2019_02_19 — “Will There Be a Default Wave or Ripple? Private credit to the rescue”
February 19, 2019
Will There Be a Default Wave or Ripple? Private credit to the rescue
Coming Default Wave or Ripple? Private credit to the rescue
If you think there is a huge debt default wave coming soon, you may be wrong; but not for the right reasons.
In other words, a magical economic or business resurgence might not be the reason for much debt not defaulting in the next few years; rather, institutional stressed and distressed investors may supply struggling companies with sorely needed capital through covenant heavy or secured financing that places itself in the capital structure above existing covenant light loans and other high yield debt.
Private credit to the rescue
Fixed income markets have recently adjusted to two new realities:
- Widespread downward revisions to 2019 earnings forecasts and economic outlook;
- Higher market volatility driven by quantitative tightening and less accommodative monetary conditions.
Against this recent backdrop, debt concern has mounted over the last two years, as investment grade and high yield bonds have become increasingly expensive (spreads have tightened), and as the quantity of corporate debt has markedly increased. Interest coverage is below 2007 levels, cash to debt levels are low, debt leverage is high, and debt supply has ballooned.
Trust Company of the West (TCW) believes that bonds only dropped to fair value during the market dip in December. Jeff Gundlach, the noted Chief Investment Officer of DoubleLine advises carefully avoiding the corporate bond sector because it is too expensive relative to economic risk. Many other market observers note that the swollen ranks of BBB bonds could easily (with a downgrade) cascade into high yield. In addition, more than 80% of new loans are covenant-lite, the covenants that are in place are weak, and earnings adjustments for compliance have become aggressive. Some investors will declare light covenants okay because they give the equity class more maneuverability to fix a company; the flip side of that argument is that increased management flexibility can mean less recovery for debt holders if the fixes go wrong.
Concerns over the value of debt are probably not misplaced. However, actual default rates may remain low or less than predicted because a lot of stressed and distressed rescue capital is on the sidelines. This capital will provide financing that will give a company funds for capital expenditure (capex) on high margin projects or for debt paydowns, but it will feel covenant heavy, secured, or like debtor in possession (DIP) debt.
Large institutional alternative investment firms like Cerberus Capital Management, Angelo Gordon, Ares Management Corporation, The Blackstone Group, and Oaktree Capital Management are notable investors in stressed and distressed debt.
Their opportunity set should expand specifically because the mountain of debt that is covenant light, doesn’t have the necessary catalyst to force a restructure. Therefore, stressed and distressed financing from institutional investors can come in ahead of existing senior debt. Such stressed as destressed financial maneuvers can be credit negative for loans because they erode recovery values; thus causing loan and debt values to decline even though actual defaults are averted or at least delayed.
Expect institutional alternative investors to raise more capital to take advantage of capital needs and weak covenants. Such stressed and distressed investors should delay a default wave, but probably won’t preserve existing debt values.
Michael Ashley Schulman, CFA
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Disclosure: The views and opinions expressed are those of Michael Ashley Schulman, CFA and are subject to change without notice. The views and opinions referenced are as of the date of initial publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Forward-looking statements cannot be guaranteed; neither can backward-looking nor current-looking statements. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each person’s or investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.
