#42 – The Credit Expert

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STEPHEN CLAPHAM: I interviewed Dominique Miel in episode 18 in December 22, when we talked about distressed debt, which is a very specialist area and quite akin to equities, but more complex. But I’ve been hoping to speak to a credit expert for some time, because when I deliver my forensic accounting course to credit teams, they’re much more switched on.

STEPHEN CLAPHAM: About the numbers. So I thought my listeners, who are mainly equity professionals or serious amateurs, and I might learn something different from speaking to a credit specialist, and not any specialist. In this episode, I speak to Greg Peters, who’s co-CIO of PGM, which manages $700 billion. Yep, debt markets are quite big.

STEPHEN CLAPHAM: In this fascinating conversation, we discuss the differences between equities and credit. The legacy of the zero interest rate period, why PGM uses scenario-based forecasting in preference to single point estimates, why covenants have gone out of fashion and why that’s dangerous, and we explore the areas of high yield, government bonds, and private credit.

STEPHEN CLAPHAM: Reg and I recorded when he was in London in summer and I planned to publish much earlier than Nav, but opportunities to record with Bill Nygren, with Lionel Barber, and then the live episode with Anthony Bolton meant this conversation got pushed back.

STEPHEN CLAPHAM: So listen on the very end, where I recorded again with Greg a quick 10-minute update on what we should expect in markets in 2025. Greg’s a highly experienced and thoughtful investor and focused on the long term. I learned a lot, and hopefully you too will learn something and for sure you’ll enjoy our conversation.

STEPHEN CLAPHAM: Greg. Welcome to the podcast. It’s very interesting because this is the first time I’ve interviewed somebody from the credit world. You studied finance, you worked at Morgan Stanley, at Salomon Smith Barney, the Department Of U. S.

STEPHEN CLAPHAM: Treasury, all before you moved to PGM. How come you ended up in fixed income and not in equities or some other area? And how come you ended up as the co-CIO of one of the largest credit investors in the world?

GREG PETERS: Well, you know, like with everything, it’s a happenstance. So I was fortunate to start with the U. S. Treasury. Which was just a fascinating time. It was right after the savings and loan crisis. And it was a tremendous training ground. So just, you know, digging through loans, digging through credit there, just really kind of set me in that direction. And it’s been just in the fixed income credit markets ever since.

STEPHEN CLAPHAM: So and fixed income, there’s a clue in the name, right? So how difficult was it? The zero interest rate environment for somebody in your shoes?

GREG PETERS: It was very bleak from a business perspective. So you rewind the clock. You know, we’re staring down the barrel of tight credit spreads and zero to negative interest rates. The future prospects look bleak. It was just yields were just entirely too low.

GREG PETERS: You know. The good news is that we’re in a very different interest rate regime today. The bad news is that the adjustment process was really quite challenging. Yeah. So you’ve seen a tremendous amount of volatility.

GREG PETERS: The rate rises have, you know, been a tailwind behind fixed income, but the adjustment process has really, you know, hurt a lot of investors at the same time. So. It’s a path-destination problem, as Amphanda is saying, so the destination is much better, but the path was quite rocky.

STEPHEN CLAPHAM: I mean, presumably you’re in a much better place today because a pension fund, you might be able to do 7% in credit alone today with where yields are. And we had Jonathan Ruffer, the founder of Ruffer LLP, a $25 billion asset manager who are very heavily in exposed to equities rather than credit.

STEPHEN CLAPHAM: He actually suggested recently that perhaps the age of equities might be over. And what do you think about this? I mean, do you think pension funds could survive without equities? Do you think that how would that change the shape of markets? I mean, it’s a big change, right?

GREG PETERS: The funded status has clearly improved, rates higher, equities have… You know, rallied quite significantly as well. So the funded status puts pension funds in a much better place than where they were before. So the need to go out the risk curve ala equities might not be what it once was, as you will see, I think, some de-risking, some defeasement of those pension plans on the margin.

GREG PETERS: But I would be quite audacious to say that the age of equities are over. I think equities are still a tremendous investment and asset class. And the reason why equities have done so well is because the fundamentals have. So this has not been a multiple expansion story. This has been an earning story. And I think that proves equities worth.

STEPHEN CLAPHAM: Let’s just turn to the analysis, because one of the things I’m keen to talk to you about is the difference between a credit analyst and an equity analyst because you know i’ve got training business we train both credit people and equity people and the credit people tend to be much more focused on the numbers and equity people are much more focused on the narrative and i think there’s quite a lot that we can learn from each other actually first thing i want to ask you about are credit investors better than equity investors.

STEPHEN CLAPHAM: Because if you look at the number and the percentage of equity investors that are underperforming, obviously there’s huge concentration in equity markets, but I think something like 80% underperformed last year. The credit world isn’t nearly as bad as that, is it?

GREG PETERS: No, but it has a lot to do with the index construction aspect as well. So just the comparative from an equity manager to an index is quite different than the fixed income side. I would argue that the hurdle rate for fixing commanders is much lower than the equity side. So that kind of skews the numbers. But you’re quite right as far as the analysis is concerned.

GREG PETERS: You know, the podcast is behind the balance sheet, which to me says it’s a credit podcast because credit investors focus on the balance sheet. And I think that is a key difference, right?

GREG PETERS: The upside for a credit investor ostensibly is getting their money back. So it’s a deep analysis on the cash flows, repaying that debt, and a focus on the balance sheet and the interplay. And, you know, we have a lot to lose and not a lot to…

STEPHEN CLAPHAM: Kind of be rewarded for so that makes one sharpens one’s pencil i mean i’ve been sort of you know saying that equity investors should be more focused on what they can lose of course people who have listened to me probably would be quite annoyed because recently you’ve made a lot more money by not worrying about balance sheet and these balance sheets haven’t been an issue but my contention is that with higher rates then balance sheets are going to become much more important.

STEPHEN CLAPHAM: And companies are a lot more levered than they used to be. Is that something you would agree with?

GREG PETERS: That is precisely right. We are in a new world that looks very similar to the old world pre-GFC.

GREG PETERS: Companies, sovereigns have loaded up on low-cost debt. That debt will ultimately start to roll off and continue to roll off and be refinanced with more expensive debt. And that puts a lot of pressure on these capital structures. And so margins, I think, will be hit.

