FS Investments
FS Investments is a global alternative asset manager dedicated to delivering superior performance and innovative investment and capital solutions, including closed-end funds and interval funds. Learn more here.
Transcript
CEFA:
Welcome to CEF Insights, your source for closed-end fund information and education brought to you by the Closed-End Fund Association.
Today we are joined by Robert Hoffman, Managing Director with FS Investments. Among its investment strategies, FS Investments manages income portfolios focused on public and private credit.
Rob, we are happy to have you with us today.
Robert Hoffman:
Thank you very much. It's great to be here.
CEFA:
Rob, before we discuss your investment strategy, interval funds have been gaining interest in the marketplace. FS has experience with the interval fund structure. What advantages does this structure provide and likewise, what should investors be aware of when considering an interval fund product?
Robert Hoffman:
Great. No, thank you. So, interval funds, interestingly, they've been around since the early 1990s and some of the first floating rate corporate credit funds or what were then known as prime rate funds utilize the interval fund structure. However, the growing trends towards low cost, passive indexing, innovations, and improvement in liquidity across various markets, I think kept interval funds sidelined as almost a forgotten fund structure. But this started to change in the middle of the last decade as we've seen growing investor demand for alternative investment strategies and greater tolerance for limited or semi-limited investment structures outside of traditional LP-GP drawdown funds that were really only available to institutions or ultra-high net worth investors. This is an area where interval funds have shined and continue to see a tremendous resurgence in popularity. To me, interval funds really fit as an in-between, between traditional open-end mutual funds and publicly traded closed-end funds because similar to regular mutual funds, interval funds are continuously offered, they price daily at net asset value and investors buy, and then at designated intervals tender or sell back at net asset value.
But similar to closed end funds, interval funds have far greater flexibility to own illiquid or semi-liquid investments and don't need to manage to the possibilities that investors can redeem all of their investment at a moment's notice. So, providing some visibility for managers about when they need potential liquidity to meet redemption. The trade-off is where these funds get their name from, the often quarterly interval that these funds offer to tender shares from investors and the limited nature of that tender, where in most cases 5% of the fund’s net assets are made available to meet the quarterly redemption. But the advantage for investors is that the interval funds provide a strictly regulated, open and transparent way to access potential alternative investments in opportunities that may not be appropriate in a regular open-end mutual fund. But they do this with fund pricing that occurs at net asset value, and they don't have the secondary level of volatility that a regular closed-end fund has, where it's public share price can trade above or sometimes meaningfully below its underlying net asset value.
So, like any other potential investment, investors should develop a clear understanding of the underlying risk and rewards of the investment. The interval fund is just the fund structure. It means nothing as to the specific characteristics of the investment itself and is different than regular open or closed-end funds. Investors need to be aware of the typical quarterly tender schedule that an interval fund follows if they want to redeem and perhaps the history of that specific interval fund redemption experience. Since there is no guarantee that investors will be able to redeem a hundred percent of their investment through the quarterly tender process.
CEFA:
Rob, as I mentioned, FS manages an income strategy that invests in a broad range of public and private fixed income securities. Can you discuss the investment strategy as well as the key objectives?
Robert Hoffman:
Yeah, of course. So, as I mentioned before, the interval fund is just the fund structure and within that structure, managers can choose to employ any number of investment strategies. That being said, many interval funds, especially the ones that have grown very strongly over the past several years, have been focused on domestic corporate credit markets. And this is where we have also chosen to target our strategy, which is managed in partnership between FS Investments and Golden Tree Asset Management. As we look at higher yielding areas of corporate credit, like high yield bonds, floating rate loans, other structured credit investments like collateralized loan obligations or CLOs, what we have seen historically is either single asset class, siloed investment options like a specific high yield bond fund or a floating rate loan fund, or really non-existent or much more limited investment options like in the case of CLOs. So, our intent was to bring what we have seen as a growing approach that institutional investors have brought to these markets.
And by the way, an approach that retail investors have employed for a long time in other parts of fixed income markets, which is a multi-strategy approach, but focused more on these higher yielding investment areas within fixed income compared to most multi-strategy fixed income funds. And so, when you think about many strategic income funds or XYZ income fund, most do not have particularly large exposures to these higher yielding asset classes, and we wanted to change that. So, by targeting asset classes like high yield loans, structured products, both public and private, we aim to deliver a high level of income for investors while also being able to potentially capture capital appreciation through active management. I think by deploying this type of strategy in an interval fund structure, we feel it really opens up the investment universe available across corporate credit.
