Q3 2020 Outlook: The State of The Credit MarketsQ32020Outlook:TheStateofTheCreditMarkets

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  [Cameron Lochhead is the first speaker]

  [AUDIO: Welcome, everyone, to PGIM's State of the Credit Markets, Downgrades, Defaults and Opportunities. Good morning, afternoon and evening to our impressive global audience today. And thank you for joining us for our live webinar here on July 23rd. I'm Cameron Lochhead from PGIM's Institutional Relationship group, and I'm joined today by my expert friends at three specialized PGIM asset managers with very different perspectives. As you can see from their impressive bios, my guests average about 30 years of experience in their respective debt markets.

  And today we're going to be diving into investment grade, high-yield, fallen angel public bond markets, commercial mortgage debt underwriting and investing, and direct lending and mezzanine financing to middle-market companies. As many of you know, PGIM and Prudential's insurance legacy means we have a long history of debt investing, and specifically credit management. Today's format is a radio talk show style with a lot of interaction amongst our speakers. I hope you'll feel that. And we invite you to jump in with your questions during our 20-minute Q and A at the end. We'd like to now extend a warm welcome to our experts. First, Ms. Jackie Brady, a global debt product specialist and executive director from PGIM Real Estate. Jackie and her colleagues look after a commercial real estate mortgage debt portfolio of more than 70 billion dollars. And this group is very well-known as one of the largest non-bank lenders in the world. Say hello, Jackie.]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Thanks, Cameron. Hello, everyone. Delighted to be with you today.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Itís great to have you. And then Mr. Jeff Dickson a managing director and head of alternatives at PGIM Private Capital. Jeff and his teammates originate and manage over 90 billion dollars of investment-grade, mezzanine and direct lending assets, mainly to middle market companies with more than 14 offices around the world. Jeff, tell the audience you're with us.]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: I am with you. Greetings.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: All right, great to have you here. And finally, our third expert's Mr. Steve Kellner. Steve is a managing director and head of corporate bond portfolio management at PGIM Fixed Income. He and his team run over 300 billion dollars of investment-grade fixed income securities, and he works very closely with the high-yield team run by Rob Signorella and has some interesting insights on fallen angel markets. Steve, wave and say hello to the crowd.]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Hello, everybody. And thanks, Cameron. Really exciting times on the credit markets right now, so glad to have this opportunity to speak to you all about it.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Well, the timing is really interesting. People have asked, what is our objective of today's discussion with you all? And really the goal is to deliver some fresh ideas and a longer-term view on the fragile debt capital markets.
  On one hand, it's an issuer and borrower's paradise, right? Everybody's refinancing. Everybody we know, everybody's refinancing their homes. Companies are refinancing long-term debt. But on the other hand, fiduciary investors like many of you on the call have to make prudent decisions about asset allocation.
  And this is all the while navigating personal and professional impacts of the COVID pandemic. We've got lower for longer interest rates. We have central banks with hyper-stimulus, and a huge wall of worry about what's coming next with disrupted national economies. We have dislocated industries, bankruptcies on the horizon, and then the likely restructurings in the aftermath into 2021. But this is no problem for our panel of experts on this call. Brian Chipata from Bloomberg -- I was doing some research yesterday, and Bloomberg news ran a very interesting opinion piece which reminded us that investment-grade bond yields today averaged just over 2 percent. And he also suggested the Fed's new support facilities are now forcing credit investors like many of us on the call to take more and more risk to deliver yield with triple C bonds like American Airlines and WeWork. They were trading at par in January. They're now trading to yield 20 percent plus. We've also read headlines about missed rent collections in places like New York. Crisis in the CMBS markets means leverage funds are shutting down. And the implosion of retail trade and restaurant receipts. And this working from home deal doesn't feel like it's -- feels like it's going to be with us for a long while. So, it's a yield-starved world to be sure. Where do we turn now for coupon income and total return? For me, that's a key question I get from a lot of chief investment officers that I speak with. What do we overweight? What do we underweight in our portfolios? Big questions to answer. We hope to challenge your current thinking on the unfolding drama and leave you with a couple of fresh ideas today. Before diving in with Steve Kellner, I'm going to give you a few details to help improve your experience. On the screen are multiple boxes. But the most important one is the Q and A box. We encourage you to submit questions at any time, and we will try to answer all questions during the webcast. But if we do run out of time, we'll make every effort to answer your questions via email. Also, there's an on-demand version of the webcast which will be available after today's event for colleagues who may be interested. Okay, let's get to our discussion which we will conclude at the top of the next hour. Steve let's start with you. Thinking about the big picture, what's happening? What's happening with the Fed stimulus and the economic outlook for not only the United States and our capital markets, but how is that ripple effect of the pandemic impacting credit in your world?

