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- Imbalances in credit markets have grown in scale and are presenting increasingly frequent exploitable inefficiencies.
- These imbalances are a structural and recurring seam across the entire fixed income market.
- We see opportunities today and several catalysts for further dislocations over the next 12 – 18 months.
- Opportunistically-minded investors can be liquidity providers and potentially earn compelling returns with an attractive skew.
Opportunities exist today and should continue in the future
The COVID-19-driven global sell-off during March 2020 represented the latest catalyst that highlighted the increasing imbalances in credit markets. Forced selling and deleveraging drastically impacted prices across virtually all segments of credit markets. Opportunistic investors with access to capital were able to buy individual credits at much wider spread levels than we believe were warranted by their fundamentals.
Unprecedented stimulus and the reopening of the global economy have subsequently enabled markets to partially recover, prompting many investors to ask, “Did we miss it?” Our answer is “no.” In our view, the imbalances in credit markets are a decade in the making and have not changed. We see attractive opportunities today, and we believe there are several other dislocation drivers on the horizon for readied capital to pursue, including:
- Economic-induced dislocations. While we are hopeful that the end of the health care crisis is imminent, we think the fundamental fallout from the economic shutdown is still in its nascency. Our economists believe the global recession underway will result in output levels significantly below 2019 levels. Notably, we think credit spreads have tightened as a result of extraordinary monetary stimulus, not due to improvements in corporate fundamentals, and, in many cases, are not appropriately discounting the likely increase in defaults (Figure 1). In addition, economies moving into recessions have historically created potentially profitable dislocations.
- COVID-19/energy-related dislocations. Energy-impacted credits and those heavily affected by COVID-19 are both still being shunned by markets. Our analysis has found several opportunities in these areas of durable, going-concern credits that are dislocated.
- Structural and idiosyncratic dislocations. In our view, several other potential dislocation catalysts exist. For example, we estimate a wall of imminent downgrades from investment grade corporates to high yield of over US$300 billion. In addition, US-China relations, a potential second wave of COVID-19 infections, the upcoming US election, and potential stimulus withdrawal are all additional catalysts that remain on our radar. We believe each could precipitate further dislocations as we move through what is likely to be a volatile period ahead.
Dislocated credit investing success factors
Taking advantage of these credit-market dislocations is no small feat. We believe the most successful opportunistic credit strategies that emerge from this period will be those that exhibit the following attributes:
- Deep resources to source ideas. Dislocations are occurring all across the fixed income landscape. To successfully exploit them, it is important to analyze a large volume of ideas across asset classes and geographies and then invest in the strongest opportunities across the four corners of credit markets.
- Proven expertise in credit underwriting. Dislocated credit investing relies on careful security selection. Underwriting must be performed one credit at a time while managing risks and having the confidence and conviction to take concentrated positions.
- A flexible structure. To be an opportunistic credit investor, we think it is critical to have dry powder capital to move quickly when profitable opportunities are uncovered and display patience when they are not.
The markets are in a fragile state today. We believe structural imbalances have left credit markets and securities susceptible to periodic dislocations. We think this environment will increasingly create exploitable inefficiencies for opportunistic fixed income investors.