City exclusive: Fear and uncertainty present opportunities in credit markets, argues fund grandee
War in Europe, a supply-chain squeeze, and the shift to monetary tightening have created fresh uncertainty in credit markets.
Irrational exuberance seems to have been replaced by irrational pessimism. And, as a result, the market has become far more opportunistic.
According to City insider and fund manager Daniel Dolan, portfolio manager of the iMGP US Core Plus fund and Managing Member of Dolan McEniry Capital Management, “this is good news for active, long-term investors seeking high-quality assets at an attractive entry point.”
The movement in fixed income spreads underlines the relative scale of opportunity. Before this year’s storm in bond markets, the two-year Treasury was at 25 basis points. Now it is at 336. The 10-year was at 147; now it is at 337.
Dolan told City PM that “one particular statistic reflects just how extreme the bond market reaction has been. The historical spread between the Fed funds rate and the two-year Treasury has been 34 basis points since 1976.”
“Of course, there could be a little more downside for rates, but any potential upside of a position is likely to be much greater than the first five months of this year.”
Fund manager Daniel Dolan
Dolan added: “There are those that believe the yield curve is way ahead of the Fed, if you assume that Fed Funds Futures are 348 in December – it’s clear the curve is expecting the direction of travel on rates.”
“Thus, we now see the market taking an asymmetric shape where we believe the potential upside of a position is significantly greater than its potential downside,” he added.
Credit quality
Credit risk does still lurk, but overall credit quality appears strong. If the Fed continues to raise rates, some experts have suggested the economy could slow and the possibility of a recession exists.
“If that were to occur, economists have suggested the Fed would again be put in a position where they must stimulate the economy,” Dolan said.
He believes that yields and spreads are “as attractive as they have been in three years, barring the pandemic sell-off.”
“The key to this credit analysis is an evaluation of free cash flow because, companies who generate it well and allocate it wisely make the strongest case for enduring value<” he continued.
Dolan explained he looked at the free cash flow generated by a company and examine how it ebbs and flows through different market cycles.
History repeating
If you go back to periods where there have been extreme credit events, the taper tantrum in 2013 for example, or the GFC in 2008, credit quality was, in most cases, much lower.
In Dolan’s opinion, “the quality of credit remains strong, if not very strong, today.”
“The corporate credits within our portfolios seem to have, in our opinion, wide margins of safety to avoid default risk. And we will attempt to take advantage of any decrease in credit quality and spreads in quality names that we already hold, if, as some economists warn, we were to lurch into recession,” he noted.
Benjamin Graham once said, “The intelligent investor is a realist who sells to optimists and buys from pessimists,” Dolan added.
“The present macro headwinds have created plenty of reasons for investors to be fearful. But with a clear and patient mind, we see the current volatile market as an opportunity to access quality credits at historically wide yields and attractive price discounts,” he concluded.