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Well, Cameron, obviously the shutdown of the US and the global economy due to the virus has devastated economic growth. And then here in the States, specifically the first quarter was down 12 percent. The second quarter looks like it's going to be down 15 percent. We're in the midst of the recovery right now.
  Economists' best guesses which seem reasonable is that US growth for the full year is going to come in at about minus 5 percent. And that's about the number globally as well, with Europe being down more and then China being down a little bit less. I'd say that, you know, recently with the virus flaring up and spreading, you know, at probably a greater rate than expected, it feels like it's going to delay some of the reopenings. Maybe we'll even get some more closures.
  So maybe actually the GDP number comes in a little bit weaker, maybe as weak as 7 or 7.5 percent. So pretty tough environment. Now, this crisis has been met with really aggressive fiscal and monetary policy. You know, really strong intervention by our own federal government and central bank, and then federal governments and central banks around the globe. Our administration has done 2.5 trillion dollars or 12 percent of GDP stimulus so far. Obviously, they're negotiating, you know, another 1 to 2 trillion dollar package as we speak right now. The Federal Reserve has cut the rates to zero, stated, you know, out loud that they expect it to stay at zero until the end of 2022 and stay really accommodative until employment recovers. And quite honestly, that looks like that's going to be, you know, two or three years. So, you had mentioned low for longer. We think that that's absolutely the case. The Fed has put in place, you know, numerous liquidity programs to facilitate the recovery in the bond markets which is allowing all of this refinancing to take place. They've also included, you know, significant direct purchase programs, right? So, the Fed is using their balance sheet that began at 3 trillion dollars. They're buying in now 80 billion dollars of Treasuries per month, 40 billion dollars of mortgages per month. They're up to over 7 trillion dollars right now on their way to 10 trillion dollars. They're flooding the system with cash and liquidity, and that cash and liquidity, you know, is starting to make its way into the risk markets. And that's part of the reason why the stock market and the spread markets are probably doing better than most people would have guessed at this stage of the recovery. The Fed is also for the first time buying corporate bonds, you know, investment-grade corporate bonds, triple B or better. The program that they've come out with and the protocols call for as much as 750 billion dollars. It's in place until the end of September. However, the Fed has made it clear that they're going to reevaluate, and they could, you know, increase the program if necessary, or even extend it if necessary. And then these purchases also, you know, include recent fallen angels, you know, such as Ford and Macy's as an example. On average, the Fed's been purchasing about 1 billion dollars of corporates a week, so they're up to 12 billion dollars. Not a huge amount. They've been relatively constrained, but maybe that's been because of the recovery and spreads that we've actually seen. And the significant improvement in the functioning of the credit markets. Having the Fed as a backstop for the credit markets has been incredibly powerful and really increased confidence and has allowed a lot of allocations into our market to take place. Chairman Powell has not been shy at all about stating that he intends to use it, tends to use it to help corporations so that this could keep employment improving and help that to recover. And that seems to be the number one goal right now, is to really try to help the employment situation, which is very, very challenged.]

  [DESCRIPTION: Cameron Lochhead cuts across.]

  [AUDIO: Yeah.]

  [DESCRIPTION: Steve Kellner continues speaking.]

