In 2020, central banks reached into their deep arsenal of policy tools to soften the economic and financial blows from the pandemic, marking a new extended era of quantitative easing (QE) and near-zero interest rates. The Federal Reserve (the “Fed”) plans to remain accommodative until inflation is consistently above 2%, breaking its previous policy to respond when inflation moves beyond its target range.
The Fed faces many medium-term obstacles to achieve inflation goals.
- The record contraction in GDP following the pandemic shutdown is already a major deflationary force.
- Some projections indicate a quick return to pre-pandemic output, but growth above those levels could be weighed down by heavy debt.
- Aging demographics limit the ability of the labor market to raise inflation.
- The pandemic has accelerated digitization, which reduces costs across value chains.
Tightening Spreads, Deteriorating Fundamentals
After a highly volatile year in financial markets, credit investors enter 2021 facing low yields and tight credit spreads. After peaking at 10.87% in March, US high-yield (HY) spreads have tightened steadily following the $3 trillion bond buying program of the Fed to 4.18% this week from 4.33% at the end of November. The HY spread is relatively tight, being in the 28th percentile since June 2007, but may tighten further given the dearth of yield and the high historical spread over investment grade (IG). IG spreads tightened to 1.07% this week from 1.12% at the end of November, after peaking to 4.01% in March. This puts the IG at the 6th percentile over the same period, making further tightening highly unlikely. In the leveraged loan market, first-lien and second-lien spreads tightened to the 20th percentile after a sharp dislocation in March where spreads peaked to LIBOR + 10.44% and 14.76%, respectively (see Figure 1).
Corporate leverage continues to rise despite credit spreads well below historical medians and elevated default rates. At the end of Q3 2020, last-twelve-month (LTM) leveraged loan default rates reached their highest level since March 2018 for private equity (PE)-sponsored companies, and their highest since April 2010 for non-sponsored companies (see figure 2).
Another cause for concern is the increased leverage of PE-backed companies, especially through dividend recapitalization. Debt (loans and bonds) issued to finance dividend payouts grew 25% since 2019 to more than $29 billion this year and post-dividend debt to EBITDA reached a record 5.4 times in Q3 2020 (see figure 3).
Approaches for Careful Underwriting
The tightening spreads and uncertain macroeconomic environment require cautious navigation of the credit cycle.
- - Avoid industries with high-fixed-cost business models and those that are not agile enough.
- - Favor sectors with high recurring cash flows that are less sensitive to economic cycles.
- - Move higher in the capital structure and seek protection through stricter covenants.
- - Avoid passive credit investments and take advantage of illiquidity premium during crises.
- - Partner with deeply experienced private debt managers who have a proven track record in multiple recessionary environments.
The Family Office has been applying this investment approach for the past decade. Contact us to learn more.