Strategically Speaking: Muzinich & Co
We are living in Disneyworld,” says George Muzinich, the CEO and chairman of Muzinich & Co, a New York-based investment manager specialising in corporate credit.
He is referring, of course, not to his firm, but to what he sees as the unreal character of the financial markets at present. “Disneyworld is an artificial construct. It’s something which is a make-believe land and it doesn’t reflect reality.”
The allusion is clearly to the protracted period of ultra-low interest rates and extraordinary monetary policy. “Negative interest rates and the related monetary policy is not based on the reality of markets.”
He switches metaphor to describe extraordinary monetary policy as a powerful drug with dangerous side effects. “What you are doing is constantly trying to keep a patient alive through chemical means,” he says. “The longer you are on that kind of stimulant the more difficult it is to wean yourself off of it and that, I think, is the danger.”
For Muzinich there may be short-term beneficiaries, but over the long term there are losers everywhere. There are inter-connected problems for savers, investors, financial institutions and corporations.
The most obvious difficulties are for savers. Low official interest rates mean poor returns on savings accounts and government debt. In some cases, with some bonds yielding negative interest rates, savers are paying for the privilege of losing money. “For retirement savers, it’s a real problem,” says Muzinich.
Then there are the problems for the banking sector. Commercial banks traditionally make the bulk of their income from their net interest margin – the difference between the interest they pay and the interest they receive. The low level of interest rates has squeezed this primary source of earnings.
A take-off of inflation remains, for Muzinich, a possibility. He acknowledges that, while many have warned of such a risk for years, it has so far failed to materialise. But in his view the danger of inflation is too often “dismissed in a very cavalier way”.
There are several mechanisms through which inflation could take off. “Any one of dozens of things could provoke it,” he says. For instance, a sudden surge in oil prices.
The investment implications of such a shift could clearly be substantial. The real value of debt, for example, could quickly depreciate. Those who are heavily indebted would benefit substantially but those who are holding the debt would be the losers.
For companies, the picture is mixed. In the short term, many have benefited from access to cheap credit, although it could create long-term problems. “It is terrific for corporations, but then it is inducing them to borrow more and more,” says Muzinich.
However, becoming highly levered creates problems for companies not prepared for an unexpected downturn. “They don’t think about what happens if you have a recession, your business isn’t that good, you can’t sell your products that easily, you’re burdened with a balance sheet of too much debt.”
“What you are doing is constantly trying to keep a patient alive through chemical means. The longer you are on that kind of stimulant the more difficult it is to wean yourself off of it and that, I think, is the danger”
Muzinich sees particular problems in the BBB-rated segment of the credit markets. “Their fundamentals have deteriorated,” he says. “You have had a tremendous amount of borrowing by investment-grade companies and a lot of these companies have much more leverage than they used to have.”
“You cannot just invest pell-mell in investment grade and feel it is all super-safe.”
Muzinich’s claims about the Disneyworld character of contemporary investment may be true, but they beg a difficult question. How can an investment manager provide good risk-adjusted returns in such precarious conditions?
It should come as no surprise, given the business he is in, to hear Muzinich contend that successful investment in credit is possible even at present. He sees credit as an asset class that can do well in good and bad times. The pre-condition is having a judicious approach to asset management.
“The first and foremost rule for us is capital protection – to not lose money – and with that in mind we will get you a decent return. So we will take as little directional risk as possible.”
From these premises it follows that it is important to look carefully at individual firms. In relation to each, the investment manager must consider several key criteria. These include the extent of downside protection, the amount of stress it can take before running into serious problems and an assessment of the risks the enterprise faces in times of difficulty.
However, it is not just a matter of examining a company’s balance sheet or its profit and loss account. “It’s not just the financials of a firm but also the soft factors such as the quality of management,” Muzinich says. “No company, no matter how good it is, can avoid being destroyed by bad management. So you have to assess multiple factors.”
Although the analytical focus is on individual enterprises, the importance of sectors should not be ignored. For example, if the steel industry is doing badly then companies in that environment may face difficulties.
With the danger of higher inflation, he warns against having too high a proportion of a portfolio in long-duration assets. “Don’t put all your eggs in the basket of 30-year paper because you might get a surprise and then you’re going to suffer the loses pretty hard.
“The way to protect yourself is to have shorter-duration assets that are still generating nice returns.” Even if we are living in Disneyworld, as Muzinich suggests, he is confident his firm can generate reasonable returns