  [AUDIO: Iíd say that spreads have recovered about 80 percent, and we expect them to go all the way back to pre-COVID levels which the Fed has talked about as well.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Well, that's quite a forecast, Steve. You know, just to follow up on the central banking stimulus, the ECB agreed on a package just this week, a massive historic package. How does that change the picture, if at all, for credit investors?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Yeah, I think it kind of just honestly just feeds the liquidity fire that's actually out there right now. And again, it just helps facilitate more risk-taking, again, really trying to help businesses and companies and individuals so that they can get through this downturn. So pretty powerful for the risk markets.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah, there's a lot of money sloshing around the system. Jackie let's go to you and the commercial mortgage market. You know, there's a lot of depression, arguably, in real estate prices. There's certainly a negative reaction to what's happened in the last 4 to 5 months. But it also means there could be some great opportunities for global real estate investors. What do you see in your markets?
  And what do you see as some of the biggest risks in the commercial mortgage debt market?]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Well, Cameron, as you know, after almost every downturn, investors go clamoring for distressed debt opportunities. After the global financial crisis, there was, you know, CNBF delinquencies were high as they are today. There was a wall of maturities coming. And distressed debt emerged, but not in the scale as we might have expected given the tendency of lenders and credit providers at the time to pretend and extend was the phrase. Even though I don't like it, we weren't pretending -- we just weren't panicking. But the ability to restructure the debt at the time yielded up fewer opportunities than we might have imagined.
  This time it's different for a number of reasons. There is less leverage overall in the system. I mean, real estate has not returned on the debt side to the level of excess lending that we saw leading into the global financial crisis. And the impact of distress this time will be more dispersed, both regionally as the pandemic has shown, and also by sector and property type. So most immediately, we have seen, you know, kind of especially in our book, requests for borrower relief impacting say hotel or retail assets. But we know that there is a fair amount of pain to come in office for example, and our thinking about office uses around the world. And so, in our view, distressed is going to emerge and opportunities are going to come to light for investors because as we often say, duration is the enemy of solvency. So, I think at this point we're not seeing them yet, but we're expecting that they will emerge. The opportunity to acquire assets at a better basis than we've seen for quite some time.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Jackie, you have offices all over the world originating mortgage debt.
  You know, you go out to the buildings, you meet the owners. How is the origination world changed since January for your colleagues?]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Well, in terms of -- you know, in terms of the practice of origination, you know, we are -- everyone is doing things that we didn't do before, right?
  So, we have drone videos of assets now coming into us. You know, borrowers are creative in terms of our being able to view their assets. But if you think about what we are trying to do in the core of our real estate portfolio which is to think about long-term trends -- and the long-term trends are what drive our investment strategy even as short-term structure is what we use to mitigate against predative events. So, what has changed for us are the long-term trends.
  And what we're still trying to evaluate is what will be those post-COVID long-term trends, right? And so there already had been a movement towards re-densification. You know, we'd gotten too tight on office space, for example.
  We had already seen moves pre-COVID to greater interest in suburban locations for housing. What will emerge over time is, you know, how far that pendulum swings in any direction. So as we think about, you know, long-term trends and the way it's affecting our origination today, the way I would describe it to you is long-term trends on environmental hazards had already curtailed our hotel lending, beachfront hotel lending, for example. But short-term structure has allowed us to be responsive immediately to borrowers requesting relief today. Things like amortization, reserves, you know, kind of holding the line on our origination practices. That allows us to be responsive in this market even if our strategy is evolving over time.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah, those direct relationships seem very important. Let's go to Jeff for a minute. Jeff, you and your team have been originating middle market loans for what, 70-plus years. How has the latest crisis created opportunities for private debt managers focused on the mid-market space? These are companies that a lot of us wouldn't recognize, you know, on a sheet of paper. These are not the Fortune 500. Your market's quite different. Talk to us about how you're originating deals and how you're managing post-COVID crisis with your clients.]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: Yeah, thanks, Cameron. It's certainly been interesting in the private debt world. It is very much a negotiated world. You're not investing in pieces of paper and trading those. It's a buy and hold situation where typically you have two or three stakeholders sitting around the table. You've got the direct lender or the senior secured lender. You may have a mezzanine provider, and you have an owner, oftentimes a family or closely held business or perhaps a private equity fund. I can tell you the first seven weeks of the crisis when the shutdown hit in early March, it was not a fun time to be overseeing portfolios of subordinated debt in leveraged companies in the middle market. Because you had revenues approaching zero at some companies, totally uncertain. Phone calls were typically in our mezzanine businesses that have board seats. So, you could really see firsthand the adaptability that you needed to have to just survive and get liquidity. And I'd say that phase is largely over now. One thing I've been wildly impressed with is the resilience and the ingenuity that a lot of these smaller companies have to shift business models, to preserve cash flow and finding ways to survive without complaining or, frankly, without getting much help from the Fed. The area where most of our federal money has gone, it's gone into the trading markets. You have had some PPP level support. It's been very helpful.
  We have a number of portfolio companies that received that. But when you look at the private debt markets, it's really all about access to companies. And you've got about 85 percent of capital used to be from banks prior to the GFC. That is now about 90 percent provided by private capital at many points for today. And it really was an LBO business for a while, where access was coming typically from private sponsors. And now it's evolved towards the sponsorless or non-sponsored market. For every LBO, there's 15 companies that are just private businesses that used to be financed by banks that now need a non-bank solution. The challenge we have now -- and I think the investor challenge, as you sit here and look at the markets, is you've got existing investments you've made that are very challenged.
