We summarise key dynamics at play in credit markets and explore how best to capitalise on the bumps that are creating the beginnings of another fertile special situations investment environment.
Fasten your seatbelts—credit markets are going to be bumpy. Events that once seemed unlikely are all transpiring. Economic and market outlooks are uncertain. An anomaly? For the most part, no. While war and sky-high inflation are certainly not the norm, many dynamics are consistent with conditions that existed for decades before the global financial crisis (GFC), an era that saw a persistent special situations opportunity set. However, there is one critical difference between the two eras: a massive debt market, which the explosion of the leveraged finance market had fueled.
It seemed as though low rates, a dovish Federal Reserve (Fed), and easy liquidity would persist forever post-GFC. Low cost of capital, borrower-friendly documents, and central banks willing to quell any hiccup in financial conditions with sizable liquidity injections paved the way for massive debt issuance. Leveraged credit markets grew ~150% from US$1.7 trillion in 2010 to over US$4.2 trillion in 2022. Then, the unexpected. A pandemic, supply chain issues, and labor shortages, combined with a massive growth in money supply, have led to inflation levels not contemplated in decades. Seemingly behind the inflation curve, central banks have been forced to dramatically raise interest rates, leading inevitably to slowing global growth. These higher levels of inflation, and the impact on interest rates and central-bank activity, lead us to believe credit markets will have to contend with a far less-forgiving borrower environment, one more akin to the late 1990s and early 2000s. Cost of capital for US companies rose dramatically in 2022, driven by an increase in both base rates and spreads.
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