Setting aside straight private credit for a moment, there are many parts of these more traditional fixed income markets that are not readily liquid at a moment's notice and may not be appropriate for an open-end mutual fund. But investing through the interval fund really provides the opportunity to look at all potential investments across these asset classes and not be limited by those that are only daily liquid. It also creates the opportunity to invest in private credit opportunities and where I think it's been well established that it's virtually impossible to efficiently access those investments in a regular mutual fund structure. So ultimately, by being able to take this broad approach across credit markets within a strategy that's nimble, flexible, opportunistic, we feel it's a solution that can represent a better way to own credit within an investor's portfolio, helping them to achieve strong income while providing good diversification to other fixed income investments and improving overall portfolio outcomes and objectives.
CEFA:
Rob, with regard to the exposure the strategy provides to private credit markets, are there unique characteristics to this area of credit and does private credit provide a degree of diversification to a portfolio that investors may not get from more traditional fixed income investments?
Robert Hoffman:
Yeah, absolutely. I think there are great opportunities within private credit, and again, they really require a fund structure like the interval fund or some other private fund structures for efficient access. And so, as it relates to private credit, the focus within our partnership with Golden Tree is differentiated from the middle market direct lending that you might see in BDCs or other direct lending focused interval funds. To be fair, there are managers that have been very successful in that segment, but Golden Tree's expertise is in a more specialized niche. Golden Tree is a solutions' provider that can address complex situations quickly and in size and in doing so creates differentiated value for issuers and our investors. So, they tend to target larger borrowers given the significant growth and compelling risk return that that market segment presents. And so, some examples of private credit deals that we might do: financing growth acquisitions for large public and private companies, financing mergers and acquisitions to strong performing portfolio companies as an incumbent lender.
Sometimes these bespoke opportunities to refinance short maturities in public and private capital structures or unique liability management solutions for sponsors and issuers. In other words, we're focused on providing innovative financing solutions to larger companies, oftentimes those that may have liquid and traded capital structures where we can provide the anchor capital to a capital structure solution. It's very different than mid-market direct lending but can derive many of the same benefits in terms of reducing correlations to broader credit markets and potentially generating higher income. And then there are also sources of diversification as you point out. I think the more that you can tie an investment outcome to your specific underwriting thesis, the specific event that you expect to play out or the competitive dynamic of the company you're lending to and move your outcome further away from just the general beta of the markets, you're also providing portfolio diversification, incorporating less correlated investment strategies within the overall portfolio.
CEFA:
We mentioned that this strategy invests in a broad range of securities. What is your process to evaluate this investment universe to develop a workable set of potential investments?
Robert Hoffman:
Well, if you're going to allocate to a broad set of asset classes, you need to have a disciplined investment process and a well-developed method for cross-asset relative value. I think that's exactly what we get in the way that Golden Tree approaches our investment universe. But from a high level, the process starts with a robust investment team that consists of nearly 40 people spanning industry experts and analysts and a capital markets team. The corporate credit universe is a big market, thousands of potential investments, and you do need a certain level of size and scale to be able to, I think, really properly survey the landscape, and identify what you think are the best prospective investments. This team is what enables a deep bottoms-up analysis of every company or prospective investment. We're not a top-down allocator. We're really focused on an exhaustive underwriting of each individual position, and that requires people and industry experts to really understand each business and each opportunity on an individual level.
CEFA:
How do you then make specific securities selections and allocate those positions as you build your portfolio?
Robert Hoffman:
Well, as I just mentioned, it starts with a deep bottoms-up fundamental analysis of every investment. For us, we don't invest based solely on broad macro themes and increasing-decreasing exposures based on macro factors. It's really based on a fundamental view of each company and each investment. The first step is a fundamental analysis to determine an issuer's enterprise value in one that for us is typically in excess of $500 million. We're not focused on micro investments and generally want to know that there's going to be the liquidity necessary to both enter and potentially exit a position. But once determining the company's overall value, it is a hard and fast rule that every investment needs to have at least one and a half times of asset coverage above and beyond our investment within that capital structure. This excess asset coverage provides downside protection in the event that something doesn't work out as planned. Theoretically, the value of the company could decline by up to a third before the debt position that we own takes risk of impairment.