  Fits just came out with a piece suggesting that defaults and recoveries will be lower in the middle market versus the public side. Cameron, I'd argue -- I would agree on the defaults side. Because if you only have a few stakeholders and you're taking a long-term view and you know you're in a buy and hold situation, you may very well manufacture default. Meaning I don't want to clip interest right now. I want to keep the cash in the business to survive. And there's ways you can get compensated for doing so. Technically, though, that's a default.
  So, were you to compare rates, they probably will be higher than in the public bond market. The public market when you default, the bondholder council gets involved and oftentimes the bankruptcy court needs to referee. Private debt world, you oftentimes never see the bankruptcy court.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah.]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: So, default rates are higher, but your recovery rates tend to be much higher. And in the Mezzanine world, it's oftentimes -- and our experience would be you can see recoveries greater than 100 percent. Because you're higher up in the balance sheet. You can negotiate for equity and other things, and then ride the recovery over time.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Thatís an enviable position to be in, Jeff.]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: It is. And then if you flip the hat and say the investment environment, you've got Unitron funds and BDC's that really push that leverage. Jackie spoke to how prior to this event versus the GFC, that the market was in a better condition. I would say the private debt markets on the corporate side were worse in that leverage rates had been extended. Unitron's financing went to, you know, levels of leverage that now the value of a lot of these businesses are underneath the amount of senior debt even that was lent to them. So, a lot of good companies with bad balance sheets creates a great investment environment now for mezzanine and direct lending.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah.]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: And so, you're faced as an investor with watching some of your older vintages being challenged. But I'd argue if you've got good managers with good workout expertise, that you know, you'll come through this cycle fairly well.
  But a terrific time actually, and we're starting to see some of those broken balance sheet refinancing opportunities now.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Thatís great, Jeff. Thank you for setting the stage on direct lending.
  Questions are starting to come in here. The first one is asking for a deeper dive on an industry or a pair of industries that are under great stress right now.
  That's leisure and restaurants. I know Jackie had mentioned beachfront hotels.
  You'd think, who's traveling, who's on vacation? Not many of us. Maybe we'll start in the public side, go back to Steve for a moment. You know, hotels, you know, public companies that are depending on people jumping on airplanes, Steve.
  What's the outlook? These companies are just burning cash.]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Yeah, tremendous headwinds right now. It's all about getting that cash burn, you know, down to zero as quickly as possible. When you actually go through, some industries have a little bit more leeway than others. So as an example, the Reed Companies actually -- you know, several of them have curtailed their dividend payments. So, by not paying out the dividends, they're actually cashflow neutral. You've seen the airline industry, you know, raise literally tens of billions of debts almost each that they've actually done on their way to try to get the cash burn down to zero. You know, within investment grade, you know, they do have the ability to refinance. They do have the ability to cut expenses. Their priorities are much more closely aligned with bondholders now.
  It's all about focusing on the balance sheet, maximizing cash. High yield though is a different animal. While we're positive on high yield, you do have those triple C companies, and we do expect defaults to be rather high for the next 12 months. You know, somewhere in the 8 to 10 percent range over the next 12 months. And then the following 12 months, maybe 3 to 5 percent range in there. And a lot of those defaults will be coming in those leisure-related industries as well as energy.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Jeff, how about yourself? I remember a company you've lent to called Dionís out in Albuquerque. What are you seeing from your portfolio with leisure and restaurant markets?]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: Yeah, we're skeptical of the restaurant industry in general, but there are some iconic regionally oriented companies that we've invested in. You know, those that were in a little bit more casual and could adapt to the takeout world and that had a real following in their markets. The one you're talking about is Albuquerque based. And they're seeing store sales the last three months have been up year over year. It's just been a tremendous support and obviously the comfort needs for pizza and casual sandwiches and eating at home has really benefited.
  On the other hand, we've seen some of the more white tablecloth that can't adapt, particularly in the seafood category, where you know, delivering a piece of fish 30 minutes later might not be very appetizing. Those have had to completely shutter. And now when you look at reopening, you've got these accrued rents that are happening. And you're going to have to eat a lot of losses because there's a high level of fixed costs in these industries. And so, you'll experience a lot of losses to get reopen. In fact, it would be interesting to get Jackie's view on retail real estate and restaurant-related real estate. We've seen some numbers as much as 25 to 50 percent of locations might not ever open again, or at least not in their current form.]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Yeah. That's right, Jeff. I mean, I think there's enormous pressure.
  And if you think about retail in general, the move away from regional malls and towards what we would consider lifestyle retail -- think of a leisure, you know,
  kind of focused center with movie theaters, gyms, a spin studio, restaurants, entertainment-focused retail. All of that is under tremendous pressure today.
  And we are seeing that throughout our retail portfolio on the debt side. And several of those tenants will be under severe stress. But what I would say, you know, as a countervailing position to that, even while we will go through stress, good quality real estate tends to be regenerative. And so, we will see, you know, at a different basis with pressure on rent good quality real estate re-emerge and its uses re-emerge in locations that we feel very good about. So, I think that we are going to experience pain. There's no way around it. And we do know that, you know, the restaurants and the other kind of hospitality tenants in our lending book are, as I said before, the places where we have most immediately seen requests for relief, forbearance and other help. But we still have found ways to kind of keep working with many of those borrowers. Because as I believe, there's really no substitute for direct origination and direct relationship with our borrowers when we come into situations like this.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yep, certainly it's a relationship business on every level, public and private. Here's a question that just came in. This is a technical question.
  Maybe I'll point to Steve first and maybe Jeff could react. But this is about the high-yield market, Steve. With current OAS of 500 basis points and defaults running at 7.3, where are the opportunities at this point for high yield?]

