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  • ED HARRISON: Ed Harrison here for Real Vision.

  • I'm talking to Dan Zwirn, who is the CEO of Arena Investors.

  • Dan, great to have you here for debt week.

  • DANIEL ZWIRN: Thanks for having me.

  • ED HARRISON: I think before we came on camera, I was telling you off camera that we're having

  • what's called debt week, with the beginning of 2020.

  • The reason that we're talking about debt is because a lot of people don't understand that

  • debt is actually a bigger market than the equity market is.

  • That's right, isn't it?

  • DANIEL ZWIRN: Yes, the debt markets overall are far larger than the equity markets across

  • loans and mortgages and tradable bonds, and treasuries, and all the different obligations

  • out there.

  • There's an enormous number of things to choose from when you're thinking about playing the

  • markets.

  • ED HARRISON: Give me a sense of the comparative size of the market because when I look on

  • television, I get the sense that it's all about stocks.

  • DANIEL ZWIRN: Yeah, well, you can imagine, there are literally trillions of different

  • opportunities out there and in fact, we've never had more debt than we do now because

  • of the tremendous amount of issuance that happened over the last 10 years.

  • A lot of that debt ends up getting bought by the very same people who issue it when

  • you think about the sovereigns globally.

  • Basically, if you're an owner of an asset, there's never been a better time to raise

  • debt against it.

  • ED HARRISON: Now, we're going to do a soup to nuts conversation on debt, because my understanding

  • is you look at a full panoply of different markets, where their potential dislocations.

  • I think of it, there's this term that I came across called fingers of instability that

  • accumulate over time and then at stressful points, maybe you'll have a trigger, and it

  • will cause a mini crisis or a larger crisis, like we had in 2008.

  • Your thesis is basically that it's not a question of if, it's a question of when we get to the

  • next crisis.

  • January 13th, 2020 - www.realvision.com 3 The Interview: Profiting from Mispriced Credit

  • Risk DANIEL ZWIRN: Yeah, I think there's two parts of it.

  • First of all, there's always some combination of industry product geography where there's

  • a debt crisis ongoing whether that's due to a particular issuer or a particular country

  • or other geography, like a Puerto Rico or a Greece or an Italy, or whether that's related

  • to a particular industry like oil and gas, there's always something going on.

  • When we look at all of the things out there, we're always comparing risk reward and thinking

  • where are people running from, so that we can take a look at where we might want to

  • place ourselves.

  • At the same time overall, there can be-- at the end of the day, everything's correlated.

  • There are times of extremes like in a way, or a 102 or 98 or 94 where a lot of the issues

  • that arise in one or more market starts to bleed into the other ones.

  • In an ideal world, we like to avoid macro views generally, because markets can be if

  • you will, stupid longer than you can be solvent, so to speak.

  • We try to focus on where the actual idiosyncratic or alpha related distortions are the greatest.

  • ED HARRISON: One of the things I guess that I'm thinking about is the length of this credit

  • cycle or this business cycle.

  • You hear the term that we're near the end of the cycle and as a result, these kinds

  • of issues are things that we want to talk about.

  • Before I go into what those issues are, because I think you have an interesting framework,

  • what does that term we're late cycle, what does that mean to you?

  • DANIEL ZWIRN: Well, I would say it's hard to discern and that we simply, as [indiscernible]

  • of a matter, don't have that many data points, depending on who you look, who you speak to,

  • and the data that you look at.

  • Perhaps we have 100 or 300 or 600 years of data, depending on what markets you examine.

  • To draw any particular conclusions other than what goes up must come down is difficult.

  • Certainly since '08, we have had a series of basically market distortions created by

  • primarily developed market monetary authorities that preclude actual risk from being appropriately

  • priced.

  • It's been a long, long time since there's been legitimate price discovery in the markets.

  • At the end of the day, when you look at even equities, equities are ultimately the derivative

  • of the credit markets.

  • They're just the thing at the bottom of the capital stack.

  • Over time, people compare dividend yield on stocks with yields on debt.

  • That entire structure has been distorted by monetary authorities effectively underpricing

  • the front end of the term structure of risk reward.

  • What we have is a whole series of distortions that have arisen when that bubble ultimately

  • pops unclear, because when you keep rates flat or negative and there's very little premium

  • put on top of those rates to price risk, ultimately, issuers that are not terribly credit worthy

  • can frequently afford to pay very, very minimal rates to sustain a level of principle and

  • particularly, when structures are really weak, can live to fight another day for years and

  • years and years.

  • When we look at the world, we don't want to focus on what the greater fool may do or what

  • might happen.

