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.
Restructurings Require Deep Expertise
Each of these companies has a unique story with respect to the shocks it has experienced, its capital needs, balance sheet, collateral, and prospects for a recovery in a highly uncertain economic environment. Most seek to work with a seasoned and highly reputable liquidity provider, giving PIMCO a key advantage in sourcing and executing investments in what we believe are the strongest companies with the highest probability of success (see Figure 1).
We prefer investments at the top of the capital structure where we are most secure and can assert influence on the process while negotiating strict covenant packages, with the aim of protecting our rights in all scenarios. We favor credits that can play offense by consolidating their industries or by making capital investments. The credit of conglomerates, for example, have been some of the hardest hit, as the sector’s distress ratio rose to over over 70% by mid-2020 from zero at the beginning of the year. These firms aim to set themselves up for success over uncertain multiyear timeframes – rather than simply bridging a brief liquidity shortage. They need capital partners who can collaborate through the unexpected zigs and zags of recovery, even if things don’t go exactly to plan.
Although the precise contours of recovery across industries and companies is unclear, we are putting significant effort into investing in companies where our secular outlook favors long- term fundamentals but where COVID-19 has had a profound and immediate impact on operations. Broadly, we are focused on companies that are under considerable stress but which we view as having a high probability of enduring the crisis – including select credits in travel, consumer, housing, and healthcare. We are also taking senior and junior positions in companies that we think are less affected by COVID-19 and can perform well in the current climate.
PIMCO has a significant edge when participating in – or leading – financial restructurings and capital solutions transactions in an effort to create advantageous outcomes for our investors. With 65 corporate credit analysts covering industries vertically across capital structures, we have extensive knowledge of market segments and companies, and conduct ongoing research. Over the past decade, we have achieved leadership roles in some of the largest and most prominent restructurings and generated attractive risk-adjusted returns for investors. We are well positioned to participate and seek to take advantage of the growing stream of restructurings currently taking shape in the market.