Next, every investment needs to have an identifiable catalyst that we expect to play out to unlock the value that has been identified. You might find a position that looks cheap, it's got good excess asset value and coverage, but if there's not a catalyst to the value that you've identified, that position may stay cheap forever. And so, every position needs a catalyst, be it earnings that come out above expectations, ongoing debt reduction from free cash flow, the end of a reinvestment period in the case of the CLO, a merger, an acquisition, or sometimes an expected debt restructuring. But there has to be something that we expect to happen to unlock the value and cause a position to trade up. That's key for not just generating attractive income but potentially capital appreciation as well.
And then lastly, you need to do ongoing relative value analysis against every other position in the portfolio and other names or potential investments that you're monitoring in the market. Right? There has to be a method to determine if a potential CLO investment is better than a bond to a chemical company. Or is a loan to a healthcare company better than a loan to a retail business? It's not just which one has the highest yield. You need to understand the relative risk of each position and then assess that the amount that you're being paid for the risk you're taking is appropriate and the best relative value at that time. So, in the end, if you find something that's cheap, it's got good asset coverage, a fundamental catalyst that plays out and the position trades up, your relative value analysis then guides for when you sell that position. And move on to the next one.
CEFA:
What factors, issues, or events could lead you to sell a particular portfolio security or significantly change your portfolio allocation?
Robert Hoffman:
Well, I think it's that last step as the place to start. If a position is no longer fundamentally attractive from a risk return perspective because it's traded up and our forward expected return is now lower and less attractive than some other investment, it's time to sell and move on. But you're also not always going to get every investment thesis correct. Since our process starts with an identifiable catalyst, if you get that catalyst wrong, the next step for us is often to sell and reassess. You don't want to fall into the trap of continually trying to justify holding an investment for ever-changing reasons. We think it's important to recognize that if the primary thesis that you relied upon to purchase the investment changes, it probably makes sense to sell first and ask questions later. You can always buy it back once you reestablish a new investment thesis that still follows each one of those steps outlined above. So, these are the factors both on the upside and on the downside that could cause us to significantly change a portfolio allocation.
CEFA:
Rob, the Federal Reserve has been maintaining rates at current levels, inflation has slowed but remains elevated, and economic growth has been resilient. We also have significant geopolitical tensions that have added to volatility as well as federal elections coming in November. Where do you see the fixed income markets currently and what is your outlook for the rest of 2024?
Robert Hoffman:
As I think about the outlook for corporate credit markets this year, and I'll keep my comments more towards markets like high yield bonds, senior secured loans, structured products, I do have a generally positive disposition in my outlook. We are in an environment of tighter spreads and oftentimes investors look at spreads as really the key determinant for if credit markets are attractive. But what I think that misses today is just the change that has occurred across fixed income as a consequence of the higher interest rate environment that we find ourselves in. Take the high yield bond market. You're around the 80th to 90th percentile from a spread basis, right? That would make it seem like the market is really expensive and not very attractive. But from a yield basis, you're sitting right around the 50th percentile, which is much more attractive considering the all-in yield you can earn for taking credit risk versus history in an environment like today where I think fundamentally companies are pretty well positioned, especially in a market like high yield.
So, it's similar in loans and CLOs too where spreads aren't as tight as high yield but above the 50th percentile mark. But based on yield as a function of high short-term rates, you're basically in the top decile of historical yield attractiveness. So, I think credit markets overall continue to be fairly attractive. There is very strong income potential versus history. And for some of these fixed income markets, a level of current return that's basically approaching the 50-year average return of equities of roughly 8%. So, if I can get that in credit, wouldn't you rather own risk and get 8% instead of equities? And so that's why I think credit allocations make sense today as a way to generate good income, potentially benefit from upside participation if markets really want to continue to run, but also providing much better potential downside protection if eventually markets do go risk off and you start to see real declines in equity prices.