GREG PETERS: It’s, you know, you’ll see more distress and more default. So very much of the mind. We are entering a new era in the credit cycle, one that we haven’t seen with zero interest rates.

GREG PETERS: If you think about zero interest rates, it kept so many businesses in business that probably were not deserving. So we did not have this winnowing out, this Darwinian effect that’s desperately needed. And I expect that to happen over the course of the next few years.

STEPHEN CLAPHAM: I mean, it’s already started to happen in the U. S., hasn’t it? I mean, there’s an increase in the rate of bankruptcies.

GREG PETERS: It has. It hasn’t been this episodic moment like many forecasted because it takes time. And I think this will be a situation where we’ll have this elevated distress default cycle for a period of time. Now, if a recession hits, then that gets pulled forward and accelerated. But even without a recession, a lot of these capital stacks can’t survive this environment.

STEPHEN CLAPHAM: One of the things I was interested about is you talk about using scenario-based forecasting. And in equities market, we’re very focused on a single point estimate. Earnings are going to be X next year.

STEPHEN CLAPHAM: And I always thought scenario-based forecasting is a more logical, more sensible way of looking at it because, you know, the sell side analysts have got their EPS estimates to two decimal points with one of the things I hated. I always used to think, you know, if you could just get the big number right, you were doing well. Can you just talk about how you do that in practice?

GREG PETERS: Single point estimates, I’m fond of saying, is the road to ruin. It’s a false precision as well.

GREG PETERS: I believe a lot of that is because of, you know, CNBC and those types of things where, you know, analysts were forced to give a number, right, instead of giving a range of numbers. But a scenario-based approach is important because it forces you as the investor to critically evaluate your company, your market, your portfolio in multiple dimensions.

GREG PETERS: It’s never a zero-one process. So it’s important for the investor to truly understand what happens if, you know. Growth rolls over or inflation spikes versus the opposite. And so have multiple paths to understanding.

GREG PETERS: And then monitoring those changes over time is even more important. So I’m firmly in the camp. You need to understand your portfolio, your company, your sector in multiple dimensions and not be such a reductionist into a zero one. This is what’s going to happen.

STEPHEN CLAPHAM: And how do you set the scenarios? I mean, are they set centrally? Are they fixed? Do they change over time? Or is it up to each analyst to say, these are scenarios for this company in this sector? How does it work?

GREG PETERS: It’s an evolving process, but it’s basically set by our team. So at PGM, we’re very much of a team-oriented institution, from our macro team to our strategist team to myself, going through what we think are the plausible paths. And you have to be somewhat imaginative too.

GREG PETERS: You want to spread the analysis. You don’t want to be centered around the mean too much. Otherwise, it loses its efficacy. So going through that is an important part of the process. And we do it in a team-based way. But it does change over time. And those changes are oftentimes more instructive.

STEPHEN CLAPHAM: So what would make you change the scenarios, like something like COVID or?

GREG PETERS: You know, time changes and COVID would be a great example of that.

GREG PETERS: And it’s, you know, what happens in a scenario where, you know, you have this hyperinflation type of backdrop. You know, that was a scenario that didn’t have a lot of probability to it pre-COVID. So, you know…

GREG PETERS: Changing it and altering it over time and continuing to assess and evaluate is the core principle of the process. Right. Otherwise, you’re just kind of stuck in a rut. So looking through those scenarios over time is crucial.

STEPHEN CLAPHAM: That’s interesting. And when you decide, oh, there’s a risk of something coming, you say, okay, analysts, you better get your calculators out. And create a new scenario, and then you look at what in the portfolio is exposed. Is that the kind of way it works, sort of top-down?

GREG PETERS: It’s more of a calibration of upside-down side.

GREG PETERS: If, for example, a recession risk is relatively elevated, which it still is, in the U. S. We have a 20% recession probability. It’s come down from where it was two years ago. But still elevated, about 3x what a normal probability is.

GREG PETERS: And then you evaluate where current credit spreads are, as an example, and then what would happen to credit spreads in a recession. And ultimately, we’re calibrating upside-downside. So if credit spreads are really tight and you have a higher probability of extreme loss, then that recalibrates the risk that you want to take in the portfolio. Just to… Stylize it in a simplistic way.

STEPHEN CLAPHAM: And you must be very, very focused on that right now because that kind of is the big call for you, I assume.

GREG PETERS: It is. It’s very important. And credit investing, fixed income investing, is about protecting the downside. As we mentioned, the upside is quite limited. It’s about getting repaid. And you don’t want to expose your portfolio to just extreme losses. It’s such a deep hole to dig out from under or crawl out from.

GREG PETERS: It’s something you want to avoid. So upside-downside is crucial.

STEPHEN CLAPHAM: Now, I want to ask you about covenants because I wrote recently in my sub-stack about the covenants at Kantar, which is a private… Equity-owned company in the media spaces, 40% owned by WPP, the global advertising company, which is publicly quoted.

STEPHEN CLAPHAM: And I was just fascinated. The covenants were debt, including the accounting capitalization of operating leases, which is a hugely subjective number because the rules allow you quite a lot of latitude.

STEPHEN CLAPHAM: And the EBITDA was an adjusted EBITDA. Before the operating lease rentals, which obviously are a cash cost that you have to pay every year, then adjusted for the estimated run rate of acquisitions, adjusted for the pro forma run rate of estimated cost savings, the number, to my mind, was a completely nonsensical number.

STEPHEN CLAPHAM: I mean, what anybody could take away from that, I don’t understand. Why is it that the credit markets have allowed borrowers to do this? It seems madness to me.

STEPHEN CLAPHAM: I’m not owning you responsible, but I think it’s bizarre.

GREG PETERS: Ultimately, covenants have really been tossed aside for the past 15, 20 years. Covenants were the hallmark of credit investing, and that has really changed. And it’s changed because there’s so much capital chasing the opportunity set. So borrowers don’t have to provide covenants.

GREG PETERS: And if they do provide covenants, they’re ones that are so overly complicated that, you know, they’re really difficult to enforce. So the trend in the markets has been clear, cove light to no covenants. And market participants have been pretty comfortable with that for the most part.

GREG PETERS: At the same time, there hasn’t been a credit cycle. Right. We’ll see what happens when a credit cycle does come about, which I I think we will see a more classic credit cycle here over the next few years, as we discussed, and that’s when the value of covenants come into play. But you mentioned all these adjustments.