  [DESCRIPTION: Mr. Steve Kellner is now speaking]

  [AUDIO: Yeah, we think the opportunities are really in the double B's. And the OAS on the double B's right now is about 400. So, it's double the triple B's, and we think that that's actually pretty attractive. The triple C's, it's really very selective. And then in general, you really need a V type of recovery to pull the triple C's all the way back. So, we're pretty cautious on the triple C's and really focusing and overweighting the higher parts of high yield. And in addition to that, there's actually some great opportunities right now because of the fallen angels. And so far, this year we've had about 175 billion dollars in fallen angels. And you know, typically those investment-grade companies again really focus on the balance sheet. And they set their number one priority is to try to firm up the business and then work their way back to investment grade.
  So, there's some good opportunities in there.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: And are there some high-yield or should I say fallen angel high-yield bonds that you favor industry-wise over others?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Yeah, believe it or not, some of the energy names actually look pretty attractive, pretty attractive to us in there. Yeah. And then you've actually got some auto-related names in there too that we think are good value.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah. Yeah. I want to keep up. Your questions keep coming, and I'll keep the conversation moving to answer what you want us to talk about. This is a good one. I'm going to point to Jeff on this. This is a very astute question from an investor who wants to know about the direct lending loan side. How have terms changed? And he goes on or she goes on to say, financial covenants, have they made a comeback? Because lenders do have a short memory. And the question is, Jeff, how do you see this playing out? Are tight covenants, you know, something that borrowers can tolerate in this kind of marketplace? Or are you finding that you and your competitors have had to loosen up terms? What's going on with covenants?]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: Yeah, it's a great question. And I think we certainly are in a state of comeback of the covenants. And where you saw erosion was the larger deals. And if you were principally focused on financing buyouts with these sponsors, they were very good at setting up auctions and competing. And there were really three areas. You were having covenants being loosened or eliminated in some of the larger deals. About 85 percent of issuance last year was covenant-light with virtually no covenants. You also have adjustments to EBDA. So EBDA is in the eye of the beholder. And so effective leverage was a lot higher. And then you had ways in which there could be leakage. Instead of cash flow being used to pay down debt, you had big baskets for restricted payments and payments to equity. So, we saw a lot of that in our smaller end of the middle market and playing away from the leverage buyout world when things get aggressive like that. We've been able to stay disciplined. So, in our case, we've had good covenants. I think covenants are important, and the mode in which you create to trap cash flow and make sure that you service your debt obligations first is important. But in the broader markets it's coming back. I think you're seeing even in a leveraged bank loan market covenants starting to come back. Scrutinizing how much adjustments and synergies you're allowing in EBDA. And so yeah, times are a little bit better now for the underwriters than what we saw in the last few years.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Good. Please keep your questions coming in. I see a couple other good ones. One is focused on big city real estate, Jackie. Places like New York City, what do you see as the -- I think I can paraphrase the question? What do you see as the possibilities for regeneration of commercial real estate in big cities that seem like they're in deep trouble right now, you know? Both on a fiscal basis and with -- I live in New Jersey and I find that there's a lot of inquiry and homebuying from people fleeing Manhattan. Young families are headed out to the suburbs. What's to come of big city commercial real estate, Jackie?]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Yeah, it's not our first time. It's not our first-time witnessing, you know, a challenge to big cities. And I'll leave aside for the moment the second part of that question that you raised. Because we do have a fair amount of concern about city and state fiscal health and the way it will impact real estate taxation, the way it will impact housing regulation and a whole host of issues around, you know, the challenges on fiscal health. But in terms of the demographic underpinnings that keep cities strong, we do believe they are regenerative. We do believe that there is, you know, tech, biotech, health, you know, meds and eds a variety of different reasons that cities continue to be the gathering spot. And they ebb and flow. The trends ebb and flow. It's not just a long-term trend towards urbanization. It's a centuries long trend towards urbanization. So, Cameron, you know, you and I had spoken before about my recollection about underwriting deals in Seattle when Boeing had announced they were moving their headquarters to Chicago.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Right, yeah.]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: And you know, conventional wisdom was, "What on earth's going to happen to Seattle? Boeing's leaving. And look at Seattle today. So, you know, I would say that we do expect pain to come. We do expect pressure on rents. Our own collections, you know, if I look at our own book in New York, it's been higher than we would have expected at this point given everything that has occurred.
  Some of that of course is all of the federal underpinning of the market, both for corporate as well as for individual investors and consumers. So, while we expect a period of decline and a reset of the basis, I still don't see a wholesale bias against a city. We just don't see it demographically. And if I look across, you know, across the trend lines that we see in other areas where there are other markets where we see a lot of headline risk, a lot of noise right now -- senior housing is a perfect example of that. Yes, in this environment costs will be higher. Move-ins and occupancies are challenged and rent levels are challenged.
  But we don't see anything stopping the demographic tail wind. We don't see any trend towards folks lining up to, you know, kind of move their elderly relatives back home. They're just trends that move us in a direction. And I think cities are, you know, a magnet in such a way where that will continue. Now the cities may differ, right? So, it may be, you know, the growth of a whole host of what would have been considered secondary cities before that now elevate just because of demographic and migration trends. But the need to kind of gather around a city center we don't see, even as the ebb and flow of migration occurs. We don't see that, you know, kind of wholesale going away.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah. And I can attest that one of Jackie's colleagues recently told me that they're getting inquiries from large corporations in big cities like New York for more space, not less. So, you'd think intuitively there's going to be a flight to the 'burbs or a flight to work from home. But there are in fact commercial businesses that are looking to take on more space, which I thought was very counterintuitive but interesting fact. So, don't give up on New York yet, I guess is what we're hearing Jackie. We're happy to hear that.]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Thatís right. Yeah. I'm not going to bet against it.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Hereís another one that just came in. This is sort of up for grabs, panel. This is a question with the non-agency mortgage backed securities market.
  Is it out of the woods? Is now the time to buy? Steve, you sit next to the mortgage team there at PGIM Fixed Income. Low duration spread product with price upside? Or is this time different?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Well, I think in general, you know, we think that this market is actually functioning again and looks attractive. And we'll participate in the continuing rally in spreads, you know, just to make it that simple.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Okay. How about -- Steve, how about issuers? Let's talk about public company issuers. You've got treasurers and CFO's who have been just running to the banks to borrow money right now. You saw that. I mean, we've got corporate bond yields at 2 percent. Companies that don't even need the money today have this huge pool of dry powder for future use or maybe they're going to use it for stock buybacks, although that seems to have been cut back. But what's your forecast for capital raising in the investment-grade market going into 2021?