So, we do think that interest rates as it relates to treasury could be range bound for quite some time. For years, we've taken for granted the steady downward move in the 10 year for instance, and that's generated really nice returns through capital appreciation for high quality fixed income investors. But I'm not so certain that that trend is going to continue. And you could see treasury rates continue to bounce around from the low fours to the high fours or even five depending on the flow of economic data and the outlook for Fed rate moves.
CEFA:
What are the most significant risks in the current environment?
Robert Hoffman:
Well look, as a credit guy my whole career, I'm always focused on the fundamentals of companies and the health of their overall balance sheet. And in general, credit is in pretty good shape, especially for markets like high-yield bonds. But I do think that while the loan market's overall health is okay, there are some worry spots below the surface. Smaller loan only capital structures, often for private companies, are showing some signs of stress as a function of rates being higher for longer. Those deals done in 2020 or 2021 when rates were at zero look a lot different when SOFR is at five or five and a quarter. And the incremental interest expense in those capital structures poses some risk for weaker borrowers. And while credit markets do a good job of generally addressing maturities so that a feared maturity wall really hasn't ever materialized for credit, the quality of loans with shorter maturity today is quite low versus the market average. And I think that could continue to cause loan defaults to outpace bonds and is something worth monitoring.
More broadly, equities have done well as the economy has powered ahead and earnings and sentiment around topics like AI has helped the tech sector. But fundamentally, equities are on the much more expensive side of history. And our internal data suggests that forward returns for equities when investing into a market that is this expensive can be a challenge. And so, if growth slows and the equity market doesn't get the earnings growth that is priced in, I also think that that's a risk. And then lastly, I've never been as convinced as the market that the Fed is going to just start cutting rates aggressively absent a recession. It seems shocking to us at the beginning of the year that the market was pricing in seven rate cuts without pricing in any sort of earnings recession as a trigger for those rate cuts.
Somewhat surprisingly though, I think equities have more than absorbed the changes in Fed rate expectations and given the huge shift in sentiment about the Fed. But I also worry about the market becoming too complacent that the Fed is just going to bail them out in an environment where inflation is still above the Fed's 2% mandate.
CEFA:
With borrowing costs being higher than we had seen two years ago, do you expect a significant impact on the level of defaults?
Robert Hoffman:
You've already started to see default rates creep up, and I think the higher for longer environment has played a role in that. But from a dollar value perspective, defaults in both bonds and loans are only kind of around historical averages. So, I don't expect a significant impact on the level of defaults as long as the economy stays robust. Economic growth has allowed these companies to continue to generate the necessary cash to make their capital structures work. Now, if the macro environment changes, business fundamentals start to deteriorate and the Fed is really slow to lower rates, that could start to create an environment where default rates increase more significantly. But absent a recession, we may see a persistent level of default somewhat above historical averages, but nothing that I term overly significant unless we start to enter a real recession. And that's what historically has created the catalyst for a large increase in default rates across the market.
CEFA:
Do you expect there to be differences in performance between the broad public and the private credit markets?
Robert Hoffman:
I would answer this in two ways. I mean, first, I do expect that private credit markets will represent an attractive option for investors that are able to give up some degree of liquidity and capture those illiquidity premiums in the market. So, from that angle, I think that good managers that make down credit decisions can continue to generate excess returns in a private credit strategy. But on the other hand, there are scenarios where public credit markets can outperform private. For instance, there are still decent discounts in the high yield bond market where the average price of a bond is in the low 90s and the market overall is of higher quality than the loan market. But most middle market origination focused private credit funds will have an average dollar price close to par with little room for upside. So, we have generally advocated allocations to both markets because there are periods when one is expected to do better than the other and vice versa. And you always have the added challenge in illiquid private markets that if you make bad investment decisions, you can't sell out of those positions.
So, in general, my view across credit is that the manager is incredibly important. There is a great opportunity for active management to generate excess returns, but a poor manager can just as easily persistently underperform regardless of the specific focus on either private or public credit markets.
CEFA:
How is this strategy currently positioned?
