Having tumbled for much of November and December, in what was a bidless plunge as 2018 came to a close, the leveraged loan index has staged a remarkable comeback in just the past week, surging from 93 to over 97 in what appears to have been another furious short squeeze.
But instead of seeing this as an all clear, even if temporarily, private equity giant KKR has decided to cut its leveraged loan exposure to zero from overweight, according to Henry McVey, head of global macro and asset allocation and CIO of KKR Balance Sheet.
"After over two years of leaning-in to leveraged loans as a pure play idea, we are reducing this overweight to zero from 3% and a benchmark weighting of zero", McVey said in the company's 2019 global macro outlook released today, titled "The Game Has Changed".
Explaining why KKR is "consolidating" all of its liquid credit position into its opportunistic bucket, McVey writes the following:
After over two years of leaning-in to Leveraged Loans as a pure play idea, we are reducing this overweight to zero from three percent and a benchmark weighting of zero.
Leveraged Loans have had a great run in recent years, as their floating rate feature and strong technical flows have served this asset class well, particularly relative to High Yield.
Where to go in corporate credit? We now hold a seven percent position in Actively Managed Opportunistic Credit, which provides us with greater ability to toggle between High Yield, Structured Credit, and Loans. Said differently, given the dislocation of late, we want a little more flexibility to arbitrage capital structures and asset classes than in the past. We also like this vehicle because it is a direct play on our Buy Capital Structure Complexity thesis.
"Importantly" the KKR strategist adds, "Liquid Credit has priced in the growth slowdown we are forecasting in 2019 much more appropriately than many parts of Private Credit have, and as such, we skew the portfolio heavily in this direction."
The Fund's trimming in Leveraged Loan exposure is shown below (alongside the fund's 0 allocation to junk, high grade and EM debt):
KKR's exit of leverage loans comes at a time of consecutive record outflows from loan funds as most investors scramble to liquidate all exposure in a time when the Fed's tightening cycle is now seen as ending.
As Bloomberg points out, this is obviously even more bad news for the suffering loan market, "as KKR has traditionally relied on financing companies through the leveraged loans to support its acquisitions" and yet, in light of record low covenant protections, coupled with the deteriorating credit metrics of the issuers, KKR's "nervousness now is understandable."
While KKR is trimming its loan exposure, it is increasing its allocation for short-term U.S. government bonds to 7% from 3%:
we remain 2000 basis points underweight the long-end of the curve. We find U.S. short duration bonds (i.e., one-to-three year bonds) as one of the most attractive risk-adjusted vehicles currently available. The asset class provides both competitive yield and potential capital appreciation (i.e., it is one of the few positive carry hedges we can find). Indeed, despite yields that are now just 19 basis points below 10-year yields in the U.S. (and well above yields available in Europe and Japan), an investor is also paying for some capital gains if the Fed does pause because of trade concerns, growth jitters, and/or geopolitical tensions. By comparison, we remain significantly underweight in long-term global bonds of all types. Our view is that interest rates do not explode to the upside. Rather, from an asset allocation perspective, we believe the long-end of the curve can no longer fulfill its traditional role in asset allocation as both a shock absorber and yield enhancer. Also, we do not want to own a long duration position where the fiscal situation is deteriorating and there is zero embedded term premium in the security. As such, we hold a zero percent position in this global asset class relative to a benchmark of 20%.
Finally, going back to why KKR titled its latest report "The Game Has Changed", it lists the following four major influences that require a different approach to asset allocation in 2019:
- A notable shift from monetary policy to fiscal is under way;
- Technology, while still an incredibly powerful agent of change in the global economy, now faces more valuation and regulatory headwinds than in the past;
- tightening liquidity conditions amidst higher real rates are macro headwinds that must now be considered; and
- the rise of geopolitical uncertainty warrants a higher risk premium than in the past.