The "All-Weather" Credit Strategy: Navigating Market Storms with Diameter Capital

Jonathan Lewinsohn, co-founder of Diameter Capital, offers a masterclass in building a resilient credit investment strategy that thrives not just in stable markets, but actively benefits from volatility. This conversation reveals a profound understanding of market dynamics, where conventional wisdom often falters, and how a commitment to deep research, liquidity, and a flexible mandate can create enduring competitive advantages. For investors seeking to understand how to navigate the credit landscape beyond the obvious cycles, this analysis offers a framework for identifying managers who truly understand the interplay of macro trends, micro-level business fundamentals, and the critical importance of maintaining optionality. The hidden consequence of many credit strategies is their susceptibility to predictable downturns; Lewinsohn's approach highlights how to turn these very downturns into opportunities.

The Unseen Architecture of Credit Resilience

The prevailing narrative in credit investing often paints a picture of cyclicality, where fortunes are made by riding the waves of economic expansion and contracting during downturns. Jonathan Lewinsohn, however, dismantles this simplistic view, presenting a sophisticated framework for building an "all-weather" credit strategy. His approach, as detailed in his conversation with Kristen Van Gelder, is not about avoiding storms, but about architecting a portfolio that can harness their power. This involves a deep dive into understanding industries from the ground up, a relentless focus on liquidity, and a willingness to embrace both the long and short sides of the credit market, a duality often underutilized by traditional managers.

The core of Diameter's philosophy lies in its commitment to a deeply integrated research process. Lewinsohn emphasizes that true insight doesn't come from simply looking at a company's balance sheet or its immediate prospects. Instead, it requires a granular understanding of the underlying industry and its place within the broader macroeconomic ecosystem. He recounts his early experience at Anchorage Capital, where his boss asked him to determine "how many cars should we sell in the United States." This wasn't a question about specific automakers, but about modeling the entire industry demand. This top-down, industry-first approach allowed them to identify the fragility of auto companies even before the '08 crisis, demonstrating how understanding macro trends can preemptively reveal micro-level vulnerabilities.

"My boss at the time, Tony Davis, said, I want you to figure out how many cars we should sell in the United States. And that feels like a bit of a crazy question, but instead of first going to look at General Motors or Ford or American Axle or Lear, we first said, we built a model to think how many cars should we sell."

-- Jonathan Lewinsohn

This dedication to fundamental, often unglamorous, research is a cornerstone of Diameter's strategy. Lewinsohn contrasts this with firms that prioritize capital structure analysis first, then fit the business into it. Diameter, conversely, starts with the business and the industry, then considers how credit markets can be used to express a view. This distinction is critical; it means Diameter is less likely to be caught off guard by secular shifts that erode value, even in seemingly stable industries. The narrative around a company can change rapidly, and understanding these shifts, both positive and negative, is paramount.

The Liquidity Imperative: Optionality in a Volatile World

A recurring theme in Lewinsohn's discussion is the paramount importance of liquidity. In an industry often drawn to the perceived higher returns of illiquid assets, Diameter actively prioritizes maintaining a liquid book. This isn't about avoiding complexity, but about preserving optionality. He points out that during frothy markets, illiquid assets become "in vogue," but when the "world changes," a lack of liquidity can trap a portfolio. This philosophy proved prescient during the COVID-19 pandemic.

Diameter entered 2020 heavily long, anticipating a strong year. However, the rapid shutdown of Wuhan in January served as an early warning sign. Their deep understanding of China's trade and production hubs allowed them to recognize the potential severity of the situation. This led to a swift pivot: selling off longs, particularly in cyclical industries like energy and travel, and reducing both gross and net exposure. This agility was only possible because of their liquid book.

"So really, we kept the book very liquid. Secondly, we hear from a lot of people that they want to concentrate. They always want concentrated portfolios. You want to, especially in an expensive market, you want to have big positions. It's hard to find something good. Well, guess what? Everyone is smart."