Robert Hoffman:
Well, in general, we have favored higher quality investments with decent yields and good discounts, going back to our requirements that every investment needs to have a catalyst to unlock value. It's not just about the highest current yield, but the all-in return can be very attractive if there's the ability for a position to trade higher. And we see a lot of those opportunities in the high-yield bond market. And so, we've had a more favorable view of that market versus loans, for instance. Loans are generally lower quality with weaker covenant protection. They have high current yields because short-term rates are so high. So, there are good investments at an individual level, but we caution against just a broad allocation to loans. Even within high yield, we are shying away from CCC-rated bonds. In our view, the long-term risk-adjusted returns of large CCC allocations just aren't great. You can do well in certain periods, and in fact, CCC bonds have done well over the past couple of years, but you need to be really selective in what you own.
And then lastly, we continue to structure products like CLOs. We've been focused in BBB and single-A rated debt tranches where you can get a significant yield pickup over comparably rated corporate bonds. And many of these structures are now entering the end of their reinvestment period where subsequent pay downs of the debt can cause lower rated tranches to improve over time and ultimately become candidates for upgrade, creating a catalyst for price upside and total returns.
CEFA:
In the current market environment. Are there specific areas where you are finding attractive valuations or opportunities?
Robert Hoffman:
Well, broadly speaking, we want to be invested in credit. We like the yields in high yield. We selectively like specific loan investments. We like CLOs, we like the optionality of certain private credit investments that meet our investment style and criteria. But overall, we do think valuations are attractive. You just need to focus on the right metrics. In the higher interest rate environment of today, it's become much more of a yield story than a spread story. And as I stated before, we think the price upside and high yields makes it more attractive on a relative basis versus loans where average dollar prices are much higher and credit quality is lower. So, we're pretty diversified when it comes to industry exposure since our focus is so heavy into bottoms up credit selection. There have been some themes that we've leaned into, the strong propensity of consumers to seek out leisure travel, the opportunities that's created for some companies in that sector.
And then we're always on the lookout for the next source of dislocation wherever it may occur, because inevitably when everything looks good, there's always a mini banking crisis or something like that right around the corner. And those types of events can create some of the best opportunities if you're equipped to move quickly into them.
CEFA:
Rob, how would you see an actively managed credit strategy with an opportunistic blend of public and private securities best positioned in a diversified investment portfolio?
Robert Hoffman:
Well, I'm a firm believer that nearly every portfolio should have an allocation to credit, be it public, private investment grade, or sub-investment grade. And that's where I think our partnership with Golden Tree can be beneficial for investors since we seek out returns across a broad range of fixed income investments. Look, sub-invested grade allocations in either public or private assets since private credit would generally be sub-investment grade rated, if it had a rating, they're never supposed to be a hundred percent of an investor's fixed income allocation. But when you look at returns over the past five years, high quality fixed income as represented by the Bloomberg Ag has given you essentially a zero return. Meanwhile, high yield and loans are up four to five and a half percent annualized and actively managed strategies may have done even better. And so, I think it's short-sighted to say that spreads are too tight in credit, and so someone should just wait to buy those markets.
I've heard countless investors say the same thing but maintain high quality fixed income exposures that have given them no returns or worse. And we preach to investors that they shouldn't try and time the market, but I'm always surprised by investors that still think they can time credit. It's not inherently different just because it's credit. So, to your question, I think a diversified investment portfolio needs to have broad credit exposure. And I think the data shows that active management incorporating public and private credit assets can provide meaningful out-performance against credit indexes, and it can help generate attractive income, provides significant correlation benefits against high quality fixed income exposure, and over the long term can be a really nice complement actually.
CEFA:
Rob, thank you so much for taking the time to join us today.
Robert Hoffman:
Thank you. It's been great to be here.
CEFA:
And we want to thank you for tuning into another CEF Insights podcast. For more educational content, please visit our website at www.cefa.com.
Podcast recorded May 2024.
Disclosure
This material is not, and is not intended as investment advice, an indication of trading intent or holdings, or the prediction of investment performance. All fund-specific information is the latest publicly available information. All other information is current as of the date of this presentation. All opinions and forward-looking statements are subject to change at any time.
FS Investments (FS) disclaims any responsibility to update such views and/or information. This information is deemed to be from reliable sources; however, FS does not warrant its completeness or accuracy. This presentation is not intended to and does not constitute an offer or solicitation to sell or solicitation of an offer to buy any security, product, investment advice or service, nor shall any security, product, investment advice or service be offered or sold in any jurisdiction in which FS is not licensed to conduct business and/or an offer, solicitation, purchase or sale would be unavailable or unlawful.