The Sunday Drive - 10/20/2024 Edition [#133]
Musings and Meanderings of a Financial Provocateur
👋🏼 Hello friends,
Greetings from Saratoga Springs, NY. Let’s enjoy a leisurely Sunday Drive around the Internet.
🎶 Vibin'
No particular theme this week, just a mashup of the Bee Gees look, the Indiana Jones hat, and a voice that doesn’t remotely match the artist you’d expect to see. This week, I’m vibin’ to Bobby Caldwell’s 1978 hit, What You Won’t Do For Love. Enjoy.
💭 Quote of the Week
“Getting old is like climbing a mountain; you get a little out of breath, but the view is much better!“
— Ingrid Bergman
📈 Charts of the Week
We have two Charts this week which show a couple of different ways of looking at some of the risks that appear to be bubbling up under the surface of the financial system. The last time credit spreads were this tight was at the height of the housing bubble in 2007.
We know what came next… The Great Financial Crisis.
I often stress to investors the importance of managing risk and making sure we can expect returns that are adequate compensation for the risks we do take. I also stress that what worries me most are the risks that we don’t see.
With publicly traded bonds more or less priced for perfection and at a level of incredible complacency, it won’t take much for them to trade very poorly.
Which brings private credit to mind, and by extension, private equity given how intertwined they are.
Private credit is typically priced at a premium compared to publicly traded bonds. The illiquidity of private credit means that investors demand higher yields to compensate for the risks associated with longer lock-up periods and less transparent information. This illiquidity premium, which can range from 200 to 500 basis points, depending on the credit risk and market conditions, reflects the bespoke nature of private credit deals. While public bonds are rated by agencies such as Moody’s and S&P and traded on secondary markets, private credit is typically unrated and negotiated directly between lenders and borrowers.
Another differentiator in pricing is the lack of mark-to-market requirements in private credit, which reduces volatility for investors but adds complexity in determining the real-time value of these assets. Unlike publicly traded bonds, which fluctuate with market conditions and interest rate changes, private credit is often held at book value until realized.
The relationship between private credit and private equity has become increasingly symbiotic, with private credit often acting as the financing arm for private equity deals.
While private credit offers benefits such as increased flexibility for borrowers and higher returns for investors, its growing role in the financial system poses potential risks. One significant concern is the opacity of the private credit market. Unlike public markets, which are subject to regulatory oversight and disclosure requirements, private credit operates in a less transparent environment. This lack of transparency can obscure the true risk profile of these loans, potentially leading to systemic risks.
A major driver of the Great Financial Crisis of 2008-9 was the degree of leverage that had built up in the financial system through mortgage related derivative securities and the like. The forced deleveraging of the financial system during that time brought to light just how fragile it had become.
We don’t really know just how much leverage has built up in the private credit and private equity markets, but their heavy reliance on leverage and their significant growth in recent years suggests it’s quite a lot.
I don’t know what the catalyst might be to force another Great Deleveraging, but it’s important to look for signs of it.
Warren Buffett once said, “Be fearful when others are greedy and greedy when others are fearful.”
Given how tight credit spreads are in the bond market, I don’t see much fear at all… and that makes me a little fearful.
🚙 Interesting Drive-By's
💡 Too Much Faith in Government, Too Little in Markets (and AI)
🤔 The Changing Face of Finance
📈 The Second Coming of Inflation
📉 The Baby Bust Will Reshape Public Schools
👋🏼 Parting Thought
If you have any cool articles or ideas that might be interesting for future Sunday Drive-by's, please send them along or tweet 'em (X ‘em?) at me.
Please note that the content in The Sunday Drive is intended for informational purposes only, and is in no way intended to be financial, legal, tax, marital, or even cooking advice. Consult your own professionals as needed. The views expressed in The Sunday Drive are mine alone, and are not necessarily the views of Investment Research Partners or Cache Financials.
I hope you have a relaxing weekend and a great week ahead. See you next Sunday...
Your faithful financial provocateur,
-Mike
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