Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. For professional or institutional investors only. Your capital may be at risk. Please refer to any investment risks noted near the end of the content available for download below.
THE PACE OF CREDIT MARKET DETERIORATION IN THE EARLY WEEKS OF THE COVID-19 CRISIS was unparalleled in modern financial history. Liquidity evaporated and two-way market functioning came to a screeching halt, leaving even the most bulletproof credits with few bids from the street or end buyers. While the pandemic may have caught investors off guard, the violent reaction of the credit markets should have come as little surprise. For years, the credit community has flagged the vulnerabilities of these markets, brought on by factors such as the growth in investment-grade and high-yield corporate debt (fueling shareholder-friendly activities like M&A), deterioration in credit quality, the rise in “covenant-lite” loans, the growth of passive strategies/ETFs, and the rapid post-GFC decline in dealer intermediation.
As the crisis continues to unfold and the full picture of the economic damage comes into focus, we expect further bouts of volatility. While credit spreads have tightened from the wides, they generally remain up to two times higher than their February lows as of this writing. And the path to recovery, whether U-shaped, W-shaped, or L-shaped, is uncertain at best. Amid the bleaker realities of this environment and the underlying credit market vulnerabilities, we see four potential drivers of opportunity, which we discuss in this paper:
- Dislocations in sectors such as consumer and energy, as well as in structured securities
- Elevated security- and issuer-level dispersion
- Market dysfunction related to factors such as liquidity and market depth
- Market distress and resulting defaults or restructurings
We believe certain alternative credit strategies, including long/short, opportunistic, and private credit strategies, may be well suited to these drivers. In this paper, we discuss the potential roles of these strategies and important implementation considerations.
Opportunity drivers: The four D’s1
Credit market dislocations can be defined in several ways, but it boils down to situations where a security’s risk premium (credit spread) exceeds the implied risk given underlying economic conditions and issuer fundamentals. In some cases, these dislocations are caused by the market punishing spreads across an entire industry or sector, rather than distinguishing between good and bad investments. Capturing this excess risk premium can potentially lead to…
To read more, please click the download link below.
1Opportunities are presented for illustrative purposes only. There can be no assurance the investment opportunity will be profitable and an investment could lose value.