Q & A with PIMCO´s Dan Ivascyn, Christian Stracke, Adam Gubner and Neal Reiner
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 DO YOU 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-toGDP 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, our 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.
Q: REGULATION ENACTED AFTER THE GREAT FINANCIAL CRISIS CREATED DISINCENTIVES FOR BANKS TO LEND TO MIDSIZE COMPANIES, BUT NOW THEY LEND TO PRIVATE LENDERS. WHAT STRESSES DOES THIS CREATE AT THE PRIVATE LENDERS?
Gubner: It is with some irony that the banks themselves are not making middle market loans, but they will lend to direct lenders against these same loans in a loan-on-loan type of structure. In a buoyant economy and improving credit environment, those loans perform well and most private lenders use this leverage to deliver higher returns to their investors. The problem is that banks will only lend to managers against their performing loans. Once a performing loan starts to weaken, private lending managers are typically required to remove that loan from the borrowing base and pay down the bank facility debt associated with the position.
Ordinarily, that is not a problem. There’s cash coming into the system through interest payments or paydowns of existing loans. Private debt fund managers (direct lenders) can use that cash to pay down the leverage. In the current higher-interestrate environment, however, loan paydowns from refinancings are shrinking considerably and at the same time, banks’ tighter lending standards will constrain liquidity for these managers As a result, we anticipate a growing number of managers will be compelled to consider selling existing positions and be forced to receive a discount from their current net asset value (NAV) carrying values.
Q: HOW WOULD YOU CHARACTERIZE THE CURRENT MARKET FOR PRIVATE AND PUBLIC LOANS AND HIGH YIELD DEBT?
Gubner: Traditional markets for public and private loans are largely shut and liquidity remains thin. As recession looms, investors have rushed to reduce exposure to more economically sensitive assets. For example, more investors are redeeming shares of private closed-end funds – known as business development corporations (BDCs) – that invest in debt of midsize private companies. Redemptions have been so high at some of the largest non-traded BDCs that they hit preset limits, forcing managers to restrict investors’ liquidity. Similarly, investors have sold shares in public BDCs, pushing those shares far below their managers’ current NAV’s, which alludes to the disconnect between public and private valuations.
An increasing number of these private funds are seeking to sell their underperforming credits at a significant discount in an effort to upgrade credit quality, maintain a target yield distribution to investors, and avoid a lengthy and timeconsuming restructuring processes. We expect this trend will accelerate as banks increasingly tighten lending standards, forcing private debt funds to sell underperforming positions that can no longer be included in their leverage facilities. We anticipate increased opportunities to either purchase these loans at a discount or refinance companies directly with more flexible capital solution structures.
The clamor for liquidity as also hit the broader high yield market with investment banks suddenly unable to sell debt issued to finance mergers and leveraged buyouts, (known as “hung” loans or bonds). Banks committed to financing these transactions, expecting to sell the financings to investors. But investor demand has weakened considerably amid the sharp rise in interest rates, weaker earnings, and rising risk aversion. In turn, banks have retrenched and many remain overextended.
Q: THE CAPITAL MARKETS IN EUROPE HAVE BEEN SHOWING CONSIDERABLY MORE STRESS THAN IN THE U.S. DO THEY OFFER A UNIQUE OPPORTUNITY RELATIVE TO THE U.S.?
Stracke: European capital markets present a different set of opportunities. The energy crisis and the war in Ukraine have put Europe under greater economic stress. Similar to the U.S., core inflation in Europe remains elevated, yet interest rates are lower than in the U.S., leaving the European Central Bank (ECB) to confront a steeper tightening curve as it moved off negative interest rates. We believe the steep tightening cycle will remain particularly challenging for European credit markets: It has sapped investor demand and, in turn, public credit issuance fell more than 70% in 2022.i As in the U.S., the collapse in investor appetite has left banks saddled with billions of dollars of hung deals where funding was committed to borrowers but the banks were unable to place the debt.