  I mean, at some point they're going to exhaust themselves, or rating agencies are going to say enough. How does this frenzy to borrow end from an issuer point of view? And how are the smart ones dealing with sort of the strategic money raising?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Itís actually all kind of starting to fall in place right now, right?
  So, we've had this, you know, Cameron, this huge amount of issuance in the last three or four months. And you know, the issuance so far this year has eclipsed 1.2 trillion dollars which, you know, which was last year for the entire year.
  And we've had something like 48 of the 50 biggest borrowers have actually accessed the market. So pretty much the companies are all flush with cash. You know, they've all issued debt. They've increased gross debt on their balance sheets. But a lot of that's coming to an end. And you know, again, they're going to be pretty cautious on average, so, it's going to be a while before they actually start to bring the share buybacks back, except for the top-performing companies with a lot of free cash flow. And we expect that they're going to start using this cash over the next 12 months to basically start to pay down debt. We think the M and A is going to be really light because there's low confidence right now. It's actually -- it's actually, you know, in spite of the economy being really tough, adversely it's actually a great time for credit looking forward from here. And we've talked about the fact that the credit fundamentals will actually start to improve as management's focus on deleveraging. And then in addition to that, really strong technicals for the market, because we're not going to have this issuance. We're not going to have this supply that we've experienced already. Yet we're still going to have all this central bank accommodation, all this fiscal stimulus, and it's going to continue to kind of fuel the fire. Recall too that Chairman Powell actually said in front of Congress that he really wants the spreads to go back to where they were pre-COVID. And they're going to use the balance sheet. And it's all about trying to deal with this, you know, record amount of unemployment that we have. In addition to that, the employment environment is going to be really tough for a couple of years because, you know, we're not going to have all of these people that are taken care of on the PPP CARES Act program right now. You know, when that runs out, they will be laid off. You'll have some people coming back to work, but all the large corporations are going to be really cutting expenses and they're going to be announcing lots of layoffs looking forward. And it's going to make the employment environment challenging, which means that the central banks and the stimulus is going to continue.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah. Yeah. That's -- we're getting a lot of pressure in the healthcare market. I know, you know, some hospitals are laying people off. But yet, you know, there have been huge advances in healthcare. This one came in -- this is a question from the audience. I'll turn to Jeff actually first, and then Jackie and Steve can comment. But this is about credit needs in the healthcare market. I think everybody has some exposure to that world that's getting a bigger and bigger part of GDP certainly in the US. Jeff, what are you seeing in terms of borrower needs in your healthcare portfolio companies?]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: Yeah, healthcare particularly in direct lending is -- as it's represented in GDP, it's from 15 to 20 percent of issuance in the direct lending market. And you really had two situations. You had part of healthcare that was related to the support of fighting all things COVID, and so, we saw a number of companies from linen businesses on up that did extremely well, and you know, are making a ton of money, probably don't need that much financing. On the other hand, all of that expenditure crowded out all elective procedures and physician practices couldn't see patients. The reimbursement for telemedicine rates are a lot lower than in person. So, there was a need and I think it's fueling a little bit of a mini M and A effort of groups consolidating. And you also had some portfolio issues and new capital needed to be raised in that part of the business. Now there seems to be a recovery going on there, and I think the view is that the portfolios should hold up pretty well. You may see some defaults, but recoveries will be fairly high going forward. And you know, if we get into a bit of a relapse here, you could see more of an extended problem for those parts of the healthcare industry that are outside fighting the COVID situation.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: How about on the public side, Steve? What do you see in terms of issuance and opportunity or risk on healthcare names?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Yeah, pretty consistent with Jeff's comments. He did say that there's the haves and the have-nots. You know, in terms of the big healthcare systems, the hospital companies themselves, you know, obviously they're taking a hit because of the curtailment of elective procedures. However, they also are participating in the government's CARES Act. And, just as an example, like HCA, a huge hospital company today, they actually reported really strong numbers because of the grants from the government in here. And that's the case with all the large healthcare systems where it's probably really risky, would be the smaller ones in here that are more focused on just the elective procedures and are not part of the big diversified portfolio on the healthcare side. So, in general, the CARES Act is taking care of them. And then there's smaller ones that are at risk. And I would expect that we're going to see some defaults on those real small entities within healthcare. But overall, you know -- but overall, looking forward, you know, going through this terrible virus, you know, we're only going to spend more money on healthcare, not less. And there's going to be more government support for healthcare than there's ever been. So, you know, so for the majority of operators within that space, you know, it's probably a pretty favorable long-term outlook.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Iím glad there's a silver lining somewhere, Steve. We need that. I'm going to switch gears here and put our experts on the spot our last 15 minutes and talk about opportunities. Looking forward in your respective realms, I'll start with Jackie. Jackie, what kind of investors do you see jumping into your asset class, the commercial real estate debt world? And how are they using commercial real estate debt in their portfolio? Why now?]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Well, Cameron, you know, commercial real estate debt is not monolithic.
  So, at certain points in the cycle and in certain pieces of a portfolio allocation, distressed debt, alpha opportunities, higher yielding strategies clearly play a role in analysis seeking piece of a portfolio. But commercial loans also play a role in a liability hedging or an asset liability matching portfolio allocation. And those are two different approaches to how investors can use or think about commercial mortgage debt in their portfolio. So, what we spend a fair amount of time on, if we look at the bulk of our book, it's largely long-duration. You know, we're targeting a high-quality credit, trying to replicate something that would look more like an investment-grade credit. We are definitely seeing currently a yield premium to corporate. So even those spreads are tightening in. And so, what we look at across all those cycles is how to create a long-duration strategy that can survive via several or through several potholes and kind of, you know, credit events along the way. And so that leads us to think about housing in all its forms. You know, I already mentioned senior housing, but the broad spectrum of housing that is affordable to a wide swathe of US and global consumers, it leads us to think about things like cold storage. Which even though it's capital-intensive had not yet seen the kind of e-commerce penetration that we've seen in other segments of retail sales. And we know -- you know, even pre-COVID we know that there's a limit on what one can