-- Jonathan Lewinsohn

When the market began to truly panic in February and March, Diameter was positioned to capitalize. They were able to short travel-related businesses with negative working capital at high prices, seeing their value collapse as the pandemic took hold. Crucially, they didn't chase the cheapest, most distressed assets. Instead, they bought high-quality investment-grade bonds from companies like McDonald's and Starbucks, and software loans, recognizing that in a crisis, the safest assets often offer the greatest opportunity for policy-driven rebounds. This strategy, of buying quality when it's temporarily devalued, is a testament to their forward-looking, liquidity-conscious approach.

The Power of the Short: Unbiased Truth-Seeking

Lewinsohn's embrace of shorting is not merely a hedge against long positions; it's an integral part of their truth-seeking methodology. He argues that to be a complete and unbiased investor, one must have the freedom to identify both opportunities to go long and opportunities to go short. He uses the example of a CEO versus an analyst: while a CEO is inherently biased towards their company's success, an analyst can offer a more objective view, especially on shorter time horizons.

The ability to short allows Diameter to avoid the pitfalls of narrative bias. When a company's market share declines due to a lack of capital expenditures, it's easy to construct a narrative around reinvesting in CapEx to regain that share. However, Lewinsohn points out that this narrative might ignore more fundamental secular shifts, like a new competitor or a disruptive substitute.

"The freedom to think long and short is really what allowed us to realize that COVID was really bad and then turn around and say, we still think COVID is really bad, but the Federal Reserve just said they're going to buy investment-grade bonds and high-yield ETFs. Everything is going up."

-- Jonathan Lewinsohn

This narrative-driven approach extends to their view on distressed investing. Lewinsohn notes that the distressed debt market has become more efficient and that many distressed businesses are simply "bad businesses" with shrinking pies. Diameter focuses on distressed situations that are primarily cyclical, allowing them to invest and exit before secular decline takes hold. This selective approach, combined with the ability to short, ensures that their investment decisions are grounded in reality, not just optimistic narratives.

Building an Enduring Edge: Process Over Perfection

The conversation underscores that Diameter's success is not accidental; it's the product of rigorous process and a deep understanding of human behavior in markets. Lewinsohn is candid about the challenges of building a team, acknowledging that not everyone is suited for a process-heavy startup environment. He emphasizes the importance of preparation, citing their intensive earnings previews and reviews, and annual offsite primary data research.

This commitment to process is particularly evident in their approach to distressed and stressed credit. While many firms seek to control distressed companies, Diameter aims to be influential but ultimately exit before the long-term challenges of a potentially mediocre business become insurmountable. They are willing to take on illiquidity when the situation is cyclical and offers a clear path to exit, such as their investments in rental car companies, airlines, and cruise lines during COVID-19.

The ultimate goal, as Lewinsohn articulates, is to provide returns that are the best available in credit for that given year, dynamically moving across different segments of the market. This requires constant learning, a willingness to challenge assumptions, and an unwavering focus on what truly drives value and risk in credit markets.

Key Action Items

• Deepen Industry Analysis: Move beyond company-specific metrics to model industry-level supply, demand, and competitive dynamics before assessing individual businesses. (Immediate)
• Prioritize Portfolio Liquidity: Actively manage for liquidity, especially in bull markets, to retain the flexibility to pivot and capitalize on market dislocations. (Ongoing)
• Integrate Short Selling: Develop a robust process for identifying short opportunities, not just as a hedge, but as a means to uncover market inefficiencies and biases. (Longer-term investment)
• Focus on Cyclicality in Distressed: Target distressed situations driven by temporary, cyclical downturns rather than secular business model decline. (Immediate)
• Build a Process-Driven Research Team: Implement rigorous, repeatable processes for research, analysis, and portfolio review to ensure consistency and mitigate bias. (Immediate)
• Embrace Narrative Evolution: Continuously assess how macroeconomic and industry narratives are changing and how they impact company valuations, being wary of narratives that ignore fundamental shifts. (Ongoing)
• Develop Macro Context for Micro Decisions: Always contextualize company-level investment theses within broader economic and market trends, understanding how macro factors create or destroy value. (Ongoing)