As investors and banks retreat and spreads widen, we see opportunities for investors with fresh capital to plug the liquidity gap. Yet investors need to be quite selective and mindful of the vagaries of Europe’s restructuring laws. An on-the-ground broad, highly experienced restructuring team is critical in our view, with the resources and networks to bring a restructuring either through the courts or through an out-ofcourt consensual agreement.
Q: HOW DO YOU VIEW INVESTMENT PROSPECTS IN THE OPPORTUNISTIC CREDIT SPACE?
Ivascyn: In crisis comes opportunity. The pullback by traditional lenders is creating very attractive opportunities for new entrants with fresh capital to demand wider lending spreads and better structured deals with more downside risk mitigation and less reliance on leverage. Yields have climbed to enticing levels and the risk-adjusted return profile has considerably improved from just nine months ago.
Gubner: With private direct lending firms, syndicated bank loan markets, and commercial banks now all quite constrained, borrowers are increasingly seeking private capital solutions transactions. These bespoke one-stop financings can provide more flexible capital to borrowers with customized terms and structures. That often means loans structured with both a cash and a “paid in kind” interest component (under which the loan amount grows in lieu of cash interest)ii, upfront fees, and equity warrants or exit fees. We believe demand for bespoke capital solutions will mushroom over the next several years as borrowers face increasingly acute liquidity needs and the lending environment becomes challenged. As a result, we see opportunities to provide liquidity across the middle market to performing companies that face challenges funding working capital needs, closing on acquisition targets or refinancing existing debt maturities. We think the landscape of opportunities will get more attractive with increased maturities in 2025 and 2026, and as higher-than-expected financing costs and earnings headwinds drain liquidity.
We also expect to see private debt funds and banks seek to sell private loans held in their portfolios. Private debt funds will likely face curtailed lending from banks, forcing them to improve their overall credit quality and sell weaker positions. Similarly, banks are likely to continue reducing their illiquid exposure on their balance sheets and pivot to higher-liquidity assets.
As we evaluate the market, we see a meaningful mismatch in the supply of private capital to address these opportunities. According to industry sources, only approximately $200 billion of capital was available for more bespoke private capital solutions financings at yearend. As a result, we expect strong return opportunities for managers with clean balance sheets to provide liquidity to these vehicles.
Q: RECOGNIZING THE RENEWED ATTRACTIVENESS FOR OPPORTUNISTIC CREDIT STRATEGIES, HOW DO YOU COMPARE THE RETURN PROSPECTS BETWEEN OPPORTUNISTIC CREDIT AND PRIVATE EQUITY FOR INVESTORS SEEKING ABSOLUTE RETURN STRATEGIES?
Stracke: A primary source of private equity returns over the past decade has come from leverage and its declining cost. Alongside falling interest rates, private equity benefited from steady corporate earnings growth and a buoyant equity market where exit valuation multiples for asset sales were consistently higher than the initial purchase multiples. Looking forward, we think earnings growth will likely remain challenged, specifically in some of the high growth sectors that private equity has been favoring in recent years, including healthcare and technology. Finally, traditional leverage is less available now and considerably more expensive than it has been, creating headwinds for private equity performance. Over the next several years, we believe the median returns for opportunistic credit investors will be similar to those in traditional private equity but with lower volatility and improved risk profile. And should we enter a more prolonged distressed period, opportunistic credit returns for managers skilled in restructurings could be quite favorable, as they should be able to buy at a material discount to par.
Gubner: More broadly, slowing M&A activity, weak valuations, and rising interest rates are material headwinds to traditional private equity in our view – both in terms of putting capital to work and attractive realizations at the back end. To be sure, we have evaluated the significant dispersion in private equity fund returns and see possibilities for materially lower returns in the current vintages. In contrast, opportunistic credit benefits from collateral and is less dependent on multiple expansion or earnings growth. Returns are expected to mostly materialize in the form of coupons and cash payments, and benefit from debt maturities which can create a shorter weighted-average life for capital deployment – all of which seem like a defensive way to invest in this environment.
¹ S&P, LCD
² A structure in which the issuer has the option to make interest payments “in kind,” or in additional loans, rather than cash.