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We came into 2020 after a good year for credit markets, expecting the strong global economy to roll on and for markets to continue to grind higher. We argued that in a strong economy with a strong bid for yield, liquid credit would deliver coupon-like returns with private credit delivering an illiquidity premium, particularly by focusing on less competitive parts of the market.
Four months later, the world we live in has been transformed.
In March we endured a sharp sell-off across asset classes, driven by forced deleveraging. Credit was not immune. But with central banks and governments stepping in with significant firepower to help bridge the resumption of economic activity, we have seen valuations in many parts of credit retrace much of the losses endured in March and now look forward into this post-Covid world with important investment decisions to make.
Broadly, we believe there are three clear opportunities to focus on within the world of credit and we will be helping our clients in the coming months to capture those opportunities.
(1) Liquid credit markets – concentrate on selectivity
The first relates to liquid credit markets and we would describe this as a ‘value trade’. Although credit spreads have tightened since the lows of the crisis (on March 23), spreads at +700bps remain in the cheapest quartile historically. This somewhat masks the underlying reality as there is significant dispersion in yields between the highest quality credits and some of the higher risk Covid-impacted sectors. This is a potential ‘stock-picking’ paradise and so for active managers and skilful investors, there is an exciting opportunity to invest in good credits at attractive valuations via established strategies (e.g. high yield strategy / loans etc) or through multi-strategy credit solutions which are becoming more popular as investors seek out the best set of credit opportunities in a larger, more dynamic investment universe.
The credit drawdown speed rivals 2008
Source: J.P. Morgan High Yield Index. As of 3/26/2020. Past performance is not a reliable indicator of current or future results. Index are unmanaged and it is not possible to invest directly in an index. Index performance is for illustrative purpose only.
(2) Financing solutions at higher yields with better downside protection
The second opportunity is to provide financing solutions to companies both in public and private markets and we could break these financing opportunities up into two segments:
- The reissuance and refinancing of existing private direct loans to performing companies and
- Providing incremental liquidity solutions to public and private companies
For many companies, the key to surviving this short term lock down is the ability to access liquidity so we are seeing some interesting opportunities to provide loans to these firms at attractive terms. To take advantage of this opportunity, it is important to have lock-up capital as well as an ability to source interesting deal flow across public and private credit markets. With many middle market borrowers set to return to the market to refinance their loans from 2015, 2016, and 20171, we believe that Senior Secured Direct Lending remains an interesting space and in today’s environment, these loans will be reissued at better terms. Four or five months ago, there was a growing chorus of concern about rising leverage levels, falling yields, covenant lite loans and generally weaker credit quality. Today, the lending environment has been somewhat reset. The market is currently very slow as lenders and borrowers carefully assess the new world, but over the coming months and years, we would expect senior secured loans to be underwritten at relatively higher yields and with better protections. The next two to three years could therefore be strong vintages for direct lending funds.
For those direct lending funds that came into 2020 fully invested, there will be challenges ahead with rising defaults, but the illiquid nature of these strategies means they are not forced sellers. Provided these funds maintained a disciplined approach to underwriting in recent years, they will have the chance to work with the borrowers on any challenged loans to get to the best outcome for their investors. The senior secured direct lending space performed relatively well through the GFC and we are optimistic that this time will be no different.
(3) Distressed credit opportunities on the rise
The third opportunity we see in the next one to two years is related to distressed. In recent years many investors have been deploying into distressed funds in anticipation of the turn of the cycle. Many funds were raised early with deployment opportunities limited to secularly challenged industries like retail. With default rates expected to rise across credit markets, there are going to be more interesting distressed credit opportunities ahead across sectors and regions.
At BlackRock, we believe credit can play a valuable role in your portfolio in the months ahead – in a yield starved world, that coupon will be relatively attractive, and you may benefit from being up in quality when it comes to the capital structure. There are interesting opportunities today to invest in good credits at relatively cheap valuation and to potentially earn attractive risk-adjusted returns providing financing solutions to performing and non-performing companies globally, and BlackRock is focused on helping our clients capture those opportunities.
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A historical perspective: what implication does the market’s “risk-repricing” have for future return generation?:
High yield and bank loans returned 65% and 63% over the next 12-months during the last comparable market dislocation.
BlackRock, Bloomberg, Barclays, S&P LCD. Data based on BBg Barclays US HY Index and S&P/LSTA US Loan Index, as of 4/9/20. Past performance is no guarantee of future results. Index performance is for illustrative purpose only. Investors cannot directly invest into an index.
1 Source: BlackRock, May 2020
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