  • We try to focus on places where those distortions have presented themselves typically in some

  • particular, again, geography or industry, etc., that allow us to hopefully take advantage.

  • ED HARRISON: I want to get to that, this specific markets that we're going to be talking about,

  • but first, let's go to your framework in terms of what you were thinking about in terms of

  • where these fingers of instability are.

  • That's because since 2008, there've been some institutional changes within debt markets.

  • I think you enumerated five basically that are critical to thinking about how this could

  • play out.

  • Can you go through step by step, maybe we'll go through the five, one after the next?

  • DANIEL ZWIRN: Sure.

  • Well, I would first say I enumerated those five factors in an academic paper.

  • There's only a subset of those things that we see that were able to be substantiated

  • in an academic level.

  • It's not to say that there are no other factors that we see in the marketplace every day,

  • but it's hard to get your arms around some of the numbers.

  • With regard to those five, I would start with collateral.

  • At the end of the day, a number of folks look at default rates as an example.

  • When they think about the quality or lack of quality of debt obligations, what we have

  • seen is that at the extremes, if I have incredibly weak covenants, and I charge a really small

  • coupon, well, then I can have no defaults.

  • People tend to-- agencies and other evaluators of credit, look at coverage meaning how much

  • cash there is to cover the obligations that I have from my debt instrument.

  • Well, again, if I don't charge a whole lot, then I can have high coverage and I can be

  • comfortable.

  • Nevertheless, I may have an actual overall obligation that's very large.

  • In fact, maybe larger than my asset value.

  • We like tend to look at leverage, not coverage.

  • When you just dispassionately look at the amount of leverage in the system across corporate

  • property, structure, finance, consumer and other personal applications out there, what

  • you see is an enormous amount of debt relative to the underlying asset value.

  • Actually, you have a tremendous appreciation in asset levels.

  • What is not necessarily understood is the degree to which people perceive there to be

  • substantial equity value, because debt is cheap and lenders tend to-- there are situations

  • where lenders tend to price very low because they perceive a lot of equity value.

  • Those two things are not independently evaluated.

  • They're effectively a zero sum.

  • ED HARRISON: Basically, you're saying that equity is the residual value with debt at

  • the top of the stack?

  • DANIEL ZWIRN: Correct.

  • We're at historical highs in terms of the enterprise value divided by cash flow that

  • people are willing to pay for businesses or assets.

  • Part of that is because we can access very cheap and large amounts of debt that allow

  • us to make equity returns that we otherwise wouldn't have been able to make.

  • At the same time, providers of debt are saying, well, this, I have real confidence that my

  • loan to value is relatively low because of all the equity that these people with equity

  • are willing to put in underneath me.

  • Effectively, it's like two drunken sailors keeping themselves up.

  • At some point, one of them might stumble over.

  • When you look dispassionately at the credit statistics out there, you're seeing enormous

  • amounts of debt relative to asset values, you're seeing structures that are very, very

  • weak, where people are not getting appropriately protected as creditors at the top of a capital

  • stack.

  • You're seeing terms in duration, which effectively, we have not seen the intrinsic risk of duration

  • priced as low as it has for decades.

  • Everything is set up for such that people are not getting compensated for risk they're

  • taking.

  • If you look at the stats across the-- and I think we go into the second area, the ratings

  • agencies, you're seeing a tremendous amount of BBB relative to the rest of high yield.

  • Why is that?

  • Because there's a very particular subset of investors that will only invest investment

  • grade and above.

  • There are tremendous incentives to do a whole lot of numerical gymnastics to be able to

  • access an investment grade rating that otherwise perhaps 10 years ago, wouldn't have been given

  • in order to access that group of investors that tends to be comfortable taking a relatively

  • low return for any given risk that they're assuming.

  • ED HARRISON: Let me back up on two things because yeah, and by the way, when you were

  • saying that, I was thinking about David Rosenberg, as I spoke to him, and he was talking about

  • this too, I want to get a point in about the credit quality of BBBs relative to what they

  • were before.

  • The interesting thing, I think maybe this is a rhetorical question on some level, because

  • you mentioned the Fed and other central banks in the developed economies.

  • Why is it that these investors are not being compensated for extending out for duration,

  • or for taking on the risk that they're taking off?

  • DANIEL ZWIRN: I think it comes down to the sheer supply and demand.

  • There's only so many issuers.

  • There's such a tremendous volume of capital that needs to be deployed, it needs to attempt

  • to get some level of return, that people are willing to accept historically low levels

  • of return when they think about the return they're getting relative to the other alternatives

  • they have.

  • When you see, unfortunately, a vicious cycle where if you lower rates, you make that hunger

  • for yield all that greater and we'll have people who are willing to buy more of it and

  • take less return over time until the market tells them no.

