Adam Gubner
Chris Neumeyer
In the months since the COVID-19 pandemic jolted the global economy, corporate bond markets have evolved into a story of “haves” and “have nots.” Credit sold off across the board following economic shutdowns and liquidity shortages. But the subsequent recovery has primarily favored borrowers with large capitalizations, pandemic-resistant businesses, and collateral to pledge in exchange for liquidity to survive. Credits of many smaller-cap and private companies have been and will continue to be left behind. As they burn through their current liquidity, we believe they will ultimately face an environment marked by limited access to liquidity amid uncertainty about economic recovery.
For PIMCO, the early phases of this abrupt cycle provided a potent (yet relatively brief) opportunity to invest in high quality publicly traded credits at dislocated valuations. Now, however, we believe that some of the most attractive risk-adjusted opportunities are shifting toward the private market, where smaller-cap borrowers remain under stress.
In our view, we’ve entered the early innings of a challenged economic recovery, where we anticipate seeing borrowers with acute liquidity needs and a stream of corporate debt restructurings that will extend over time. These could provide significant opportunities for investors who have the sophistication and resources to navigate complex situations.
An Enlarged Opportunity Set
The heightened opportunity in distressed credit reflects the staggering growth in credit market segments that are now vulnerable to restructurings. As we entered 2020, the size of leveraged finance markets (high yield bonds, bank loans, and private debt) had nearly tripled since 2008, with roughly $2.5 trillion in public market debt plus the recent proliferation of almost $1 trillion in private debt, according to BofA Securities and Credit Suisse, and UBS, respectively.
Given indiscriminately strong markets in recent years, the majority of new debt was issued with weak covenants and large EBITDA adjustments (earnings before interest, taxes, depreciation, and amortization), and it was absorbed by leveraged investment vehicles such as collateralized loan obligations (CLOs), private debt funds, and business development companies (BDCs).
Now, with credit rating agencies anticipating a sharp increase in defaults, we see significant stresses developing not only for these middle market borrowers but for the holders of their debt. By design, these leveraged investment vehicles are not equipped to take companies through restructuring, and they cannot continue to hold downgraded and defaulted debt. We believe this presents fertile ground for more opportunistic and credit-intensive investors who are willing to take on the risks and get involved in bankruptcies, restructurings, and capital solution transactions.
In addition to the immensity of today’s market, we can make a further contrast with 2008, when policy responses helped many companies overcome their immediate illiquidity challenges. In 2020, although fiscal relief efforts have bought time for some sectors, in general the U.S. government can’t do much to solve the problem of companies running out of money.
Although many can turn to financial sponsors for help, a sizable portion will have little choice but to engage financing partners. This is creating a significant and growing pipeline of investment opportunities, particularly for middle market companies that need capital in the range of $50 million to $200 million, the focus of PIMCO’s capital solutions efforts.
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