The next five years offer great potential for investing in stressed and distressed credit.
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By Parul Garg
High-yield credit spreads this quarter hit a decade low of 3.05%, reflecting a decline in demand for coverage for credit risk. This signals market confidence that credit risk is low going forward, but this optimism leaves little margin of safety.
Credit spreads act as a premium offered to investors to offset the risks associated with bankruptcy, but despite strong economic indicators and persistent inflation concerns, the market as a whole has been unable to adequately compensate for such risks, leaving opportunities for risk-adjusted returns limited.
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This situation reminds me of a quote from Benjamin Graham: “Just because the crowd is against you doesn’t make you right or wrong. You are right because your data and reasoning are correct.”
Current market sentiment suggests investors believe interest rates may have peaked, but with the Federal Reserve targeting the 2% level, there are growing signs it will keep rates high to combat inflation.
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The large-cap market has been hovering near historic highs, driven in large part by optimism about artificial intelligence, leading to inflated valuations and lower risk premiums, especially in the U.S. large-cap and high-yield indexes now being rebranded as the “Magnificent Five.”
However, concerns are emerging on a number of fronts, including political unrest in North America, Europe and elsewhere; soaring government debt; ongoing military conflicts (including between great powers) in Ukraine, Haiti, parts of Africa and the Middle East; and conflicting views on the societal impact of AI, which could have ripple effects on the broader market.
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Market changes are always difficult and therefore unreliable to predict. Changes often happen quickly, taking many people by surprise with their scale and impact.
Although a market pullback seems imminent, smaller companies may nonetheless perform well. Despite being some of the most undercapitalized in the market, smaller companies are well positioned with attractive valuations and continued earnings growth.
Warren Buffett said, “Size is what destroyed us…For a while there were so many candidates to evaluate that if you missed one (and I missed many), another one would always come along. Those days are long gone.”
Berkshire Hathaway is a $905 billion company. To grow, it needs to buy giant companies. The same competition for assets applies to private credit giants such as Oaktree Capital Management, whose liquidity constraints mean they can’t take into account a secondary market that is inevitably made up of smaller companies.
On the other hand, size is an important asset for smaller funds, which are less dependent on credit cycles and have much more exposure to investment opportunities in the small and mid-cap capital structures, which can include unrated credits with attractive spreads that are often overlooked by indexes and larger companies.
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Smaller companies with simple capital structures can be catalysts for greater yield potential and growth. For example, in distressed sectors, we can identify opportunities where spreads are over 1,000 basis points. Similarly, distressed assets have spreads over 600 basis points.
Sectors currently facing capital shortages and falling out of investor support include healthcare, biotech, electric vehicles, and cannabis. Over the next five years, we see great potential for investing in troubled credit ratings and distressed debt.
Parul Garg is Portfolio Manager, Pender Credit Opportunities Fund I.
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