Should investors start to consider the emergent opportunities in high yield and distressed debt? We think so. The market stress that arose in late 2015 resulted in a significant widening in credit spreads as price moves were exacerbated by severely reduced liquidity.
As the credit cycle continues to mature, we believe that stressed and distressed credit (especially in the US) could offer investors a rare opportunity to generate attractive returns in today’s low (or negative!) yield environment.
Fundamental and technical headwinds
Much of the poor performance of corporate credit in recent years has been due to losses in energy and commodity-related issuers, as weaker worldwide demand and excess supply sent oil and commodity prices down.
The other big problem has been reduced liquidity, as tighter regulations have discouraged banks from holding credit. Without the banks, there were often no willing buyers, spreads widened and the absolute price of many corporate credit securities plunged. This, in turn, exacerbated volatility, leading to dramatic swings in prices.
Number of US HY Bonds experiencing more than a 10 per cent price loss in a month
Credit fundamentals have also shown signs of deterioration as 2015 company earnings reports came in weaker alongside rising debt levels.
The low default rates of around 1 per cent to 2 per cent in recent years may be due to low interest rates masking the weakness of many company balance sheets. In this environment, idiosyncratic risk is heightened and dispersion in performance at the security level more likely.
The proportion of corporate credit trading at distressed prices now surpasses the levels set in 2011. The illiquidity in credit markets has had a disproportionate effect on lower-rated credits which have significantly underperformed higher-rated credits. The ratio of spreads on global CCC-rated debt to B-rated debt (a measure of stress in credit markets) has become wider than at the worst point in 2008.
Many macro risks are likely to persist, and the stability of capital markets depends on effective management by central banks. Geopolitical risks abound and China’s gradual slowdown will continue to place pressure on emerging markets. Default rates will eventually rise and volatility is unlikely to abate.
The opportunity for investors
It is often at the darkest hour that opportunities present themselves. We therefore believe that it is now time to consider how to take advantage of the structural changes and dislocations arising in credit markets.
Having highlighted many of the negatives in the current environment, it is worth noting that we believe we are unlikely to be in a 2008-style scenario.
Leverage is manageable and although some industries are stressed, it is likely that access to capital will remain relatively accommodative.
Federal Reserve policy along with easier underwriting may extend the cycle and postpone the uptick in defaults. It is now, more than ever, a “market of credits” rather than a “credit market”, affording those with rigorous research coupled with patience, capital and flexibility the potential to generate attractive returns.
Any further deterioration in economic conditions, combined with rising default rates as the credit cycle matures, could create significant opportunities for investors willing to tolerate a degree of volatility and illiquidity.
While investors will need to take into account their own specific return objectives, liquidity constraints, time horizon and risk tolerance, options worth considering include:
- Long-only credit opportunities funds. These strategies could be thought of as sitting further up the risk–return spectrum and with less liquidity than traditional multi-asset credit funds.
- Credit-oriented hedge funds. These strategies would have the flexibility to invest both long and short and will rely to a greater extent on manager skill than market beta when compared with long-only credit opportunities funds.
- Private markets vehicles. These typically focus on opportunities at the higher end of the risk–return spectrum and tend to offer the least liquidity to the end investor.
While the opportunity may not yet be upon us, investors would do well to heed the military maxim that “time spent in reconnaissance is seldom wasted”.
Phil Edwards, European director of strategic research, and Diane Miller, senior manager researcher, Mercer