GREG PETERS: What we’ve seen, particularly in the levered loan market, is this pro forma EBITDA. So if you do a transaction, you’re getting, let’s say, LBO type of transaction. The actual, just call it, you know, EBITDA is, you know, half of what’s being put forth on a pro forma basis. So leverage is double.

GREG PETERS: It’s not coming anywhere close to realization one year later. So you have a pro forma leverage number that is, quite frankly, heroic and not achievable. And investors are underwriting it quite happily.

STEPHEN CLAPHAM: So, I mean, this sounds like we’re going to have a really much higher instance of defaults going forward because we’ve got more levered companies and the leverage number. Has been wrongly calculated. I mean, this sounds like maybe it’s a bifurcated market in which there’s more companies with stronger balance sheets and more companies with weaker balance sheets. But on the downside, it looks quite risky, no?

GREG PETERS: It’s a twofold effect. I do believe you’ll have higher defaults. You’ll also see lower recovery rates as more of the assets have been attached and senior. Lenders, senior bondholders, senior secured don’t have the same protection that they have had historically.

GREG PETERS: So yeah I believe it’ll be a twofold effect and the extension of credit in a zero interest rate environment was was tremendous. It’s just you know profligate. So I do expect a different credit cycle with higher defaults and lower recoveries.

STEPHEN CLAPHAM: And I’m not really that familiar with the credit world. The one thing I would be worried about is, are there a lot of fund managers coming in, new fund managers who are perhaps less experienced, perhaps don’t have the depth of research and the resources in research to filter out these more risky loans? I mean, is there going to be a problem for the end investors, do you think?

GREG PETERS: I think that’s right. Credit… Individual credit work hasn’t necessarily been rewarded in a zero interest rate environment or an environment where central banks were so dominant. I believe that world has changed and you will see more dispersion and credit selection will matter much more. Arguably, it really didn’t because it’s been a market, like I said, driven by central banks.

GREG PETERS: And so bad balance sheets were rescued by cutting interest rates and the like. And credit work wasn’t necessarily rewarded in that environment. But you’re seeing a very different environment today. So if you look at the high-yield bond market as an example, credit spreads are arguably on the tighter end of the range, 10th decile in its historical period.

GREG PETERS: But dispersion is incredibly wide, the widest we’ve seen in over 15 years. So what that tells you is that even though the you know the macro aspect of the high-yield bond market is is rich and not necessarily attractive for credit investors the winners and losers that dispersion around credit fundamentals is creating a real opportunity and i think that’ll just continue i.

STEPHEN CLAPHAM: Mean funny my Paul Jonathan boyer who runs boyer research another equity guy Said quite recently, investors have been buying sub-investment grade companies should be aware of how little they’re being compensated for purchasing the riskier debt.

STEPHEN CLAPHAM: And he said, you know, five year treasuries are currently yielding four and a half. I don’t know what they’re yielding today, he said a couple of months ago. But is it worth taking so much additional risk for only a few percentage points of additional yield? So there could be a fallout from that, right?

GREG PETERS: I do believe so.

GREG PETERS: There should be a more natural risk aversion trade given where rates are generally. When rates were, once again, at zero, we keep going back to when rates were at zero. When rates were at zero, investors were forced, induced to go out the risk curve. That was the whole idea behind QE.

GREG PETERS: The idea around QE is to, quote unquote, effectuate the portfolio channel, which is a Fancy way to say force investors into taking risk. And so there was so much uncomfortable risk-taking, unnatural risk-taking, as investors didn’t have a choice. Earning zero was just not something that was, you know, helping their pension funds along.

GREG PETERS: So they were moved into either more equities, out the credit curve, into crypto, all these other types of endeavors. That will continue in my mind to unwind and there’ll be a natural de-risking as a result. It hasn’t necessarily happened yet. It’s been very slow. To move. I’m somewhat surprised by that. I was expecting…

STEPHEN CLAPHAM: Why do you think that is? Because crypto is hitting new highs all the time.

GREG PETERS: I think it’s the muscle memory effect. There’s a recency bias. This is a market that there’s a very high majority of investors have only invested in. And this is what they know. And so the experience level in the marketplace has dipped. And it’s been this one aspect. In the markets and I think there’s a slow realization that we’re in a different market today.

STEPHEN CLAPHAM: And do you think there’s going to be something that will, you know, some catalyst that will just change things overnight or do you think it’ll just have people have to lose money before they kind of repair, you know, introduce more sensible, more cautious approach?

GREG PETERS: Likely a combination of both. A recession would clearly push that along. But you’re seeing it currently in the credit side. You’re seeing, you know, bankruptcies. You’re seeing bondholder groups behave very differently today than they’ve had historically.

GREG PETERS: It’s much more draconian. So investors are really starting to realize that details matter and where you are in the capital stack, covenants, all these aspects that haven’t mattered all that much. But it takes time. It takes time.

STEPHEN CLAPHAM: There’s one thing that I’m curious about in the government bond markets. Ken Griffin at Citadel recently said he was concerned there would simply be a day where a major auction fails and then you see a panic start to brew in the treasury market. And the question will be, how fast will the Fed intervene?

STEPHEN CLAPHAM: What panic will that induce? Because government intervention under duress often creates more panic. And then we see a flood of treasuries coming back into the market from holders around the world. He likened it to the great crash of 1987 when there was no warning. Do you think that’s a possibility?

GREG PETERS: Yes and no. It’s important to note in the U. S. The auction system is built that it can’t fail. You have this primary dealer component to it where dealers have to take down the auctions.

GREG PETERS: Now there’s other ways for it to be tenuous. It could tail, meaning it… And prices higher than where it was expected and other kind of worrisome signs. So I don’t agree with that necessarily. At the same time, debt levels are really quite high globally. This is not just a U. S. Phenomenon. Sure. It’s everywhere.

GREG PETERS: You’re getting a whiff of how important elections are. And strong governments in France. You had it with Liz Truss. And you constantly hear these Liz Truss moments. And the markets are really worried about that. The scary part about debt sustainability is that it doesn’t matter until it matters.

STEPHEN CLAPHAM: Yeah.

GREG PETERS: And you don’t know, right? So it’s an important issue that a few…

GREG PETERS: Investors are talking about, but it’s not a political issue as of yet. And there’s no change in trajectory until it becomes a political issue.

