Opportunities That Lie Beyond the Low-Default Era

Apr 18, 2023

One of the hallmarks of the current market environment is the numerous macro issues that could affect credit fundamentals going forward. Rather than focusing on issues with highly uncertain outcomes, we’re more confident in the broad effects from the collective reduction in central bank liquidity. Namely, it will mark the end of the low-default era and the revival of a multi-year cycle that many will find unfamiliar as default rates revert to higher, historical norms.

As we assess the coming default cycle, we can draw some generalizations about the effects of cheap capital—and its subsequent withdrawal—in the leveraged finance markets. The influx of capital distorted market structure in areas such as ownership, investment objectives, and financial symmetry. These distortions will increasingly come to the fore as liquidity evaporates and restricts the flow of capital to where it is needed most. As a result, more borrowers and equity sponsors facing credit situations will likely seek “self-help” by exploiting weak covenants to extend optionality and attract opportunistic capital, regardless of the market conditions.

While many investors have only known a world with a central bank backstop, those days are likely over. As stress begins to build in credit markets, investors can prepare their portfolios by enhancing liquidity, allowing them to pivot quickly when opportunities emerge.

For investors who are unprepared for the increase in special situations activity, it presents risks that can cut two ways. Their credit positions could be subordinated and consequently devalued over the course of several transactions as the cycle matures. This can lead to secondary effects, such as foregoing allocations that potentially generate equity-like returns in otherwise sound businesses. Navigating these risks requires familiarity with the approaching conditions, recognition of the potential capital needed throughout the cycle, and awareness of the opportunity set created through market dispersion.

Uncomfortably Numb

Given the prolonged environment of central bank liquidity, it’s not surprising that many investors have become accustomed to longer business cycles, lower default rates, and cheaper capital. With central bank reserves set to decrease, the potential for wider spreads—not to mention the effects from the global surge in policy rates—increases the cost of a corporation’s debt refinancing or new debt capital.

Figure 1: Credit spreads have moved in tandem with central bank reserves (LHS: in $trillions; RHS: in bps, inverted)

Source: Citi Research. As of May 31, 2022

Many borrowers will take a proactive approach to achieving a more stable credit profile rather than relying on market conditions. Therefore, those capitalizing on the embedded optionality within loose covenants will force the issue and drive the increase in distressed and special situations activity within the leveraged finance markets.¹ While many of these situations will undoubtedly draw investor interest given the potential returns, the question shifts to whether there is enough capital to seize on the opportunities.

How Much Dry Powder is Sufficient?

A few remnants from the prior cycle shape our estimates for the amount of dry powder needed going forward. The first is growth in the leveraged finance markets, which roughly doubled in size following the GFC. When either the current level of market distress or Moody’s 1-year forward default rate is applied to the outstanding debt in the US and European leveraged finance markets, a distress level emerges that is 2-5 times the amount of allocated dry powder. A more moderate scenario, which looks at the median level of max distress in every recession going back into the mid-1980s, would create more than $1.4 trillion of opportunity. Moody’s moderate and extreme scenarios only consist of one-year default projections (13% and 19%, respectively).

Given our view of the economic backdrop, we believe the next cycle will resemble those which occurred with relative frequency before the GFC when the average five-year cumulative default rate was around 30% (6% per year). Considering that the length of this default cycle will likely be measured in years, not months or quarters, roughly $100 billion in dry powder could be less than half of what is needed to navigate just one year of the cycle.

Powder May Be Dry, But Stranded

With the effects of central bank liquidity and historically low interest rates in mind, it’s easy to understand allocators’ decision to move into private equity and private direct lending, particularly given the illiquidity premiums and other advantages of holding illiquid, hard-to-value assets. Direct lending capital surged from essentially zero in 2006 to a peak of nearly 50% of private debt capital raised in 2021. That increase came at the expense of distressed and special situations capital, which declined from about 50% per annum to around 20-25% over the last several years.

Figure 2 ($ in billions)

Source: PGIM Fixed Income and Pitchbook H1 2022 Global Private Debt Report. YTD as of June 30, 2022.

It is difficult to foresee existing direct lending managers pivoting into distressed and special situations in the public fixed income market, given the likelihood that dry powder will be used to reduce portfolio leverage in private investment vehicles. Private equity holds about $1.3 trillion in dry powder, but we suspect a portion of this capital will be reserved to defend existing transactions through equity injections and leverage reductions.

Dispersion in leveraged credit spreads took a multi-year hiatus amid central banks’ unprecedented responses to the pandemic. This incentivized investors’ reach-for-yield, leading to the distortions mentioned earlier. Those often serve as catalysts for distressed and special situations transactions as the distortions essentially tighten financial conditions in specific credits further than what is experienced at the index level. Dispersion remains below pre-pandemic levels, thus raising the risk that valuations quickly gap lower.

Conclusion

The idiosyncratic distortions exposed by the pullback in central bank liquidity point to a prolonged period of “self-help” by companies and sponsors, which may create a level of volatility and opportunity that surprises many participants. As we assess the complex cycle upon us, we’re keenly interested in second and third derivative distressed opportunities that we expect to emerge this year and next.

Developments during the coming cycle can reveal attractive risk/reward opportunities for investors with adequate dry powder and the experience to navigate an array of situations. Indeed, enhanced discipline, patience, and in-depth analysis of unique situations will be required to meet the primary challenge of unlocking a company’s needs and capitalizing on the opportunities that lie beyond the low-default era.

^{1. We define distressed as >750 bps of OAS.}

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