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.
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 collective experience 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. For example, Figure 1 shows that two of the prior four business cycles set records for their longevity and each was about three times longer than the average extending back to 1854. Further to the influence of monetary accommodation, the COVID-related default cycle—which was countered by an unprecedented global central bank response—was the fastest of the prior four cycles to drop below its pre-recession lows.
From the perspective of historical default rates, Figure 2 highlights the market’s altered state amid the liquidity deluge as default rates since 2004 were nearly 50% below their long-term average and 70% below the pre-GFC average.
Figures 1 & 2
The extension in U.S. business cycles contributed to the low-default era (default rate %)
PGIM Fixed Income, NBER, Bloomberg and Moody’s Investors Service.
Changes in central bank reserves may also contribute to a higher cost of capital for borrowers with lasting effects. Figure 3 shows how U.S. investment grade credit spreads have shifted in tandem with global central bank reserves in recent years. With 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.
As policy tightening lowers the net present value on strategic and growth capital, it will also expose other, idiosyncratic problems not readily visible to the marketplace. These include operating inefficiencies, bloated costs, negative operating leverage, and unbalanced cash flow generation.
Figure 3
Credit spreads have moved in tandem with central bank reserves (LHS: in $ trillions; RHS: in bps, inverted)
Citi Research. As of May 31, 2022.
As borrowers confront increased capital costs as well as the prospects of business cycles and default rates that revert to historical trends, it isn’t surprising that many 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 available to capitalize on the opportunities.
How Much Dry Powder is Sufficient?
Considering the prolonged benefits of central bank liquidity, investors may believe that about $100 billion in dry powder may be sufficient to manage through the coming distressed situations in the U.S. and maintain the status quo in terms of credit conditions. However, $100 billion may only be a fraction of what is needed, and a few remnants from the prior cycle shape our estimates for the amount of dry powder needed going forward.
The first is the growth in the leveraged finance markets, which roughly doubled in size following the GFC in an expansion that is often overlooked by investors who focused on private direct lending or private equity. Figure 4 shows that when either the current level of market distress or Moody’s 1-year forward default rate is applied to the outstanding debt in the U.S. 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%, i.e., 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.
Figure 4
The progression of U.S. distressed scenarios vs. dedicated capital (in $ billions)
PGIM Fixed Income, Moody’s Investors Service, and Preqin
Powder May be Dry, but Stranded
How did we get here? With the market-related effects of central bank liquidity (e.g., 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. Figure 5 highlights the surge in direct lending capital 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.
Now that these private buckets are full (thanks in part to the denominator effect), the pressing question becomes how capital will shift into more opportunistic debt strategies, which have a far lower stockpile of dedicated capital (Figure 6). The simple answer is that it probably won’t.
Figures 5 & 6
Distressed and special situations consistently trail direct lending in debt capital raises (Figure 5: %; Figure 6: in $ billions)
PGIM Fixed Income and Pitchbook H1 2022 Global Private Debt Report. YTD as of June 30, 2022.
We struggle to see existing direct lending managers and their dry powder pivot into distressed and special situations in the public fixed income market given mandate limitations and the general lack of qualifications. Additionally, we expect a portion of the dry powder will be used to reduce portfolio leverage in private investment vehicles as the credit cycle matures and asset marks push leverage to untenable levels.
Although there is about $1.3 trillion in private equity dry powder, we suspect a portion of that capital will be reserved to defend existing transactions through subsequent equity injections and leverage reductions. We highlight these trends as a rebuttal to the preconceived notion that there is a considerable amount of dry powder “waiting to capitalize when markets dislocate.”
Structural Dispersion and its Opportunities
The points above culminate with observations from the changing levels of structural dispersion in leveraged credit spreads. Figure 7 shows that spread dispersion was steadily increasing before the pandemic and took a multi-year hiatus amid central banks’ unprecedented responses. This incentivized investors’ reach-for-yield—often amongst those unfamiliar with the leveraged finance sector—leading to the distortions mentioned at the top of the post. 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.
Although dispersion has recently increased, it remains less than pre-pandemic levels, thus increasing the risk that valuations quickly gap lower to the surprise of unsuspecting investors.
Figure 7
The structural dispersion in leveraged credit spreads reflects various distortions and can catalyze special situations transactions (U.S. single B OAS in bps)
Bloomberg. As of September 30, 2022.
Conclusion
Unlike the last two default cycles (i.e., those pertaining to the GFC and the pandemic) where the generic market dislocations warranted broad exposure, this cycle will arrive amidst a vast withdrawal of central bank liquidity. The idiosyncratic distortions exposed by the pullback in 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.
While developments during the coming cycle could be jarring for investors who ignore the uptick in special situations activity, they can also reveal attractive risk/reward opportunities for those 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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