deliver in an e-commerce context in terms of grocery delivery from the retailer, from the store, from the grocer. So, as we think about where we see opportunities migrating you know in the future, some of these opportunities are, you know, are still to be determined. We know that 30 percent or so of folks who made their first online grocery order in the early days of COVID of the pandemic were doing so for the first time, right? And some of that will continue. We've already seen the trend emerging, and that will continue. So, we've been lending for, you know, I don't know, over a century. We've been investing in equity real estate for over 50 years. And I like to remind myself that when core equity real estate got started, when the index got created, only office and regional malls were considered core assets. At the time, multi-family was considered way too risky. Because why would you want ordinary, you know, individual consumers to be paying your rents as opposed to a long-term lease to a corporate tenant? And that has definitely, you know, kind of switched on its head. So, if we think about trending in cold storage, self-storage, you know, following up on the question that was just asked about healthcare, lab office, medical office where we definitely see differences in collections and physical occupancy even today in our COVID environment, those are kind of the long-term lens with which we are looking at our book to build a diversified credit exposure over a, you know, 10-plus or minus duration.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: What a diverse set of opportunities you have to tap really beyond the scope of most people's expectation or understanding of commercial real estate opportunities. And not only very diverse, but very demographically sensible.
  So, thank you for your thoughts on that, Jackie. Let's go to Steve now. Steve, you're on the record calling for spreads tightening and investment grade back to pre-COVID levels by year end. We know you like some energy names. We know you're looking out at the fallen angel market. If you're advising an asset allocator who's thinking about creating a bond portfolio, a public fixed income portfolio from scratch, how should they think about allocating that portfolio opportunistically if they're looking for, you know, some medium degree of alpha over the next say two years? How would you divide that up? What are your thoughts on that?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Yeah, and you know, we have actually had, you know, a decent amount of recovery in here. And I'd say in general, the overall market, we're about 80 percent back to the pre-COVID levels. You know, obviously, we think we've got that other 20-plus percent to go in here. Those opportunities are really more down in that triple-B, double-B type of spectrum down there which is lagging, you know, the higher quality markets down there. And you know, one of the things that we've just kind of launched that we've had some interest in and have had some subscribers in are kind of these crossover strategies which would include triple-B's and double-B's. And that's where the picking is, and you know, we've got a huge research group -- that bottoms up credit analysis is really the sweet spot of our investment process. So, we think it's kind of picking and cleaning our way through there. But in general, you know, lots of headwinds for the economy, lots of, you know, struggles on the revenue side for companies. However, their behavior is now aligned with bondholders and there are going to be terrific opportunities in that, you know, crossover space. We also like the money center banks. You know, they've kind of gotten --]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: You guys have been investing in money centers for a long time, especially as they -- it's a very different world than 2008, 2009, isn't it?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Yeah, and from a bondholder perspective that feels pretty good. Because of all the, you know, new heavy regulation that they've been under for the last ten years. That honestly, they look more like utilities than they do like, you know, historical banks. They hold significantly more amounts of capital in here. The ones that we really like are the large money center banks. We've seen them take advantage of all the profits they've made on trading in capital markets over the last couple of quarters. And really just kind of recycle that into, you know, building up really strong reserves. So, as we come in, we expect that they're in pretty good shape to handle them. So, we still actually like them. Very well reserved, very heavily regulated and lots and lots of capital, almost double the capital they had a year ago.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Yeah. Yeah, it's impressive how far they've come since the financial crisis. Well, how about in mezzanine or energy or direct lending, Jeff? You have some very interesting niche investing strategies, and certainly a very long history. What industries do you like? What new kind of companies? I mean, obviously there's the traditional industrials and so forth. But I'm wondering, you deal with entrepreneurs as well as companies that are in trouble. So, I'm curious, what do you see opportunistically for your direct middle market world going out beyond say 2020 into 2021, 2022?]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: Yeah, I think you've got strategies and sectors you could look at. And certainly, we've been well-served with our business services sectors that are more variable cost. They can shrink and grow without needing a lot of capital to build inventory for example. And so, we've seen about 40 percent of our overall portfolio would be in that type of business. And I think that's going to continue going forward. And you're seeing a lot of business models transform from heavy fixed cost type, heavy operating leverage into more of a variable cost model.
  In fact, PGIM's written about that more extensively. So, I think what you get in private debt is a broadly diversified portfolio with a little bit of a shift towards non-heavy cap X and working capital intensive businesses. And fortunately, the middle market is awash with those types of businesses, probably 200,000 or so between western Europe and the United States of target middle market companies. Of course, access is the key to being able to find the good businesses. And we're fortunate with 44 deal teams making 4,000 direct calls a year that we can do that. A cautionary note I'd throw in, Cameron, is where I wouldn't go right now, or I'd be a little bit careful about it, the business development companies, the publicly registered retail-type structured organizations of which there's now 60 or 70 of them -- a lot of them are trading below net asset value. There's a lot of bad news still to come I think in valuation marks there. They use leverage. Also, there were a lot of funds that got very aggressive on the Unitron side, pushing leverage to 5 to 6-plus times in some of these businesses. And I would argue not really getting paid for that risk, in effect taking more mezzanine risk but packaging it as senior secured. So, from a strategy standpoint, where I would go is true first lien senior secured debt, and that's defensive, should do well through cycles, very low losses. That's been proven over time. And then mezzanine strategies where you still have some defensive elements to it, you're higher up in the balance sheet but you also have some equity upside potential. So, as we ride through into the recovery phase, this should really be a good vintage time of mezzanine. And on the energy front, I think there's a terrific contrarian, upstream oil and gas play. The whole world is running away. Capital has fled from the banks. And you can now get proven producing reserve coverages that used to be, you know, L plus 300 bank-type deals and you could underwrite to mezzanine returns there. And there's a lot of orphan properties outside of the big integrated players and some really good operators that you can access there. So, you know, from a mezzanine perspective, a really interesting go forward purely contrarian play to what conventional wisdom would say.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: If you have the courage. That's very difficult.]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: Yep.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Great summary, Jeff, on that. Well, here's one last question. I think we have time for this one with five minutes to go. But this is reminding us, we've been a little US-centric. Let's look outside the US as you think about opportunities you all know best. Where are the opportunities to invest outside the United States?]

