Sharply rising interest rates, a slowing economy, and tighter lending conditions are leaving many highly leveraged borrowers straining to service their debts. Here, Dan Ivascyn, group chief investment officer; Christian Stracke, global head of credit research; and Adam Gubner, corporate special situations portfolio manager, review PIMCO’s market perspective with Neal Reiner, alternative credit strategist. They discuss the challenges facing public and private credit markets and why they see a better value and risk profile in opportunistic corporate credit strategies than in traditional private equity.
Q: A sharp interest rate reversal has ended one of the longest bull markets in corporate credit. How does PIMCO look at corporate credit markets today?
Ivascyn: Corporate debt, particularly in the United States, has soared, fueled by a decade of low interest rates. U.S. corporate debt-to-GDP exceeds levels reached before the global financial crisis (GFC) in 2008. This excess has been most noticeable in senior corporate loans: The market for these floating-rate instruments – which are purchased by public and private institutional debt funds – has tripled since before the GFC to nearly $3 trillion. With elevated debt levels, sharply rising interest rates leave many borrowers struggling to meet higher debt-service costs at the same time the slowing economy squeezes profitability. As a result, PIMCO’s base case view is that cumulative three-year default rates for these loans across public and private markets could reach 10%–15% over the next several years, which translates into at least $300 billion of potential distressed opportunities.
Q: Where are we seeing stress – and strength – that differs from past credit cycles and dislocations?
Ivascyn: In past cycles, junior high yield debt and securitized mortgage holdings were the stress points. Today the challenges are coming from the unprecedented volume of senior loans issued over the last decade in the public leveraged loan market (syndicated bank loans to large companies) and in the new private senior lending space (loans issued by investment funds to smaller companies). Together, these loans account for essentially all sub-investment-grade net issuance over the last seven years.
The private segment of the market has grown rapidly since the global financial crisis – when large commercial banks stepped away from lending to small and midsize companies – and now rivals the public loan market in annual issuance. We believe private loans will be a growing source of stress – and opportunities. These borrowers are more vulnerable to economic downturns: Many are smaller companies that have narrow business strategies, less-resourced management teams, high leverage relative to assets, and little access to the broader capital markets. As the Fed raises interest rates and a recession looms, these borrowers face both sharply rising debt service costs and earnings headwinds.
Credit risk in these senior loans is further heightened by the issuers’ weak investor covenants. Amid the last several years’ historically low interest rates, investors poured capital into both public and private markets, leading lenders to compete and issue deals with some of the highest leverage in history – often anticipating big future cost savings – alongside weakened covenants.
Not every corporate credit suffers weak fundamentals, though, and some areas of the market look reasonably healthy in our view. These include many areas of the high yield bond market, particularly larger issues rated BB or B that have weathered multiple cycles. We think these borrowers’ high yield ratings are appropriate for their balance sheets, but they could still be fairly resilient. There's been very little net issuance in the high yield market in the last several years, which also should help support prices.
You can read the full Q&A here.
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