Corporate credit markets are suffering a lot of dislocation and, therefore, offering many opportunities, especially in the US and Europe. A confluence of factors is presenting a favourable environment for opportunistic distressed debt, according to PIMCO’s Sai Devabhaktuni.
Devabhaktuni, a PIMCO executive vice president and head of distressed corporate debt portfolio management at Newport Beach head office, says in a client note that the ability of larger companies to finance themselves at low interest rates has resulted in sharply increased financial leverage alongside significant industry changes.
These changes include excess capacity in certain sectors, technological disruption and aggressive regulation, which are creating dislocations which the big bond fund manager predicts will escalate.
As reported recently (Investor Strategy News, October 26) by Paul Hatfield of Alcentra Group, which is the largest distressed debt specialist manager in Europe, many of the new issuances there have not been priced to reflect their true risks. PIMCO concurs about the opportunities.
PIMCO’s research note says: “Global policy divergence, a strong dollar, lower commodity prices, demographic shifts and a slowdown in China’s growth, when combined with the tremendous growth in recent years in the leveraged credit markets, are all creating stress, and the Fed has not even begun tightening yet. We expect these uncertainties could prompt an increase in defaults and distressed exchanges, creating opportunities.
“But our opportunity set goes beyond just investing in distressed companies. In the post-crisis global economy, many smaller businesses have limited access to credit and frequently pay a premium to gain financing in illiquid and less efficient markets. These smaller companies often provide opportunities to make direct hybrid investments (for example, debt with warrants) and provide ample risk premiums, and many reach out to PIMCO directly…”
Devabhaktuni says that investors need to be mindful of the enhanced volatility and the considerably larger scale of the leveraged finance markets today, however. The combined market for high yield debt in developed economies plus US bank loans rose from around US$2.1 trillion in 2010 to more than US$3.2 trillion in 2015, according to Deutsche Bank.
Also, the changing regulatory environment – including the Volcker Rule, Dodd-Frank and OCC rules limiting bank funding for highly leveraged transactions – is driving a decline in leveraged finance market liquidity, creating opportunities in illiquid and private credit, he says.
“The middle market in particular offers a steady stream of opportunities that is likely to increase in the years ahead. Indeed, stress is most visible today in companies exposed to natural resources … however, we are seeing broader dislocation in suppliers to natural resource companies as well as opportunities in the aerospace and defence, agricultural infrastructure, basic industrials and consumer products sectors.”
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