  [DESCRIPTION: Jeff Dickson is now speaking]

  [AUDIO: Cameron, I'd jump in there just to say in our private portfolio, our 90 billion dollars, more than a third of that is outside the United States and growing most rapidly. And where we see a lot of everything from investment grade down through mezzanine would be in the UK and the continent, you know, broadly defined, western Europe. And also, Australia which is a significantly growing market for us right now. I'd say, you know, Europe is right behind the US in terms of the banks moving away from middle market private lending and fund-like capital coming into that marketplace. I'd say it's a little behind on the non-sponsored business. A lot of the European market is developed around LBO financing. And I see a lot of growth on the non-sponsored side. And we're seeing a tremendous amount of business there, of just directly calling on companies in the advised market away from LBO's. So, I'd say Europe is still very much growing. And Australia's been dominated by big banks, but that's starting to change now. And we're taking advantage of that.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: That's encouraging. Steve, how about investment grade -- oh, Jackie, please go ahead.]

  [DESCRIPTION: Jackie Brady is now speaking]

  [AUDIO: Yeah, I was going to jump in and say similarly in terms of our real estate global book, we too are lending throughout Europe, you know, the UK, Germany and in Australia and Asian markets as well. We're a global lender. Our European platform I think will have everything I said about distressed opportunities. We do expect a similar profile of distressed emergence to occur in Europe. And we do have a slightly different, you know, investor market and borrower market that we see there relative to what we see in the US, given the preponderance of total debt lending. You know, there are not as many specific mezzanine debt funds, so there's an opportunity to control entire capital stacks.
  Exactly what I was suggesting before about the need to directly originate, the need to kind of form partnerships and approach the debt market holistically, a lot of opportunity for that kind of investing to come. Not yet emerged. Still a little early. You know, Brexit kind of had delayed quite a bit of that in the run-up to this particular downturn. But we definitely see those opportunities emerging for higher-yielding investing in European debt.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Excellent. Well, I know it's very important to have feet on the street.
  And all three of your businesses do in fact have very significant presence, especially in Europe. Steve, anything you wish to add based on your conversations with Ed Farley and the team over there?]

  [DESCRIPTION: Steve Kellner is now speaking]

  [AUDIO: Sure, a couple quick comments on that, Cameron. Thank you. You know, European investment-grade market is I would say kind of closely aligned with the US market. It's got the benefit of all the stimulus there, so we think it's going to participate in the recovery. The high-yield market over there probably offers a little bit more opportunity. It doesn't necessarily have as bit a weighting in energy in there, so we actually do like the high yield over there. And then we actually look to EM. Generous amounts of spread right now in EM. In the aggregate it looks cheap to high yield. However, there's lots going on there and you've got to be able to do your bottoms up work on those countries and those opportunities there. And then maybe the very last comment I'll make is, you know, we always say don't fight the Fed. But I think we're only 50 percent of the way through all the accommodation that we're going to get from the central bank. And it's really powerful for risk markets.]

  [DESCRIPTION: Cameron Lochhead is now speaking]

  [AUDIO: Wonderful. You guys did a nice job summarizing the opportunities. Thank you all. Well, I've tried to take some notes for our audience and for myself.
  Let me see if I can summarize a couple of things I learned. One of them is that relationships matter when you're lending money to people. Second one is that Steve expects investment-grade bonds to continue to tighten, and he just explained that very clearly. And there will continue to be opportunities in certain sectors like energy. I thought that was an interesting overlap between he and Jeff agreeing on that. And obviously, the fallen angel opportunities, investment-grade companies that are temporarily hopefully in high-yield land automatically become of great interest. Lending standards are tightening. You know, make sure you've got the first lean. And I think Jeff and his team make it very clear they have that. And Jeff reminds us, be a contrarian investor.
  That takes some courage, as everyone knows, but certainly over the long-term, contrarian investing tends to pay off. And Jackie gave us some confidence that we shouldn't give up on New York or our big cities. You know, we continue to lend there, and we're very optimistic that there's a continued commitment hopefully to pay rents indefinitely. So those are some of my takeaways, but I'd like everyone here to join me in thanking Jackie Brady, Jeff Dickson and Steve Kellner. I hope you agree that they've been at the top of their game in a very challenging playing field. All of us are working from home and so we at PGIM are constantly experimenting with these virtual events and the content, the format. So please let us know what you like and what you prefer to see more of in the future. Let your people, your best contact at PGIM know what you think about these events and we'll try to make them better and better as we go. This event today was taped, so feel free to share it with your friends and investment committees. And we hope to see you all at our next quarterly update in October. From all of us at PGIM, I'm Cameron Lochhead saying thank you and stay safe.]

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