STEPHEN CLAPHAM: It’s a massive problem with the deficit. You’ve got low unemployment and still a deficit and all this fiscal spending. How concerned are you about the U. S.?

GREG PETERS: I am not overly concerned. I think the fiscal story at this point in time… Is more of a kind of politicized one than a real one, at some point you do need to see a path to fiscal restraint.

STEPHEN CLAPHAM: Where is that path? I mean…

GREG PETERS: Well, I don’t see it yet, Steve. You know, that’s the whole thing. But all fiscal isn’t created equal either. In the U. S., the fiscal side has been very different the past few years than what we’ve seen. The previous in the form of government programs like the IRA, the CHIPS Act, infrastructure bills, very different than just tax cuts. So the multiplier effect is different, I would submit.

GREG PETERS: But it is something that has to get under control.

STEPHEN CLAPHAM: I’m not at all expert in this, but the U. S. Government has been issuing very short-term debt, hasn’t termed out its debt. Why is it doing that? I mean, that seems a puzzle to me.

GREG PETERS: There’s a component of refunding and funding in the U. S. Treasury market called regular and predictable. What market participants want and expect is that regular and predictable. So it’s not achievable where all of a sudden. The government can kind of change where they issue based on what they think is rich or cheap.

GREG PETERS: That doesn’t create a sustainable bond market. It takes a long time, therefore, to change the maturity profile. But arguably, there should have been more money put out in the back end when rates were as low as they were. But there was a worry they would also crowd out the back end and hurt investments out there. So it’s a delicate balance for sure.

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STEPHEN CLAPHAM: You’ve got people like Senator Wicker proposing a jump in defense spending from, what, sub 3% to 5%. Are we going to go back to guns or butter?

GREG PETERS: And, I think.

STEPHEN CLAPHAM: Guns and butter.

GREG PETERS: That’s the story. This is the global fiscal story, which is where the concern ultimately seeps in. We have a more geopolitical, volatile world.

GREG PETERS: So defense spending will increase globally, not just the U. S. You’re seeing it across Europe as well.

GREG PETERS: At the same time, the energy transition will be a bumpy one. But that’s a double spend.

GREG PETERS: Countries have to spend for near-term energy security and then for the green initiatives and the renewables.

GREG PETERS: So I see fiscal spending on the margin higher, not lower, over time. And I’m not sure what the right number is in terms of defense spending, but my strong suspicion is it’s going to be higher everywhere. Not lower.

STEPHEN CLAPHAM: Yeah. But that’s a problem, isn’t it? Everybody’s got so much debt.

GREG PETERS: It is.

STEPHEN CLAPHAM: So, I mean, at some point the bond markets are going to say, well, hang on a second. This is the sums don’t add up unless you’ve got inflation. I mean, maybe you is that is that going to be the thing?

GREG PETERS: Exactly. That’s what I was going to say. It manifests itself most clearly through the inflation lens. And inflation, all else equal, I think will be higher, not lower here over the next 10 years or so. Everywhere I look, I see more inflation, not less.

GREG PETERS: You include post-COVID, this refitting of supply chains, also important from an inflation standpoint. Companies are willing to spend a little more. On supply chain control a little less efficient, which is inflationary, to make sure that they have a cleaner supply chain. And you add on the defense side.

STEPHEN CLAPHAM: Everything is And the energy transition because you have a duplication of Inflation, inflation, inflation.

GREG PETERS: So that’s on the margin. I don’t know what the actual calibration will be. Is it 2.72? I’m not sure. But on the margin, it will push inflation higher than the 2 percent, not below.

GREG PETERS: If you think about the world that we were living in the past 15 years, it was one of persistent undershooting of inflation. Yeah. And now I think we’re in an environment where there’ll be a persistence in inflation to the upside. And that changes how central banks behave, changes behaviors broadly.

STEPHEN CLAPHAM: And do you think we’re going to have, as a result of that, we’re going to have more volatile interest rate environment, more volatile economic cycles? That seems a logical corollary.

GREG PETERS: I think that’s quite right. I look at the world and I see a world where we’re moving to what used to be, where inflation will be more volatile, growth will be more volatile. It’s driven by factors that we talked about. The geopolitical factor and political factor is crucial in here and just drives more volatility.

GREG PETERS: As you have political systems that are more polarized, it just creates more unorthodox policy, potentially, and that creates more volatility as a consequence. What markets like and what investors like is the middle, right? With the risk of the tails coming into play, that manifests itself in a more volatile marketplace, more volatile growth and alike.

STEPHEN CLAPHAM: And in theory, that’s an opportunity for investors. But how do you set yourself up to cope with that? Because it’s really difficult in real life, in real time, to manage that sort of process.

GREG PETERS: All is equal. I think it has to manifest itself through higher risk premium. It hasn’t occurred yet, necessarily. But investors have to be paid for that additional risk. And I also think it manifests itself through inflation as well, which means likely higher bond yields.

GREG PETERS: But it’s not easy. It’s not easy to protect your portfolio from a low probability, high risk event. It’s just definitionally really difficult, mathematically quite challenged. And that’s the world that we’re in. And the geopolitical world is emblematic of that.

STEPHEN CLAPHAM: And higher bond yields, I mean, that’s not going to be good for equities either.

GREG PETERS: Not if it’s just purely inflation. If it’s growth with a little inflation, then it is.

GREG PETERS: You know, equities, you know, reset real, right? It’s a real asset. So it does actually okay in that environment. But it’s not the zero interest rate environment that helped so many equity companies along.

STEPHEN CLAPHAM: We touched on the corporate side earlier and the likelihood that there’s going to be more defaults. I mean, a lot of it’s going to be focused in the private end of the markets. And that’s a bit of a worry in the sense that there’s much less data available.

STEPHEN CLAPHAM: And I just wondered how you thought about the private credit market because it’s gone from, I don’t know what it was in a global financial crisis of about, it was less than a trillion dollars, maybe 800. $800 billion. Now, I don’t know, $1.7 trillion at the end of 2023. BlackRock estimates it will double.

STEPHEN CLAPHAM: So it’ll be $3.5 trillion by 2028, which is 15% per annum in a very, very large market. How should we think about that? Because in my experience, anything in finance that grows at that pace ends up in trouble. And that’s even more so in the credit world, isn’t it?

