Published April 2020
Question 1 of 2
Will the current market situation (Coronavirus) be the catalyst for a major credit crisis where late-cycles symptoms (e.g. cov-lite/doc-lite, loosening of covenant headroom, wider allowances for EBITDA adjustments, strong inflows of capital/competition among lenders, historically low default rates etc.) have already been addressed by many participants in the market?
Eaton Vance Management
While it feels like we might be on the cusp of an increase in defaults and restructuring transactions, it’s impossible to predict whether we’re on the cusp of a “credit crisis”. Quarantine and isolation will undoubtedly hit consumption and cause economic hardship, and certain sectors may be brought to their knees (Leisure, Airlines, etc), with very worrying newsflow coming out of these sectors in recent weeks. Simultaneously, policy-makers around the world have acted very quickly with monetary and fiscal measures. Furthermore, high-yield bond and loan market participants have typically used the low rate environment to term out their debt. An inability to refinance is one key driver of increased defaults but if no one needs to refinance, a credit crunch is less likely. Additionally, the timeline on how long the virus will disrupt global economies is unknown.
BNY Mellon Investment Management
It is hard to foresee how far the virus will spread, or how long economic activity will be suppressed for, making it difficult to judge the extent of its negative impact. What is clear is that in the last couple of weeks we have seen a sharp repricing of risk, to be followed by wholescale credit rating downgrades and by a rise in corporate defaults from abnormally low levels. The scale of repricing has made valuations more attractive than they have been for many years. While not calling the bottom, the combination of monetary and fiscal policy may mitigate the worst of the current downturn, serving to avert a prolonged recession and re-engineering a return to growth providing interesting entry points for investors.
MAN GLG
It is likely that we see a global recession and a large hit to corporate earnings, though we could be looking at a short, sharp shock, rather than a deep, prolonged recession. We think in the current environment, many, if not all, high-yield issuers should focus their attentions on preserving cash and adopting measures to help ensure their survival. We believe realised defaults could potentially peak around 10%, mainly in consumer-facing sectors and US energy.
While creditor protections have been eroded across the market, we are particularly concerned about leveraged loans, where recoveries may be much lower than in previous cycles. We think loan deals have been issued at ever-tighter spreads with fewer protections for ever-more questionable credits, with excessive leverage applied to underwhelming companies.
Pacific Asset Management
The implied loan default rate is +20% at current levels. However, our view is that the default rate will be substantially lower than what the market is pricing in. In our opinion, much of the default environment will be determined by how quickly the domestic economy gets back up and running, the spread/containment/impact related to COVID-19, governmental bailouts effects, and the abatement of indiscriminate forced selling resulting in a liquidity crisis. Current market expectations are pricing in a lot of bad news and it is not our base case this level of defaults come to fruition. The current price of the Credit Suisse Leverage Loan Index is trading at $78 (representing distressed levels).
Question 2 of 2
How can institutional investors act in this situation (e.g. is there any manoeuvrability at this point in time, e.g. liquidity, opportunities to explore etc.)?
Eaton Vance Management
Buying opportunities often exist when everyone else wants to sell, and a number of our conversations with institutional clients are currently about topping up, not redemptions. In fact, top-ups offer excellent opportunities to reshape portfolios, only needing to access one-sided liquidity. This may be a blessing for clients brave enough to top up into what feels like the eye of a storm. Our estimation of the default rate currently priced into high-yield bond markets is substantially worse than that endured during the GFC. This feels overly pessimistic to us and the forward returns for long-term investors who buy into high-yield and loan markets at the prevailing credit spreads have historically been positive.
BNY Mellon Investment Management
The return of volatility provides ample opportunities for institutional investors. A bullish approach would be to take the view that, given monetary and fiscal policy announcements, the worst of the volatility is behind us, although that is still hard to say with any certainty. This would be consistent with advocating buying a selection of credits marked below 80, to aim for returns in excess of 10%.
MAN GLG
Value dislocations have appeared at levels seen once in a cycle (or even a generation) across numerous sectors, including telecoms, gaming, services, but also travel and energy (ex-shale). In our view, market turmoil has been exacerbated by unsuitable investment vehicles (e.g. ETFs with asset/liability mismatches and CLOs exposed to the ratings downgrades. We believe it is a buyer’s market, with no lack of liquidity for bids, with bonds trading substantially below screen prices. In this scenario, the best opportunities may be found in generally well-run but overleveraged credits, including former LBOs, where creditors may provide liquidity and/or obtain control via debt equitizations.
Pacific Asset Management
Historically, the loan asset class has had a lower default rate along with a higher recovery rate than traditional High Yield. Additionally, the loan asset class has lower exposure on a market weighted basis to energy related sectors (which we believe will remain under pressure for an extended period) as well and lower historical volatility versus traditional High Yield. Going forward, it is likely that default and recovery levels adjust. Given the current similar yield environment between loans and high yield bonds, we think the argument favors the loan asset class, at this point and time. One input to this is the view that the energy sector is likely to undergo drastic reshaping and the high yield bond universe has far greater exposure to this sector than the loan asset class.
Disclaimers
MAN GLG: Opinions expressed are those of the author as of the date of their publication and are subject to change. This material is for information purposes only and does not constitute an offer or invitation to invest in any product for which any Man Group plc affiliate provides investment advisory or any other services. Some statements contained in these materials concerning goals, strategies, outlook or other non-historical matters may be “forward-looking statements” and are based on current indicators and expectations at the date of their publication. We undertake no obligation to update or revise them. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those implied in the statements. 20/0576/RoW/GL/I/W