The evolving corporate credit market offers compelling opportunities for private investors, says Bruce Richards, CEO and chairman of Marathon Asset Management.
The credit markets today represent one of the most anomalous investing environments since the advent of the high yield bond market in the 1980s. Persistent inflation and higher interest rates have created significant challenges for companies, corporate earnings outlook, and creditworthiness.
The Federal Reserve, the Bank of England, along with other central banks around the globe, have embarked upon a policy path of tightening financial conditions to fight inflation, collectively raising rates at the most aggressive pace in recent history. With higher interest rates and wider credit spreads, the cost of capital has begun to constrict issuer cash flow generation, dampen valuations, and limit refinancing prospects.
The US, the UK, and European non-investment grade credit markets have tripled in size since the Global Financial Crisis (GFC), from $1.7tn to $5.1tn. This was largely due to zero interest rate policies (ZIRP) that fueled the credit markets to grow disproportionately relative to GDP, creating a larger basket of riskier assets compared to past credit cycles. Leverage ratios have now reached 20-year highs, creating unsustainable capital structures for a large cohort of corporate obligors.
Many investors seeking to win deal flow sacrificed covenant protections, reducing default probabilities and future recovery values for companies that will ultimately require a restructuring solution. Aggressive earnings projections have driven a significant divergence between adjusted EBITDA and actual cash earnings. There exists a strong probability of 2,000 downgrades and 200 issuer defaults during the credit cycle in the next 2-3 years.
This credit cycle will be defined by a recession with persistent inflation, falling consumer demand, rising input costs, and interest rates, resulting in a repricing of certain risk as well as a multi-faceted opportunity to wisely deploy capital in both the private credit markets and dislocated secondary public credit markets. Investment managers who are experts in navigating complexity in public and private markets are best positioned to capitalise on this upcoming opportunity.
Creative Solutions
The greatest risk-reward outcomes occur at the market trough when wounds are the deepest, and fear is most pervasive. Banks, historically the primary source of underwritten debt capital for acquisitions and buyouts, have retrenched from the space after recent headline losses.
Creative private capital solutions will undoubtedly emerge as issuers face a liquidity crunch, while weak covenant packages enable new money solutions to take priority positions in capital structures. In the public credit markets, we expect leveraged loans to represent an outsized portion of the opportunity set as compared to its high yield bond counterpart given (i) the lower credit quality of loan issuers resulting in higher default rates; (ii) the floating-rate nature of leveraged loans that puts incremental pressure on issuers’ cash flow; (iii) covenant-lite structures offering limited protection to legacy creditors; and (iv) the prevalence of unitranche loans resulting in less equity cushion than has historically supported first-lien loans.
New money solutions attach within the capital structure at a point that is senior to existing creditors with attractive economics that often generate excellent risk-adjusted returns. Companies can partner with long-term oriented private credit investors to help extend, structure, and execute on their business plan in times of complexity, while avoiding Chapter 11 and saving significant sums of money in legal and bankruptcy fees.
The expectation is that the Federal Reserve and other central banks will be reluctant to pivot while levels of inflation remain above their 2% target. Investors should prepare for a higher-for-longer policy and interest rate structure in the coming year. Given the confluence of factors, we anticipate the cumulative default rate over the next two years will approach ~10%, creating a ~$500B opportunity – greater than twice the size of the GFC opportunity in nominal terms.
Downgrades lead to dislocation; defaults lead to a range of opportunities from rescue to debtor-in-possession (DIP) finance to purchasing the ‘fulcrum security’ to be a partner in leading companies through restructuring.
The many vulnerabilities, opportunities, sectors, and asset classes within corporate credit may help investors put together the pieces of the puzzle. As investors evaluate the 2023-2024 credit cycle, we are highly confident that there will be a historic investment opportunity as we embark on the golden era for credit.
The golden opportunity lies in unique ability to provide capital, buy dislocation and distress in good businesses with over-levered balance sheets, as well as invest in quality credit during a period of high base rates and wide spreads. Private credit investors have a compelling opportunity to invest within the $5tn+ US & Europe corporate credit market that continues to evolve.