GREG PETERS: Yeah. So let’s zoom out. Why has there been such tremendous growth in private credit markets? It’s grown as a byproduct of central banks and regulatory constructs pushing it out there. Right. In order…

GREG PETERS: To stabilize the financial system, they wanted to diffuse risk. So they wanted to get the risk outside of the banking sector.

GREG PETERS: And so while there’s less systematic risk as a consequence, the opacity is far worse. Therefore, regulators just don’t have the same eye into what’s going on. And equally, they don’t have the same control if something does go pear-shaped. So that really drove that.

GREG PETERS: The other part that drove investors into that space was zero interest rates. Investors were looking for additional yield spread, carry, return, however you want to define it, and they would be quite willing to take the illiquidity risk and the opacity risk to do so.

GREG PETERS: So that fueled the growth in the private credit. What you’re seeing currently is the false and distress are actually higher on the private side currently than the public. So it’s already coming through and it will continue to come through that way. I would say as far as the growth is concerned, I’m not sure I agree with that assessment as I think the market will be.

GREG PETERS: Very different five years from now than it is today. And what I mean by that is this public-private divide will be no longer the case. What you have is this continuum of credit. You have what’s called public bonds, you have levered loans, and then you have private credit.

GREG PETERS: And what you’ll see increasingly is one credit market. So what we’re seeing currently, companies are using both private and public markets at their disposal. So we’re getting refinanced out of our private into publics and our publics into privates.

STEPHEN CLAPHAM: And why is that?

GREG PETERS: Because companies will use whatever they can to refinance.

STEPHEN CLAPHAM: So that’s because availability or price? Both.

GREG PETERS: It’s both. It depends on both.

GREG PETERS: But it’s highlighting to me that the credit market will just be this one credit market. If you rewind the clock, the levered loan market in the, you know, the 90s was basically how private credit is today. Why did investors like levered loans?

GREG PETERS: Well, it had a great sharp ratio because it wasn’t marked. So, you know, it had no volatility. It had better covenants at the time. And so I’ve seen this movie before on the levered loan side. And I think the next chapter here is private credit doing what levered loans have done.

STEPHEN CLAPHAM: I mean, the real problem with private credit area is that so much of it is to the private equity backed portfolio companies, which creates a tremendous conflict of interest.

GREG PETERS: And that’s where it’s going to be extremely interesting.

GREG PETERS: When the faults pick up and the stress picks up. So you’re hearing and seeing, I’m sure, this lender-on-lender violence going on, and we’ll see how that plays out.

STEPHEN CLAPHAM: And why do you think the regulators have been slow to get involved? Because, I mean, they started off with the intent of de-risking the banks, but they’ve ended up increasing the risk in the overall system.

GREG PETERS: It was one of those unintended consequences.

GREG PETERS: And the IMF just put a great report out in the spring on private credit.

STEPHEN CLAPHAM: And they were quite scathing. I mean, they said this needs to be regulated. Does anybody listen to the IMF? I don’t know.

GREG PETERS: Well, that’s a good question.

STEPHEN CLAPHAM: Don’t worry, IMF. We’re reading. We’re reading it.

GREG PETERS: No, yeah, no, no. I’m quite friendly with the office. Author too.

GREG PETERS: It’s highlighting the issue. It takes time for it to change. But I do believe that there’s a worry that there’s no control. But even in the IMF paper, they readily admit that the data are so light that they really kind of not sure what they’re analyzing either. So it’s a challenge. But I do think it’s one that works itself out just through market structure as those lines become blurred.

STEPHEN CLAPHAM: Seems to me, I mean, getting some sort of more extreme instruments coming in, which I always think is a signal of a problem to come. So Grant’s interest rate observer said more lenders are taking more risk for less reward.

STEPHEN CLAPHAM: And they’re talking about the PIKs, the payment in kinds, and synthetic PIKs, which, as I understand it, a synthetic PIK is a loan without any cash interest payments to service the interest in another loan. If I tried to explain that to a non-financial person, they would look at me like I was crazy. Why does this even exist?

GREG PETERS: It is a vehicle or a mechanism to allow the company to be a going concern. And limp along and fight another day potentially.

STEPHEN CLAPHAM: But this is like worse than equity. These are very, very risky instruments. Where is the money coming from? It’s from the private credit funds.

GREG PETERS: It’s oftentimes investors who are already part of the capital structure and they’re looking to protect their current investments. It’s a way of biding time potentially, but it’s not a long-term solution.

STEPHEN CLAPHAM: No, of course. It’s kicking the can down the road.

GREG PETERS: It’s like, let’s save cash. Cash flow is key, of course. And preserving that cash, you know, hopes for a better day to survive, you know, potentially turn it around. That’s the idea behind it. Rightly or wrongly. Probably wrongly.

STEPHEN CLAPHAM: Well, I mean, I can understand. It’s perfectly logical that you want to try and protect your existing investment. But, I mean, this whole area just seems to be slightly… to my sort of simple eyes as an equity investor, and it seems very risky.

STEPHEN CLAPHAM: Moody’s downgraded three business development companies, and in grants, they quoted a private credit executive saying, things are deteriorating. The economic backdrop isn’t that bad. Can you imagine how it would be if we actually had a contraction? If we do get a recession, it’s going to be awful, isn’t it? It’s going to be quite messy.

GREG PETERS: I do think it will, what I keep calling the… Classic credit cycle. We will have a much higher default rate that’s longer. The last few credit cycles were, you know, over before it even started, you know. So I think that excess needs to clear out of the system. But I do agree with that sentiment.

GREG PETERS: This has been a very strong macro backdrop. And you’re, you know, seeing companies flail. And they’re flailing potentially because they can’t handle the higher cost of capital. It’s a very different business model operating at a zero cost of capital versus 7%. That’s where we’re at.

STEPHEN CLAPHAM: Tell me, when you’re sitting in your seat, how does foreign exchange factor into your thinking? How do you look at the relative merits of government bonds in different countries and interest rates? And how do you manage that?

GREG PETERS: Yeah, so the FX market has also been a very difficult one in the era of zero interest rates. What you’re seeing currently in FX and the global bond markets as well is a greater differentiation.

GREG PETERS: On the FX side, you continue to have this dollar dominant story that I think is a long tenor. I’m a long-term dollar bull.

STEPHEN CLAPHAM: So even from here?

GREG PETERS: Yeah. Yeah. I mean maybe not the same kind of upside but A kind of a core thesis that we have that I have is U. S. Dominance. And I think that translates in a stronger dollar. And, you know, I think that’s going to be the backdrop for quite some time.

