By Timothy J. Gramatovich, CFA
Founder and Chief Investment Officer
I have spent an entire career in what is now known as Leveraged Finance. I began working for Drexel Burnham Lambert in Los Angeles in 1985, which was the beginning of the original issue High Yield Bond market. I left at the end of 1989 just before our firm collapsed and the Savings and Loan crisis hit. Given the uncertainty of whether the High Yield market would even exist, I became an independent consultant to the US Trustee’s Office in Los Angeles which is a fancy way of saying the Federal Bankruptcy Court. I learned about restructuring and valuation and worked as a CFO for several debtors getting a real-world education. I took that education and moved into the buyside of the High Yield business, first at Aegis Asset Management, then at Lehman-Travelers and finally launching my own buyside business-Peritus Asset Management (“PAM”) in 1995.
The High Yield bond market was approximately $150 billion in 1990 and by 1995 it had grown to almost $1 trillion. The market had numerous inefficiencies including the simple fact that it was an Over the Counter (“OTC”) market meaning one where you called dealers and negotiated your purchase price. No electronic or automated trading platforms existed (nor do they today) but in 2002 “TRACE” or Trade Reporting and Compliance Engine came into existence which provided more pricing transparency. By far the biggest anomaly we found and exploited related to the rating agency algorithms. In rating agency models, size matters. Companies with smaller revenue lines were and remain punished with a significantly lower rating regardless of fundamental credit quality. As time rolled forward, the High Yield bond market became larger and more institutionalized, squeezing out many of the original inefficiencies. The largest High Yield bond ETFs began setting size limits on what they could purchase. This trend led to larger issues and with-it higher ratings. Today, BB rated bonds are the majority of the High Yield bond market-something unheard of 30 years ago.
Where did all those smaller issuers go? The answer is the Institutional Term Loan market. The same rating agency algorithms we targeted in bonds is now prevalent in the $1.5 trillion Broadly Syndicated Loan (“BSL”) market. We have found great value in the single B ratings category and this cohort lies firmly inside the loan market where single B ratings (and lower) represent approximately 2/3 of the market. In addition to the size or ratings arbitrage, the loan market presents additional challenges such as information flow requiring relationships with the agency banks who underwrite and administer.
Peritus is uniquely qualified to deliver this alpha script in loans having a multi-decade experience in the High Yield bond market.
Most importantly, and why Peritus Credit Partners (“Peritus”) has been launched, is that the loan market has been delivered almost exclusively through what we would call beta. The driver of the loan market has been Collateralized Loan Obligations (“CLO”) which typically contain 300+ loans in each structure. The focus for CLO managers is about adherence to the structured credit documentation which boiled down is ratings, recovery and spread. While most of the platforms talk about fundamental credit analysis at best it is secondary. These structured credit vehicles are a bet on the asset class (beta) with significant amounts of leverage. While we love the asset class, we believe that the time has now come to focus on alpha vs beta delivery.
While the world remains focused on MAGA and President’s Trump trade rhetoric, our work suggests that the global economy had been slowing rapidly prior to the tariff announcements. The façade of growth created by the liquidity pumped into the markets by the Central Banks from both the Great Financial Crisis (“GFC”) of 2008-09 and Covid starting in 2020, is being exposed as it is burnt through. Demographics are destiny and with Japan, China and the Eurozone quite literally dying, this secular trend will dominate going forward meaning very slow economic growth exacerbated with a new world trading scheme which is still yet to be determined.
Peritus is uniquely qualified to deliver this alpha script in loans having a multi-decade experience in the High Yield bond market. The historical High Yield bond market was at the bottom of the capital stack and was almost always unsecured. You got it right or you got a toe tag and a body bag. Recovery rates were often 10 cents on the dollar or less. While much has been made of lax covenants in loans, as historical High Yield managers we view the 1st lien secured nature of the loan market as playing with house money—we actually have collateral. With that said, we believe that the loan market has not been immune to very bad behavior as the traditional business/credit cycle has been continually delayed. Leverage metrics for a large part of the loan market have become absurd and as economies slow, these companies will be exposed. Peritus’ primary occupation is to avoid defaults. As always in credit, what you don’t buy tends to be more important than what you do buy.
