As the credit cycle matures, investors are increasingly concerned about the economy and the stability of credit markets. For larger institutional investors, the anxiety is compounded by implementation risks – in particular, the danger that complex and slow-moving governance structures could impede their ability to move swiftly when a sudden market downturn lowers asset prices to attractive levels.
Fortunately, a potential work-around exists: In contingent capital strategies (also referred to as “trigger” or “dry powder” strategies), investors commit capital ahead of time – it’s generally kept on standby in cash equivalents or core bonds – and deploy it only when a meaningful dislocation causes valuations to fall to more compelling levels. By design, contingent capital strategies play a countercyclical role in an investor’s asset allocation – they seek to buy dislocated, performing assets that are temporarily underperforming. Simply put, they follow the fundamental investment adage, buy low and sell high.
To be sure, significant market dislocations – not uncommon over the past 20 years – can be painful for investors. Yet they also can provide attractive buying opportunities for those prepared to provide liquidity (at a discount) when sellers demand. Indeed, if timed reasonably well, capitalizing on dislocations has the potential to enhance a portfolio’s risk-adjusted returns.
Figure 1 illustrates how credit returns (using the Bloomberg Barclays US BBB Credit Index as a proxy) tend to mean-revert and become meaningfully positive after periods of significant dislocation.
Moreover, Figure 2 demonstrates that in these examples, timing does not have to be perfect. While performance is somewhat varied across historical periods, investing a few months early or late relative to peak credit spreads could still have generated attractive returns. Spread tightening (i.e., price appreciation) typically drives the bulk of total returns in a credit market recovery but yield and income can further supplement returns and partially cushion investors against adverse, short-term spread widening.
Learning from experience
It’s hardly surprising that investors have concerns about the credit market and the macroeconomy. Credit creation has ballooned, particularly in the corporate sector, amid ultra-low interest rates and the reach for yield. High yield and leveraged loan markets have expanded by $1 trillion since 2008 to $2.5 trillion, and the amount of BBB rated debt has mushroomed to twice the size of the high yield bond market. Leverage has increased, lending standards have eased, and liquidity has become more disjointed as the influence of liquidity- and ratings-constrained holders of corporate credit (e.g., mutual funds) has grown.
Yet, many institutional investors have missed past opportunities presented by market corrections. When high yield bonds sold off in late 2015 and early 2016, for example, many institutional investors simply could not move fast enough. For some, opportunities evaporated.
In addition to bureaucratic hold ups, behavioral biases can slow decision-making and lead to mistakes, particularly during the throes of a sharp sell-off. After all, investment committees consist of individuals who, inevitably, have a host of cognitive and behavioral biases. Although well-known and widespread, these biases – such as loss aversion – can be difficult to identify and counteract in the moment.
And herein lies another argument for an allocation to contingent capital. It may help mitigate behavioral and governance challenges by outsourcing the allocation timing decision to an investment manager with experience deploying capital during periods of stress.
The next dislocation
So, what could the next dislocation look like?
It is difficult to say with certainty, but PIMCO is quite cautious on lower-grade corporate credit, particularly leveraged loans, high yield bonds, and collateralized loan obligations (CLOs). These sectors have releveraged post-crisis – in most cases, doubling in size – due chiefly to an oversupply of capital to riskier companies (see Figure 3). Record levels of loan and high yield issuance have been accompanied by record leverage.
While these corporate-related segments may be the initial point of stress, spillovers are common to other credit sectors such as mortgages, structured credit, and emerging markets. Moreover, higher-yielding corporate credit has tended to overshoot during dislocations, even if only a small percentage of credit market fundamentals are deteriorating.
Going forward, overshoots of this sort may be even more severe as credit markets remain extremely prone to liquidity risk. Liquidity- and ratings-constrained investment vehicles, which have grown in size in recent years, may lead to significant forced selling (and potential buying opportunities for investors with dry powder). Indeed, forced sellers have been known – somewhat counterintuitively – to ignore credit quality and prioritize sales of more liquid, higher-quality credits, despite their having relatively solid fundamentals.
History has shown that vehicles offering daily liquidity, such as mutual funds and exchange-traded funds (ETFs), may be especially prone to this type of selling. This is largely because allocations to credit within these vehicles have risen substantially in recent years (see Figure 4).
At the same time, a flood of sales due to ratings downgrades or investor redemptions could overwhelm a diminished buyer base as traditional providers of liquidity have retrenched. Prop trading desks have largely disbanded, and dealer warehousing and bank balance sheets are a fraction of what they once were. Inventories of corporate and securitized credit have contracted significantly post-crisis (see Figure 5). The supply-demand mismatch may lead to more frequent, acute, and unanticipated price gaps.
Risks to liquidity in credit markets, however, also highlight a potentially rich opportunity set for contingent capital vehicles. When well-structured, these vehicles tend to have broad flexibility: They may invest across credit markets, sectors, and asset types, are unconstrained by ratings, and impose prudent liquidity terms. The ability to use leverage, when applied carefully to dislocated, yet higher-quality credit assets, can also meaningfully enhance performance potential, especially if borrowing costs decline amid central bank easing.
In practice, contingent capital strategies closely resemble opportunistic drawdown-style vehicles – capital is committed, called/invested, harvested, and ultimately distributed back to investors – with one important distinction: The strategy will only activate, call and deploy capital upon a sizable market disruption, otherwise it remains dormant (see Figure 6).
Approaches to a strategy’s activation can vary, ranging from explicit market-based triggers (e.g., high yield spreads widening to 600 basis points) to full manager discretion. Target asset types can range from a single sector to multiple sectors, across both public and private markets.
We tend to prefer a flexible multi-sector approach to public credit assets, with an activation trigger that is discretionary but guided by a comprehensive set of market factors, such as changes in spreads and issuance levels, mutual fund flows, ratings downgrades, liquidity, and financing conditions. This method helps to ensure we have the necessary discretion and flexibility to capture the most compelling opportunities across credit markets globally (see Figure 7).
In sum, as global growth slows and we enter the later stages of the economic cycle, concerns over a more severe market correction will likely rise. Being prepared is crucial, and we expect more frequent dialogue about the potential advantages of contingent capital strategies, including return enhancement and their countercyclical role in a portfolio during periods of uncertainty. The strategies’ ability to bypass time-intensive administrative hurdles also provides a key solution to institutional investors who want to prepare today for opportunities tomorrow.