GREG PETERS: But the differentiation is crucial. Correlations have dipped. So it’s no longer this global market of one. And so FX and… Global sovereign bonds, I think the value proposition there is much greater today than what we’ve seen over the past five, seven years or so, for sure.

STEPHEN CLAPHAM: And do you have a sort of DM versus EM view? Or how do you think about the world when you’re dividing up?

GREG PETERS: We do.

GREG PETERS: We definitely think about it at DM versus EM. Then with the EM, obviously, there’s, you know, different aspects to it as well and different blocks. But, you know, emerging markets, I think. Very much tied to developed markets still. You’re seeing a lot of the over-leveredness of some of the frontier markets of EM, for example, struggling.

GREG PETERS: But IMF programs and other programs are coming in and helping these countries out. But what I’m happy about from an overall investing standpoint is I believe we’re in this world, once again, differentiation, EM, countries, different growth rates, different inflation, different central bank patterns, same thing on the developed market side.

GREG PETERS: And it’s just creating more opportunities to invest.

STEPHEN CLAPHAM: So there’s a relative risk reward now changed because in DM, you’ve got all the debt. And the EM, many of these countries have got a much safer financial position than they did pre the Asian crisis. Does that sort of tilt your thinking?

GREG PETERS: That has been the case for quite some time.

GREG PETERS: You know, thinking about France is a great example. Yeah. So France is a country that, you know, many people like myself have labeled it more of a peripheral country than a core here in Europe. Didn’t matter. And now it seems to matter. And thinking about a core versus periphery in Europe, that’s inverted.

GREG PETERS: That differentiation that was so defining. Is no longer the case. You know, you think about Spain, for example, it’s behaving much better than Germany and France. So those lines that were drawn, you know, the past 15 years no longer make as much sense. And I think the same relates to EMDM as well.

STEPHEN CLAPHAM: And in Europe, since you touched on it, I mean, there seems to be a sort of pressure for… Individual governments take more control over their own monetary affairs.

STEPHEN CLAPHAM: I mean, that spells the end of the euro. I mean, what do you think will happen there?

GREG PETERS: I think Brexit was a warning shot. And I think, if anything, that brought the euro closer, not further apart, if anything. I know it’s a tenuous conversation right now with everything going on in France.

GREG PETERS: You’re definitely seeing a rise in political I’ll just call it extremism across Europe across the globe and so it’s a much more of a wild card a factor but if you look at some of the rhetoric even coming out of Le Pen and her camp it’s very different than what it was in 2016 there’s there’s more of a a nuanced approach to being part of the euro than what was stated back then.

STEPHEN CLAPHAM: Yes. No, well, we’ll watch and see what happens. I just wanted to go back to, sorry, we’re jumping around a bit, but just back to the United States and the Silicon Valley bank collapse. And you saw a very, very fast repricing on the front end. Inflation was still very high.

STEPHEN CLAPHAM: It seems like the markets are, you know, they often have very, very extreme reactions. And I just wondered, you know, how do you, you know, in the credit world, how do you cope with that? Because it must make life very difficult managing portfolios.

GREG PETERS: The microstructure of the market is vastly different today than what we, you know. Were contending with five years ago, 10 years ago. The rise of CTAs and algos, it’s a much faster response function.

STEPHEN CLAPHAM: Even in the credit world?

GREG PETERS: Even, yeah. It’s everywhere. And so you have just these more violent moves as a consequence. The Silicon Valley bank example was really an important one. And it highlighted to me.

GREG PETERS: That the market has it wrong. And so let me explain why. As you mentioned, this was a time when growth was pretty good. Inflation was 6% or so at the time. And the initial reaction from the bond market was essentially a 200 basis point instantaneous cut. Now, banking crises are scary, so I don’t want to minimize that risk. But To me, it missed the fundamental concern of central banks, and that was inflation fighting.

GREG PETERS: And what you also saw quite clearly was the playbook going forward. It’s not about interest rates as much as it is about these different policies they put in place from lending facilities, other types of programs. So they liquefied the markets. Quite significantly through these programs, and they didn’t touch interest rates.

GREG PETERS: So to me, that was the lesson where central banks are not just going to be so quick to cut rates. To save the day because they can’t because they have to fight inflation now. It’s about these other programs. So if you’re hedging your portfolio or thinking of it simply through a rate lens, I think you’re missing what central banks are really trying to achieve here.

STEPHEN CLAPHAM: So have we seen the end of the Fed put?

GREG PETERS: I think to the degree, yes. I mean, you will have some, but it’s not the same type of scope that we’ve seen before. I’d be hard-pressed to envision a backdrop where interest rates get anywhere close to zero again. That was a failed experiment. Books are written already on the unintended consequences of that.

GREG PETERS: There’s no desire to go back there. The market sold trades with a central bank put option to it, and I still think that’s a mistake. So there is some scope to move rates lower, but… It’s not nearly as much as the market will price in. The market will overshoot pretty dramatically, in my mind, how much capacity central banks can cut.

STEPHEN CLAPHAM: It’s been really fascinating for me to hear your perspective on the world. And you’ve obviously got a very different lens that you look through. One question we always ask people is, what advice would you give? What book would you recommend to a young person looking to come into the industry? And we normally ask equity investors that question. I’m interested in the advice to a potential credit analyst.

GREG PETERS: Yeah, I love all the financial history books.

GREG PETERS: I think they’re critically important to understand history around the markets, how the future might shape. But there’s a few books that I think are really quite important here. The first one is… Caesar’s Palace Coup.

GREG PETERS: We talked about the lender-on-lender violence, right? And so this is a fascinating book, true, on the bankruptcy of Caesar’s Palace.

GREG PETERS: It’s important because it just demonstrates how different the distress market is today than what it was. It’s much more brutal. And as we enter into, you know, a more significant default and distress cycle, I think this is a must-read book and a cautionary tale. So that’s one that reads like a novel, but it’s a chapter and verse of really what happened.

GREG PETERS: And then just going back in time, you know, you could watch the movie too as well, like, but Barbarians at the Gate once again talks about, you know, the consequences of debt and LBOs and private equity. And it’s still quite relevant today. And then, you know, coming from Morgan Stanley, I think a great financial history book is The House of Morgan. I think that’s a must read.

