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.
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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. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Alternatives involve a high degree of risk and prospective investors are advised that these strategies are suitable only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment.
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