The following is an except from a Benefit Street Partners’ topic paper. Download the full paper.
Fasten your seatbelts—credit markets are going to be bumpy. Events that once seemed unlikely (high inflation, limited central-bank tools, rising interest rates, unexpected war, slowing global growth, margin compression) are all transpiring.
Economic and market outlooks are uncertain. An anomaly? For the most part, no. While war and sky-high inflation are certainly not the norm, many dynamics are consistent with conditions that existed for decades before the global financial crisis (GFC), an era that saw a persistent special situations opportunity set. However, there is one critical difference between the two eras: a massive debt market, which the explosion of the leveraged finance market had fueled. In this piece, we summarize key dynamics at play in credit markets and explore how best to capitalize on the bumps that are creating the beginnings of another fertile special situations investment environment.
Key takeaways
• An end to the highly anomalous post-GFC era is near, with a return of traditional economic cycles and operating environments underscored by higher cost of capital, sustained dislocations and a rolling opportunity set.
• Leveraged credit markets have more than doubled (US$4.2 trillion today versus just US$1.7 trillion in 2010), creating an unprecedented amount of leverage in the financial ecosystem.1
• Macroeconomic headwinds and uncertain topline performance without the buffers of zero interest rates and central-bank liquidity injections are creating volatility and dispersion in the market. The stressed/distressed opportunity set has increased ~400% year-to-date (YTD) from US$75 billion to nearly US$300 billion.2
• Numerous opportunities for equity-like returns in credit, both in primary and secondary markets; opportunity set and return potential can expand significantly in the event of a prolonged global recession.
• In an uncertain environment, we believe it is prudent to be positioned in a portfolio focused on asset coverage in industries that are historically recession-resilient.
Today’s markets offer attractive opportunities in credit that cannot be ignored, even when adjusted for highly uncertain headwinds and a glut of leverage. We believe the best risk/reward today lies within a portfolio of uncorrelated and bespoke process-oriented investments, event-driven themes, and names that stand to perform during a recessionary and inflationary environment. Current dynamics are creating these investments with greater convexity, at lower prices and lower attachment points. We believe it is prudent to allocate capacity today to be able to deploy dollars now and into an accelerating opportunity set.
WHAT ARE THE RISKS?
All investments involve risks, including the possible loss of principal. Stocks tend to fluctuate dramatically over the short term. Bond prices generally move in the opposite direction of interest rates. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Investing in private companies involves a number of significant risks, including that they: may have limited financial resources and may be unable to meet their obligations under their debt securities, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of realizing any guarantees that may have obtained in connection with the investment; have shorter operating histories, narrower product lines and smaller market shares than larger businesses, which tend to render them more vulnerable to competitors’ actions and changing market conditions, as well as general economic downturns; are more likely to depend on the management talents and efforts of a small group of persons; therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on the portfolio company and, in turn, on the investment; generally have less predictable operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations, finance expansion or maintain their competitive position.
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1. Leveraged credit market sizing includes dollar value of outstanding high-yield corporate bonds and broadly syndicated leveraged loans, in addition to private credit dry powder. Sources: Goldman Sachs Global Investment Research and Preqin.
2. Defined as loans wider than 1000 basis points (bps) and bonds trading below 80. Source: Bloomberg, as of December 30, 2022.
