Seidner: Welcome to a discussion with several of my colleagues. We're going to discuss the opportunity that's being created by elevated credit risk in corporate markets. My name is Mark Seidner. I am our chief investment officer of non-traditional strategies.
Today I'm joined by Christian Stracke who is our global head of credit research Jamie Weinstein who is our head of corporate special situations, and Adam Gubner who is one of the senior portfolio managers on the credit opportunities strategies.
As many of you will know, when we met in May we published a research piece titled, Dealing With Disruption.
Our base case is that we are late in the cycle, that economic risks are growing, downside risks are mounting.
And at some point in the next three to five years, we will see a recession, not just in the United States, but probably globally.
The risks that we have identified, including mounting trade tensions, increasing political polarization and risk, demographics and aging society, technological disruption, all of which we think is leading to mounting risk and increasing financial market vulnerability.
We are certainly seeing much greater differentiated outcomes in credit markets. And we're also seeing the economy, the manufacturing sector in many parts of the world is already in recession or a downturn. And there's severe risks that the consumer sectors will follow soon.
So with that as a backdrop, why don't I turn it to Christian. It's 10 or 11 years post the financial crisis. What do you see in the credit markets?
Stracke: We've had this 10 or 11 years of either very low or very, very low interest rates encouraged by central bank accommodation, which has caused a lot of investors to look for yield. And where have they been able to find that yield has been in many cases in corporate credit. And so as we look around in the economy, there's not a lot of leverage in the economy.
Corporate leverage to GDP is at an all time high now, higher than it was in 2007, 2008. So there has been some fairly aggressive leveraging of corporate balance sheets.
And as we know, companies don't deleverage by themselves voluntarily. They usually deleverage in periods of stress and distress. And that's what we're looking for is that its late in cycle with companies with this much leverage there will be those opportunities and instances of stress.
Seidner: But that does create the opportunity. There's been a great transition of ownership away from banks, or transition of risks away from banks and bank balance sheets, to other yield induced, yield sensitive, rating sensitive buyers of credit risk.
Because here we are when the dynamic does shift, as fundamentals turn, as income streams get shut off, as ratings get downgraded, and as structures that have been created to absorb much of the credit risk that has been issued post financial crisis shifts, right?
Stracke: I mean we're in a really perverse kind of situation right now where for the system, the capitalization of banks right now is really good. Banks are much safer than they used to be. And yet for individual cases where you've got something being downgraded, where you've got something that needs to get sold, banks are not able to intermediate that risk anymore the way that they used to because of tighter bank regulation.
That creates opportunities for capital that can come in and take the place of banks either to lend or to intermediate where they once were.\
Seidner: Motivated buyers can become motivated sellers very quickly.
Stracke: Very quickly.
Seidner: Jamie, let's turn to you. I mean here we are 10 or 11 years post the financial crisis. What's — what's different this time?
Weinstein: The biggest change is the growth in the private credit markets. Estimates of the size of that market vary quite considerably because there isn't good data on exactly what has happened in the last 11 years as you referenced. But a good number to use that we've seen triangulated on is around $900 billion of assets in private credit. Now if you think about that and you say, where — where does that sit — how does that come to be, what are those vehicles constructed as. They're generally private credit funds operated by invested managers, and at least in the US context, the business development companies. Those loans that have been made as all of this capital has poured into credit broadly as you define corporate credit, the standards that those loans have been originated to have deteriorated over the last several years.
And so it's our view that the margin of safety that people thought were built into those loans won't actually be as strong as they might have thought it was. In addition to that, liquidity in corporate credit broadly is less than it was because some of the regulatory changes around banks. In private credit it's effectively nonexistent.
If you try to size how big is that opportunity set, you don't really have to be that precise. If you start with that 900 billion size, if you say only 10 percent of those loans end up under stress and those need to transition, that's a huge opportunity set for investors focused on that type of thing.
And then lastly, as you think about the banking system and what is their role in this.
The banks often are providing leverage to those funds. So even though the banks are not the actual holder of the credit risk like they might have been in prior cycles, they now hold it indirectly through these portfolio loans. And they may be one of the triggering points as you mentioned that creates that pressure for loans to move.
Seidner: So size, leverage, ownership, protections to bond holders, all risks that we see in — in the coming environment. But Adam, it's very possible, and we talk about this a lot, that recession may not be imminent.
What if it's delayed? What if the inevitable is not right around the corner?
Gubner: We've talked about all the liquidity in the system. And we've still been able to find opportunities. And in particular certain industries are still having some challenges, and we've been able to invest in things like retail and consumer, or think about specialty finance where they have nascent business models, and again aren't necessarily able to kind of attract the traditional capital.
And then lastly energy, which continues to have periods of dislocation. Where we've really tried to stay away from are companies going through secular challenges.
So coal is a great example of where a lot of folks really made some errors thinking that the decline would be slower. And ultimately they were just wrong. And again, we've stayed away from those types of opportunities.
Seidner: So in closing, we're all very excited about the potential opportunities that are coming out of an evolving secular view. The rising of balances in the corporate lending market, that the private credit markets are what's different this time, or the time horizon might be extended. There's plenty of opportunities in capital solutions to find value or take advantage of stress or distress in a rolling opportunity set as individual industries and companies find challenges.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Investing in distressed companies (both debt and equity) is speculative and subject to greater levels of credit, issuer and liquidity risks, and the repayment of default obligations contains significant uncertainties; such companies may be engaged in restructurings or bankruptcy proceedings.
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