Mike Pyle, Global Chief Investment Strategist together with Christian Olinger, Portfolio Strategist, Mark Everitt, Head of Research and Strategy, and Vivek Paul, Sebior Portfolio Strategist all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.
Many companies may need to turn to private credit to restructure post-Covid. We see potential for such investments to serve as growth assets and diversifiers when new sources of portfolio resilience are needed. Private markets are relatively illiquid and not suitable for all investors but play a key role in strategic portfolios, in our view.
The scale of the restructuring needs could exceed the previous peak seen after the 2008 global financial crisis (GFC). One big reason is the significant growth in sub-investment grade debt since the crisis. The amount of sub-investment grade debt outstanding has more than doubled to $5.3 trillion since 2007, as the chart shows. Private credit has been an especially fast-growing segment, expanding to $850 billion by financing companies that would previously have looked to banks or the public high yield market. As debt markets grew and the overall cost of debt fell, companies became increasingly levered. The average interest coverage ratio – a gauge of solvency - for middle market buyout transactions in 2019 fell to levels that were last seen immediately before the GFC and bursting of the tech bubble in the early 2000s. This left many vulnerable as their revenues come under pressure from Covid-related disruptions. It creates opportunities for restructuring and distressed debt specialists, an important subset of the private credit market. Many institutional investors remain under-invested in the growing private markets, we believe, and may be underappreciating their ability to take on liquidity risk.
Supportive fiscal and monetary policies to cushion the pandemic’s blow have helped companies raise capital and lower borrowing costs. Yet not all borrowers have benefited equally. Large companies have borrowed with ease on the public market; smaller firms have lacked the same access. The interest rate gap between U.S. middle market and large corporate loans has widened this year, according to S&P’s Leveraged Commentary & Data (LCD). Many companies will likely have to evolve their business models as the pandemic accelerates long-term structural trends such as digitalization. We see this creating a wave of restructurings – and room for private credit to cater to smaller and lower-credit quality issuers.
The ability to choose a good manager is integral to the case for holding private assets: our previous work has shown the dispersion of realized returns in private asset managers is typically greater than that of public managers. With risks of policy exhaustion and localized lockdowns rising, it becomes even more important to pick private market managers who can assess credit risk and structure resilient investments. Corporate restructurings typically involve complex negotiations between creditors. Success for creditors often means avoiding losses from defaults and restructuring by elevating the seniority of the debt in the capital structure. Buying discounted loans and bonds in the secondary market to seek control was typical after the GFC. These types of transactions will play an ongoing role, yet we see the focus potentially shifting due to a decade of erosion in lender protection. About three-quarters of the U.S. leveraged loans at the end of 2019 were considered “covenant-lite” – with fewer restrictions on the borrower and less protection for the lender – according to Moody’s Investors Service. The Covid shock has hit many companies funded by such loans, but the borrower-friendly terms could mean fewer outright defaults and opportunities for private credit investors to step in to provide fresh capital.
We see a historic opportunity for the private markets to fund post-Covid corporate restructuring. We see a case for a greater share of private market allocations to be in private credit than we typically observe in clients’ portfolios. Diversifiers are important at a time when the traditional source of resilience in portfolios – nominal government bonds – may not play the same role. We also favor high yield credit in the public market – on a strategic and tactical basis – for its income potential and adequate compensation for default risks.
We do not see the resurgence of Covid-19 as a replay of the spring. We believe daily new infections are likely a fraction of the peaks then, and rising case counts are having a diminishing negative impact on mobility. The economic restart has been quicker than expected, but the part that remains will be hardest. We do not expect a similarly large hit to economic activity as seen in the spring. But the economic restart now looks to face significant challenges in the near term. The other market focus: How the U.S. election result could shift U.S. fiscal stimulus, public investment, taxation, regulation and foreign affairs.
A spate of PMI data this week could shed light on the impact of the recent increase in virus infections on the activity restart. Rising case counts are having a diminishing negative impact on mobility, our analysis shows, and policymakers’ more localized approach to containment measure poses less of a risk to economic activity. The initial phase of the restart has been quicker than expected, but the hardest part may still be ahead.
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