Fear can trump discipline when markets become extremely volatile. In credit markets, the dramatic declines in the investment grade and high yield bond market so far this year understandably have unnerved many investors, and unfortunately, have given rise to potentially harmful misconceptions about risk and reward in the public and private markets.
As valuations begin to look attractive again, we at PIMCO have identified what we have determined to be four prevalent misconceptions circulating in the market that, if embraced, could potentially lead to poor investment outcomes.
Misconception #1: Returns in most public credit markets, such as investment grade and high yield, have been disappointing this year, and hence these asset classes are more risky
Nearly 80% of negative return in U.S. investment grade and high yield has come from interest rate moves this year as the market reacts to changes in central bank policy to address higher inflation (data according to ICE BofA corporate and high yield indices). At current valuations, where forward rates have reached close to neutral, having some high quality duration in addition to spread can be very advantageous to investors, in our view, particularly as the ongoing adjustment in global central bank policy rates helps to address the current high inflation. For investors worried about continued higher policy rates, duration risk can be hedged to various degrees while allowing investors to retain exposure to the credit risk. Current spreads – particularly in the higher-rated spread products like global investment grade and U.S. agency mortgages – have increased to levels well above their 20-year median levels in the U.S., offering compelling value over a long-term horizon, in our view, even as we recognize ongoing near-term volatility.Footnote1
Misconception #2: Bank loans are less risky than bonds
Syndicated bank loans may have less mark-to-market price sensitivity to interest rate moves because of their floating rate nature, but they still carry significant fundamental exposure to higher interest rates. Many issuers in bank loan and private credit markets issue floating rate instruments where the issuer is exposed to higher borrowing costs when interest rates rise. When issuers hedge some interest rate exposure, hedges are either partial or shorter than final liability, impacting borrowing costs when hedges expire.
For a typical low single-B bank loan issuer, a 300-basis-point rise in the federal funds rate will increase interest costs by 60%–70% (again assuming unhedged floating rate exposures). Given that so many of these single-B credits start with EBITDA/interest ratios of around 2.0x, such a steep rise in interest costs could materially erode debt servicing capacity and challenge companies’ ability to generate free cash flow. We would expect a downgrade cycle on these lower quality credit claims if current market expectations about the Fed’s path of interest rate hikes are realized. To be sure, some companies in this category are better positioned than others, and active investors should differentiate to find opportunities.
Misconception #3: Private market debt is less risky than public market debt
Private credit markets have nearly doubled in size (to $1.25 trillion globally) in just the last four years, according to Preqin, as investors looked for higher return opportunities amid low yields in public markets. The less frequent repricing of private debt versus daily pricing of public debt makes volatility appear lower in private debt, which can optically result in lower volatility in investors’ portfolios, and there can be benefits to that, such as not inciting investors to attempt to time markets.
However, the borrowers in the private credit market generally offer just as much (and in some cases more) fundamental risk than those in the high yield bond and syndicated bank loan markets. Private credit borrowers are generally smaller than issuers in the public market (after all, if they were larger they would steer away from paying the illiquidity premium in the private credit markets). Many such smaller companies have less diversified businesses, lower economies of scale, less ability to pass on higher costs to their consumers, and higher vulnerability to economic shocks. Equity valuations for many such private companies can adjust much more rapidly if economic growth starts to slow, creating vulnerabilities for debt investors.
Moreover, the price discovery of public markets can often foster a better risk management culture. In public markets a credit analyst cannot ignore or explain away bad news: The market will be flagging problems more or less immediately, in turn forcing healthy conversations about whether to engage with issuers to seek changes. Any sophisticated private market operator will have robust loan supervision and asset management functions, but the lack of price discovery in private markets is by definition a challenge to risk management in private credit.
We do recognize that in many cases private credit loans will come with tighter covenants than the covenant-light structures that have become nearly ubiquitous in the syndicated loan market. These tighter covenants are a credit advantage, all else equal. However, we are seeing an increasing trend toward “covenant loose” structures even in private debt markets as investors chase deals given the need to deploy large flows. Hence, while private credit markets still often offer better covenants than publically syndicated deals, some of those advantages are getting eroded.
Private credit offers a range of opportunities to seek attractive returns, but these inherent risks warrant management by an investment team with in-depth experience and resources to assess and manage those risks.
Misconception #4: Floating rate syndicated bank loans and private credit loans are hedged
A common refrain in the leveraged finance market is that investors can have their cake and eat it too – you can buy a floating rate note, but don’t worry, the borrower swaps that floating rate into fixed so as to hedge against interest rate increases. Never mind that this seems like a hugely inefficient way for end investors to manage their duration exposures, this claim is at best only partially true and could be deeply misleading. It is the case that most sophisticated private equity sponsors will hedge some of their portfolio companies’ interest rate exposure some of the time. But the extent of the hedging is far from complete, in large part for basic corporate finance reasons. First, traditional corporate asset/liability management theory argues for some amount of floating rate liabilities against assets that are either explicitly floating rate or indirectly supported by higher inflation and interest rates. Most investment grade companies swap significant portions of their fixed rate liabilities into floating precisely for this reason. High yield companies generally have less cash (earning a floating rate) than investment grade companies, but the basic rule still applies. Second, even where high yield companies are swapping floating into fixed they will generally look at the expected life of the liability, which in practice is generally closer to the first call date than to the final maturity of the loan. This means that the interest rate hedges are put on for less time than the final maturity, so at some point these companies go back from paying a fixed to a floating rate assuming the loan is still outstanding. Third, we simply do not know the extent and structure of interest rate hedging at the issuer level. Companies rarely disclose the granular details about their hedges that one would need to fully understand their interest rate sensitivity, and requirements around interest rate hedging are rarely if ever a part of bank loan credit agreements.
Bottom line: The declines in debt markets have been painful and at times alarming, but the rise in interest rates after a protracted period of extremely low yields is also creating attractive opportunities in both public and private markets. Disciplined investors should filter out the noise that has generated these misconceptions and focus on the fundamentals that are starting to look more attractive every day.
For insights into our views across asset classes, please read our May 2022 Asset Allocation Outlook, “Late-Cycle Strategies.”
Mark Kiesel is CIO global credit, Mohit Mittal is a portfolio manager focusing on multi-sector portfolios, and Christian Stracke is global head of credit research.