By Timothy J. Gramatovich, CFA
Founder and Chief Investment Officer
I have spent an entire career in what is now known as Leveraged Finance. I began working for Drexel Burnham Lambert in Los Angeles in 1985, which was the beginning of the original issue High Yield Bond market. I left at the end of 1989 just before our firm collapsed and the Savings and Loan crisis hit. Given the uncertainty of whether the High Yield market would even exist, I became an independent consultant to the US Trustee’s Office in Los Angeles which is a fancy way of saying the Federal Bankruptcy Court. I learned about restructuring and valuation and worked as a CFO for several debtors getting a real-world education. I took that education and moved into the buyside of the High Yield business, first at Aegis Asset Management, then at Lehman-Travelers and finally launching my own buyside business-Peritus Asset Management (“PAM”) in 1995.
The High Yield bond market was approximately $150 billion in 1990 and by 1995 it had grown to almost $1 trillion. The market had numerous inefficiencies including the simple fact that it was an Over the Counter (“OTC”) market meaning one where you called dealers and negotiated your purchase price. No electronic or automated trading platforms existed (nor do they today) but in 2002 “TRACE” or Trade Reporting and Compliance Engine came into existence which provided more pricing transparency. By far the biggest anomaly we found and exploited related to the rating agency algorithms. In rating agency models, size matters. Companies with smaller revenue lines were and remain punished with a significantly lower rating regardless of fundamental credit quality. As time rolled forward, the High Yield bond market became larger and more institutionalized, squeezing out many of the original inefficiencies. The largest High Yield bond ETFs began setting size limits on what they could purchase. This trend led to larger issues and with-it higher ratings. Today, BB rated bonds are the majority of the High Yield bond market-something unheard of 30 years ago.
Where did all those smaller issuers go? The answer is the Institutional Term Loan market. The same rating agency algorithms we targeted in bonds is now prevalent in the $1.5 trillion Broadly Syndicated Loan (“BSL”) market. We have found great value in the single B ratings category and this cohort lies firmly inside the loan market where single B ratings (and lower) represent approximately 2/3 of the market. In addition to the size or ratings arbitrage, the loan market presents additional challenges such as information flow requiring relationships with the agency banks who underwrite and administer.
Peritus is uniquely qualified to deliver this alpha script in loans having a multi-decade experience in the High Yield bond market.
Most importantly, and why Peritus Credit Partners (“Peritus”) has been launched, is that the loan market has been delivered almost exclusively through what we would call beta. The driver of the loan market has been Collateralized Loan Obligations (“CLO”) which typically contain 300+ loans in each structure. The focus for CLO managers is about adherence to the structured credit documentation which boiled down is ratings, recovery and spread. While most of the platforms talk about fundamental credit analysis at best it is secondary. These structured credit vehicles are a bet on the asset class (beta) with significant amounts of leverage. While we love the asset class, we believe that the time has now come to focus on alpha vs beta delivery.
While the world remains focused on MAGA and President’s Trump trade rhetoric, our work suggests that the global economy had been slowing rapidly prior to the tariff announcements. The façade of growth created by the liquidity pumped into the markets by the Central Banks from both the Great Financial Crisis (“GFC”) of 2008-09 and Covid starting in 2020, is being exposed as it is burnt through. Demographics are destiny and with Japan, China and the Eurozone quite literally dying, this secular trend will dominate going forward meaning very slow economic growth exacerbated with a new world trading scheme which is still yet to be determined.
Peritus is uniquely qualified to deliver this alpha script in loans having a multi-decade experience in the High Yield bond market. The historical High Yield bond market was at the bottom of the capital stack and was almost always unsecured. You got it right or you got a toe tag and a body bag. Recovery rates were often 10 cents on the dollar or less. While much has been made of lax covenants in loans, as historical High Yield managers we view the 1st lien secured nature of the loan market as playing with house money—we actually have collateral. With that said, we believe that the loan market has not been immune to very bad behavior as the traditional business/credit cycle has been continually delayed. Leverage metrics for a large part of the loan market have become absurd and as economies slow, these companies will be exposed. Peritus’ primary occupation is to avoid defaults. As always in credit, what you don’t buy tends to be more important than what you do buy.