STEPHEN CLAPHAM: Do you read a lot of financial books?

GREG PETERS: I do. I do. I try to read a lot of non-financial too.

STEPHEN CLAPHAM: What else do you read?

GREG PETERS: Well, I like to read history books. You know significant figures like i just finished up the Napoleon book all right you know Alexander great i i just feel you just learned so much and then another book i’ll throw out i’m sure others have thrown out which i think is a must read is chip war i’m always behind you know the new books come out and part.

STEPHEN CLAPHAM: Of the one of the things about doing a podcast is that you often end up having to read read people’s books so i’m always behind and chip wars is in my very elevated reading pile.

STEPHEN CLAPHAM: I know I’m in trouble when the pile starts to topple over and it goes into two piles. We’re now in two and a half. But that’s a great way to end. Greg Peters, listen, thank you so much for your time. I really enjoyed our conversation. Thank you for being here.

GREG PETERS: No, thanks for having me.

STEPHEN CLAPHAM: Greg Peters, welcome back. We’re very slow in getting our recording from the summer out and published. So I thought it’d be a good idea for us just to have a quick catch up because… Quite a lot has happened since the summer. And of course, the most significant event has been the election of a new president. So President Trump’s coming in. Are the equity investors are delighted? What are the credit investors thinking?

GREG PETERS: I think there’s a tremendous risk on environment, you know, across all different markets, right?

GREG PETERS: Credit, equities, crypto.

GREG PETERS: You name it, right? There is a euphoria out there. And it’s really curious because this euphoria is based on very much of a… A trust factor around the things to come. And so, yes, the election has been decided in the U. S., but the uncertainty has been far from decided. So there’s a lot of open questions.

GREG PETERS: And as we think about 2025, we think about the hurdle rate, right? The hurdle rate is extremely high. Valuations are much richer. It’s putting a lot of pressure. On companies and markets to really hit these high expectations, whether it’s in earnings, cash flows, you name it. And so it’ll be an interesting 2025 just by virtue of that alone.

STEPHEN CLAPHAM: And obviously, there’s a wide range of potential outcomes. President Trump’s one characteristic that I think everybody can agree on is he’s unpredictable. And what are the sort of things that you are looking for? That will give you a hint as to the path that we may go down, excepting that you may turn around and move 100%. But what’s the roadmap we should be thinking about?

GREG PETERS: Yeah, so there is a sequencing that’s important.

GREG PETERS: And so let’s kind of walk through it, right? If you think about the four pillars of kind of the Trump policy, It’s tariffs. Immigration, tax reform, and deregulation. What you’ll see early on in the administration, you’re actually seeing it now as far as at least jawboning, is tariffs and immigration are on the come. So that’s kind of first order business. That doesn’t require congressional approval.

GREG PETERS: Effectively, that’s a stroke of the pen. So what you’ll see early on maybe the first day or the first week, is a movement on tariffs and movement on immigration. Now, the markets are discounting kind of the adverse effects of that. They’re expecting kind of rational players to do rational things.

GREG PETERS: And the markets are kind of de-emphasizing those potential negatives. Either way, it’s a negative, right? It pushes up inflation on the margin and it pushes down growth on the margin. So that’s going to happen, just call it day one. And then the market positive items like deregulation, like tax reform are on the come. And so what you’ll have, Steve, is a gap.

GREG PETERS: And the markets are going to have to wonder during that gap period. How those policies are really going to be formulated and how positive they’re going to be. So, you know, to me, there’s a sequencing issue from a market standpoint. All the positives are being amplified and all the negatives are being kind of swept under the carpet. So that’s the roadmap for, I think, the first half of next year.

STEPHEN CLAPHAM: But that implies that there’s much greater risk, right? Because We’re getting all the bad stuff first. And then we hope that Elon Musk, genius that he is, will be successful in cutting trillions off your very high deficit. But the record in history, and I know you’re a study, you like to study financial history. The record of businessmen going in and sorting out governments is pretty bad, right?

GREG PETERS: I think that Doge.

GREG PETERS: I think it’s important. Important that that acronym was selected. That was the coin. That was the joke coin, right? So I’m not sure how tongue-in-cheek this is supposed to be. But either way.

GREG PETERS: I think that’s overly hopeful.

GREG PETERS: It’s important to focus on the deficit. Deficits are a problem everywhere.

GREG PETERS: And markets will hold. These countries to task. You’ve seen it in the UK, you’ve seen it in France, you’re starting to see it.

GREG PETERS: So it is important. But this, you know, Musk agenda of Doge, the first point that I think is important to note is it’s not a government agency, right? It’s just a group and it’s not a part of the government. The second is…

GREG PETERS: You know, the outlays of the U. S. Government, just a little over $6 trillion. You go through, you know, discretionary, non-discretionary. You have military. You have Social Security. You have Medicare, Medicaid. Basically what you’re left with to play with. Is a little less than $900 billion, which is a big number, of course.

GREG PETERS: But that is the pool to play with. So when you hear about trillions being cut, that just doesn’t add up mathematically. And then there’s talk about we have too many government workers. If you slash the entire government workforce, that’s less than $400 billion. So just to put it in perspective, it is a It is a numbers problem.

GREG PETERS: And so I would really heavily discount how much can really be done on that front.

STEPHEN CLAPHAM: So do you think we’ll get a wake-up moment and the stock market will suddenly, bond markets suddenly come in one morning and think, oh man, this is net. This isn’t as good as we hoped. I mean, that seems the risk, right?

GREG PETERS: That is the risk. And what makes that a concerning risk? Is there’s no magical number, right? It’s one of these risks of the unknown. The markets just wake up at one point and they decide like, this is a problem, right?

GREG PETERS: If you think about kind of the extreme example of the UK mini crisis or a budget crisis, that was just a bridge too far and the markets just penalized it heavily, right? And so you’ll get a whiff or a flavor of that, I think. And once again, you know, I think what’s been happening in France is also another wake-up call, right? The markets have been quite punitive around the politics in France, right?

GREG PETERS: Why is that? Because the deficits are so high and there’s so much debt. So if there’s one story for 2025 and beyond, it is the sheer amount of sovereign debt hitting the global marketplace. It’s just astoundingly high number. And so the stakes are soundly high as well.

