Text on screen: What's happened in the corporate credit market?
Jamie Weinstein, Portfolio Manager, Head of Corporate Special Situations: First, we have the crippling global pandemic that we’re all struggling with, and second, a concurrent collapse in oil prices. The result of this has been a swift and broad-based repricing of risk across all the capital markets, across all sectors, asset classes and geographies.
Some of the most severe impacts have been in corporate credit markets. In the best of times, corporate credit, particularly in the below investment grade space, is relatively illiquid, but now things have turned extremely illiquid resulting in market dislocations across different types of assets.
Two things to touch on in terms of some metrics to give you a sense. First, investment grade corporate credit spreads have widened to a level as wide as we saw at points during the 2008 global financial crisis, implying a five-year cumulative default rate that would be in the double digits.
Second, in the leveraged loan and high-yield bond market, there’s now over a trillion dollars of debt trading at distressed levels, and we also anticipate a default rate exceeding 10% in that space.
Text on screen: What has been the impact?
We've seen a number of key elements show up in the credit markets that we find concerning.
One, liquidity remains very constrained. That primary new issue market in particular for below-investment-grade credit and leveraged loans and high yield bonds are basically closed right now, with relatively limited trading in secondary names and difficulty with price discovery.
Second, the formation of new CLOs. This is an important one, because CLO, by our math, represented more than half of the incremental demand for leveraged loans in the last couple of years.
New CLO formation right now has effectively shut down, which limits the ability of loan transactions to come to market.
Third, redemption from daily liquidity vehicles: there has been a wave of redemptions across mutual funds and exchange traded funds, forcing managers to sell what we're perceived to be liquid performing credit at illiquid nonperforming prices.
Fourth, actions by rating agencies, where they've begun to downgrade certain issuers, particularly those most closely associated with the issues between the pandemic and oil and gas, but where we expect to see a broader wave of downgrades to come, over the coming months.
And with more of that, we expect to see more selling pressure on the part of ratings constrained holders.
Lastly, the speed of reaction of public markets: it's been much faster this time than we saw in 2008. And with the movement in public markets, it's made private market transactions very difficult to price, and we've seen private markets for new capital shut down as well for a period of time.
With this repricing of deals and risk, it will be a while before private transactions come back and can be available to fill the hole for corporate credit borrowers in need.
Text on screen: What’s next?
PIMCO remains cautious on companies where liquidity constraints and earnings deterioration are in play and we think more attractive opportunities may develop over the balance of the year.
For now, we're remaining patient and focused on higher-quality segments of the market.
We expect to see constrained liquidity along constraints on leverage, leading to further dislocations in public and private lending markets as CLOs, BDCs, and direct lending funds potentially seek to sell underperforming credit.
As rating agency actions continue to catch up, we would also expect to see these sales accelerate.
We further expect a potentially larger opportunity to develop in private markets as underwriters pivot to private markets and leveraged private lenders become forced sellers.
We believe the dynamic may drive public and private distressed financings and private capital solutions opportunities, in the medium term.
Lastly, for those investors who have the expertise and long-term vehicles, and the capability to lead restructurings we anticipate some of the highest return opportunities may be in repairing balance sheets of damaged companies.
Shots of Jamie Weinstein working.
PIMCO has been preparing for this dislocation across our credit complex, and we believe that we have a number of vehicles that can capitalize on these opportunities, and are customized to match investors’ liquidity needs and different risk tolerances.
For more insights and information visit pimco.com
Recorded 6 April 2020
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