  • ED HARRISON: One of the things that hits me when you talk about this is this whole concept

  • of servicing debt.

  • Debt service costs being the marker versus leverage.

  • To me, that smacks of hubris in the sense that as soon as rates go up, those debt service

  • costs go up and suddenly, you have what seemed like low default rates not become low.

  • DANIEL ZWIRN: Sure.

  • Well certainly, that's certainly the case with regard to floating rate obligations.

  • Ultimately, even fixed rate obligations as a reprice will be priced against the available

  • floating rate and move up themselves.

  • What I think is not taken to account by investors frequently is the fact that there's a level

  • of correlation between risk free rates and premium to risk free.

  • If you see a real move up in risk free rates, ultimately, you frequently see big moves up

  • in spreads.

  • At same time if both happen, you have potentially a reevaluation of the underlying asset yields

  • necessary to appropriately compensate investors for owning assets or enterprises, and therefore

  • a material decline in not only asset values as you perceive, but also more importantly,

  • equity values that are subordinate and effectively managed by that debt.

  • These things can spiral out of control as they have in prior crises.

  • That said, again, there's tremendous incentives on the part of monetary authorities to keep

  • rates low as well as support the term structure of risk through other means, including buying

  • obligations directly in the marketplace.

  • I think while a crisis is not inevitable, it may be highly likely and in fact, it may

  • ultimately be preferred, because I would argue that what is inevitable is either a crisis

  • or a long term malaise.

  • Where, as an example where you have Japan, already at and potentially Europe going.

  • That's not such a great thing either.

  • We have this tremendous number of distortions happening because risk isn't appropriately

  • priced and because price discovery is not out there.

  • In fact, that leads to the third issue, which is that-- in addition to the fact that collateral

  • is relatively misjudged in terms of its underlying risk, and in addition to the fact that it's

  • not necessarily evaluated appropriately by available agencies, you have the fact that

  • in the wake of the crisis, the number of people who are willing to make markets in fixed income

  • across the world is very low, and to the extent that they're willing, their abilities is in

  • turn very low.

  • ED HARRISON: Why is that?

  • DANIEL ZWIRN: Well, I think part of it is that there's been a tremendous level of pressure,

  • perhaps rightly applied post-crisis on banks, that that participate in market making.

  • One, to effectively put capital up against certain obligations in their balance sheet

  • at levels that really preclude them from owning that risk in the first place.

  • Second, through the Volcker Rule and other rules that they have to follow, there is a

  • tremendous level of pressure for them not to effectively take a proprietary position.

  • Unfortunately, in over the counter markets, the difference between making an OTC market

  • and taking a proprietary view is very hazy.

  • Why take that risk when the downside of doing is so great?

  • ED HARRISON: That means basically, liquidity has been shrunken over time.

  • DANIEL ZWIRN: Tremendously so.

  • As an example, we, in our business, we owned a few million bonds of a-- have a $400 million

  • issue and decided, after doing additional work, that we didn't want to be involved and

  • it took us almost two weeks to get out of just a couple of million bonds.

  • The reality is, and that turns to a another factor we see out there, not one of the five,

  • but as a general whole, there have not mentality which is that if you already have, whether

  • it's corporate, again, property, consumer, etc., there's really no lower bound on the

  • level at which you can borrow.

  • If you are have not, there's really no price you can pay to get access.

  • What happens is if you have an obligation of one of those have nots, it's effectively

  • a permanent holding until you effectively get your hands on the assets either through

  • a maturity or covenant violation, etc., and effectively forced the monetization.

  • That then leads to yet another factor, which is the mismatch in assets and liabilities

  • across many of the entities that have been raised in order to house a lot of this fixed

  • income.

  • You'll see in mutual funds, shorter term, shorter duration hedge funds, ETFs and others,

  • situations where there's a presumption that you'll be able to sell the obligations in

  • order to deal with redemptions that's not really there.

  • In fact, even in the last couple of years, you've had situations in Europe where there

  • are property trusts, effectively, that own giant real assets that are levered, that are

  • daily liquidity open ended and people somehow still are surprised when in fact, the redemptions

  • come that they can't effectively sell those buildings on demand.

  • ED HARRISON: I call this fake liquidity basically in a sense that the underlying asset is illiquid

  • and then you have a liquid trading ETF or other asset on top of that, and people get

  • the sense that I can get in and out of this when actually the underlying asset, there's

  • a mismatch there.

  • DANIEL ZWIRN: Either you in fact, won't be able to get out and redemptions will be suspended,

  • or there'll be relatively low correlation between the price of the ETF in which you're