STEPHEN CLAPHAM: Interesting. We’ve had a change politically in Germany, and the stock market’s up, I know, 7%, 8% in the last month since we had that change. And the French stock market’s up a couple of percent since we had the change of prime minister. So, I mean, change is a good thing, it seems. But I just wanted to move quickly outside the United States because… Geopolitically, it’s been a fascinating couple of months.

STEPHEN CLAPHAM: And when we spoke in the summer, I mean, we wouldn’t even have thought of Syria, let alone South Korea. They just weren’t even something we’d think about. It sounds a stupid question. Should we expect more surprises next year is the question. Obviously, you don’t expect a surprise, but it’s becoming a much more geopolitically changing landscape, isn’t it?

GREG PETERS: Yeah, to quote Hemingway, gradually then suddenly, that’s what we’re seeing geopolitically. But what’s been happening has just been at an astounding pace. So you’re quite right.

GREG PETERS: And that’s been our kind of base case, so to speak, that just geopolitics would take center stage in a way that we haven’t seen for years. But even with that, we’re… We’re surprised at how quickly things are occurring. So I do believe that this is the world that we’re in.

GREG PETERS: I don’t see that changing.

GREG PETERS: You look at just the elections themselves, right? You mentioned Germany, Austria.

GREG PETERS: There’s a populist rise.

GREG PETERS: Which just creates broader volatility geopolitically.

GREG PETERS: And so, yeah, this is the world that we live in. And I don’t see it changing. I honestly don’t see it changing. And investors have to adjust to it because investors have been paid largely to ignore geopolitics. And the question is, will that be a successful strategy going forward?

GREG PETERS: I don’t think so.

STEPHEN CLAPHAM: What do you do? I mean, how do you protect your portfolios? I mean, you’re not likely to have much Syrian debt in your portfolio, to be fair. But South Korea, big, established, but highly successful. Economy. Well, how can one protect?

GREG PETERS: Definitionally, it’s quite challenged, right?

GREG PETERS: But I think the way it manifests itself and the way investors protect themselves is just through the overall risk management structure. And so what I mean by that is with the volatility, with the uncertainty, risk premium at all is equal, should be higher, not lower. Right. And so the paradox that we have is that markets have really been quite strong. Risk premium has really shrunk.

GREG PETERS: Yeah. At a time, you should be expecting more, not less. So I do think we’ll have this reconciliation, so to speak, on the come. But the way we’re thinking about it is that we need to get paid for that additional uncertainty, that risk. That’s not a novel concept, right?

GREG PETERS: That’s like kind of finance 101. So we’re trying not to get sucked into it, but I think you have to just… Hold less risk as a consequence. I think these bolt from the blues geopolitically are such where you can’t run a portfolio as hot as maybe you would ordinarily want to.

GREG PETERS: That’s the first step.

GREG PETERS: And the second is, I think investors have to kind of call through their portfolio and then be much more disciplined. There’s a… A tagline about holding lazy longs, right?

GREG PETERS: So investors are broadly diversified and diversification is important, of course, but in this environment in particular, you have to kind of go through and call the herd. And if there’s inappropriate risk rewards, you need to kind of get out of those positions instead of just holding them on for the sake of diversification.

STEPHEN CLAPHAM: So are you sort of less diversified then? I mean, naturally, this sort of environment would lead you to a broader portfolio. Or is it just you get rid of the riskier stuff and have a broader spread of the less risky stuff?

GREG PETERS: Correct. And so, like, the way we’re doing at PGM Fixed Income in my portfolios is that we’re diversifying away from those types of items. And so, like, a big investment thesis that we have is in structured products. So structured products are relatively immune to the geopolitical landscape, right? You have the embedded diversification of the collateral. You have subordination. They’re less correlated to these types of items.

GREG PETERS: And so it’s less of a macro trade. It’s more of an idiosyncratic trade. And I think, you know, when you think about the future, you want to have less kind of macro driven. Factors in your portfolio and more idiosyncratic factors in your portfolio. And if you lose through the idiosyncratic factors, then that’s on you as the investor, right? Because you control that, or you’re closer to controlling that than the macro.

STEPHEN CLAPHAM: So it’s what I would call a stock picker’s market. Correct.

GREG PETERS: Yeah, yeah. That’s a better way of saying it.

STEPHEN CLAPHAM: Well, I don’t know what the… Obviously, with credit, it’s very different. And anything else, just before we go, anything else we should be thinking about for… 2025?

GREG PETERS: Yeah, I think 2025 is going to be very much a continuation of 2024. And I know that kind of goes against the outlook season, right? We were talking about earlier about how it’s outlook season and it’s like the turn of the calendar changes everything. And I don’t think that’s necessarily true. We’re talking about geopolitics. I don’t think January…

GREG PETERS: 15th is different than December 15th necessarily. Now we are getting a change in administration in the US. So some of those things change on the margin, but by and large, it doesn’t. But 2025 is about management of risk reward. And so from a macro standpoint, I’m not overly concerned from a macroeconomic standpoint. Yes, there’s this continued kind of heightened tale of recession.

GREG PETERS: All the stimulus in the system and all these factors is probably lower than what we’re stating. But macro is pretty good. It’s the valuations for that macro. So all the good news is in the price and then some. And so I traffic into credit markets, as you know, and you look at credit spreads and they’re in the top decile or the richest decile that we’ve seen.

GREG PETERS: The U. S. High yield bond market is 20 basis points. To the all-time tights. So I’m not concerned about the macro, but I’m concerned about the reward that I’m getting in high yield as an example to invest in said macro. So I think 2025 is about discipline, not getting sucked in as there’s a lot of euphoria and ensuring that you’re properly calibrating risk reward.

STEPHEN CLAPHAM: Greg Peters, that’s fantastic. Thank you so much.

GREG PETERS: Thank you.

STEPHEN CLAPHAM: Well, Greg. Peters is a serious and thoughtful long-term investor. My biggest takeaway was how PGM uses scenario-based forecasting. I teach my students not to rely too much on single-point estimates, but to think of a range of probable profit outcomes. And it’s interesting that a major credit investor deploys a similar strategy.

STEPHEN CLAPHAM: I really enjoyed talking to Greg, and it was great that second time around, we did manage to talk about the current state of markets and their prospects, as well as the geopolitical outlook, on all of which Greg has interesting views. As ever, I hope you’ve enjoyed this episode. And please, if you have, do leave us a five-star rating on Apple. Podcasts or Spotify. Thank you, as always, for your support.