The credit markets today represent one of the most anomalous investing periods since the advent of the high-yield bond market in the 1980s. Persistent inflation and higher interest rates have created significant challenges for companies, corporate earnings outlooks and creditworthiness.
The US Federal Reserve and other central banks have embarked upon a policy path of tightening financial conditions to fight inflation, collectively raising rates at the most aggressive pace in recent history. With higher interest rates and wider credit spreads, the cost of capital has begun to constrict issuer cashflow generation, dampen valuations and limit refinancing prospects.
The US and European non-investment-grade credit markets have tripled in size since the global financial crisis, from $1.7 trillion to $5.1 trillion. This was largely due to zero interest rate policies that fuelled the credit markets to grow disproportionately relative to GDP, creating a larger basket of riskier assets compared with past credit cycles. Leverage ratios have reached 20-year highs, creating unsustainable capital structures for a large cohort of corporate obligors.
Many investors seeking to win dealflow sacrificed covenant protections, reducing default probabilities and future recovery values for companies that will ultimately require a restructuring solution. Aggressive earnings projections have driven a significant divergence between adjusted EBITDA and actual cash earnings. Marathon believes there is a strong probability of 2,000 downgrades and 200 issuer defaults during the 2023-24 credit cycle.
This credit cycle will be defined by a recession with persistent inflation, falling consumer demand, and rising input costs and interest rates, resulting in a repricing of risk as well as a multi-faceted opportunity to wisely deploy capital in both the private credit markets and dislocated secondary public credit markets. Investment managers who are experts in navigating complexity in public and private markets are best positioned to capitalise on this upcoming opportunity.
Creative private capital structure financing solutions will undoubtedly emerge as issuers face a liquidity crunch, while weak covenant packages enable new money solutions to take priority positions in capital structures.
In public credit, we expect leveraged loans to represent an outsized portion of the opportunity set as compared to its high-yield bond counterpart given: the lower credit quality of loan issuers resulting in higher default rates; the floating-rate nature of leveraged loans that puts incremental pressure on issuers’ cashflow; covenant-lite structures offering limited protection to legacy creditors; and the prevalence of unitranche loans resulting in less equity cushion than has historically supported first-lien loans.
Marathon’s expectation is that the Fed will be reluctant to pivot while levels of inflation remain above their 2 percent target. Given the confluence of factors, we anticipate the cumulative default rate over the next two years will approach around 10 percent, creating an approximate $500 billion opportunity – more than twice the size of the global financial crisis in nominal terms.
Downgrades lead to dislocation, and defaults lead to a range of opportunities from rescue to DIP finance, to purchasing the “fulcrum security”, to being a partner in leading the company through restructuring. The greatest risk-reward outcomes occur during the market trough when wounds are deepest and fear is most pervasive. Banks, historically the primary source of underwritten debt capital for acquisitions and buyouts, have retrenched from the space after recent headline losses.
As Marathon evaluates the 2023-24 credit cycle, we are confident that we will see a golden era for corporate credit.
Bruce Richards is chairman and chief executive officer at New York-headquartered investment manager Marathon Asset Management.