Global Weekly Commentary: Restructuring opportunities
Key points
Private credit opportunities
We like higher-yielding credit amid low rates, and see corporate restructurings offering growth and potential return diversification for private credit investors.
Infection pickup
A pickup in Covid-19 cases may weigh on mobility and activity in the near term, but we see this wave of infections as much shallower than the spring one.
Data watch
A spate of purchasing managers’ index data this week could shed light on any potential impact that increased virus infections has had on activity.
Many companies may need to turn to private credit to restructure post-Covid. We see potential for such investments to serve as growth assets and diversifiers when new sources of portfolio resilience are needed. This complements our preference for higher-yielding credit amid low rates. Private markets are relatively illiquid and not suitable for all investors but play a key role in strategic portfolios, in our view.
Chart of the week
Sub-investment grade debt outstanding, 2007 and 2020
Sources: BlackRock Investment Institute, October 2020. Notes: Indexes used are Bloomberg Barclays Global High Yield Index, S&P/LSTA Leveraged Loan Index + S&P European All Loans Index, and JP Morgan CEMBI Index. Private credit data are from Preqin. Index data are as of June 30, 2020, and the private credit data as of Dec. 31, 2019. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index.
The scale of the restructuring needs could exceed the previous peak seen after the 2008 global financial crisis (GFC). One big reason is the significant growth in sub-investment grade debt since the crisis. The amount of sub-investment grade debt outstanding has more than doubled to $5.3 trillion since 2007, as the chart shows. Private credit has been an especially fast-growing segment, expanding to $850 billion by financing companies that would previously have looked to banks or the public high yield market. As debt markets grew and the overall cost of debt fell, companies became increasingly levered. The average interest coverage ratio – a gauge of solvency - for middle market buyout transactions in 2019 fell to levels that were last seen immediately before the GFC and bursting of the tech bubble in the early 2000s. This left many vulnerable as their revenues come under pressure from Covid-related disruptions. It creates opportunities for restructuring and distressed debt specialists, an important subset of the private credit market. Many institutional investors remain under-invested in the growing private markets, we believe, and may be underappreciating their ability to take on liquidity risk.
Supportive fiscal and monetary policies to cushion the pandemic’s blow have helped companies raise capital and lower borrowing costs. Yet not all borrowers have benefited equally. Large companies have borrowed with ease on the public market; smaller firms have lacked the same access. The interest rate gap between U.S. middle market and large corporate loans has widened this year, according to S&P’s Leveraged Commentary & Data (LCD). Many companies will likely have to evolve their business models as the pandemic accelerates long-term structural trends such as digitalization. We see this creating a wave of restructurings – and room for private credit to cater to smaller and lower-credit quality issuers.
The ability to choose a good manager is integral to the case for holding private assets: our previous work has shown the dispersion of realized returns in private asset managers is typically greater than that of public managers. With risks of policy exhaustion and localized lockdowns rising, it becomes even more important to pick private market managers who can assess credit risk and structure resilient investments. Corporate restructurings typically involve complex negotiations between creditors. Success for creditors often means avoiding losses from defaults and restructuring by elevating the seniority of the debt in the capital structure. Buying discounted loans and bonds in the secondary market to seek control was typical after the GFC. These types of transactions will play an ongoing role, yet we see the focus potentially shifting due to a decade of erosion in lender protection. About three-quarters of the U.S. leveraged loans at the end of 2019 were considered “covenant-lite” – with fewer restrictions on the borrower and less protection for the lender – according to Moody’s Investors Service. The Covid shock has hit many companies funded by such loans, but the borrower-friendly terms could mean fewer outright defaults and opportunities for private credit investors to step in to provide fresh capital.
We see a historic opportunity for the private markets to fund post-Covid corporate restructuring. We see a case for a greater share of private market allocations to be in private credit than we typically observe in clients’ portfolios. Diversifiers are important at a time when the traditional source of resilience in portfolios – nominal government bonds – may not play the same role. We also favor high yield credit in the public market – on a strategic and tactical basis – for its income potential and adequate compensation for default risks.
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