Corporate Credit: Capitalizing on Potential Disruption
Text on screen: PIMCO
Text on screen: Christian Stracke, Global Head of Credit Research
Stracke: PIMCO sees a highly compelling credit market now developing for three key reasons.
Text on screen: TITLE – Three reasons we see a compelling credit marketing developing:, BULLETS – Limited supply of flexible capital, Global macro headwinds, Increase in corporate leverage
First, the limited supply of flexible capital. Second, global macro headwinds. And third, a significant increase in corporate leverage. Increasing fragility of the market against a backdrop of rising rates, higher inflation, and slowing growth supports increasing demand for that flexible capital.
Text on screen: 1. Limited supply of flexible capital
Images on screen: PIMCO trade floor
Gubner: Demand for private credit is growing from a variety of factors. ‘
FULL PAGE GRAPHIC: TITLE – Demand for private capital has grown significantly. The bar chart shows private debt Assets Under Management (in billions of U.S. dollars) reaching a 20-year high of $1.2 trillion in 2021 from $50 billion in 2001.
Sheer growth of the market allows borrowers more certainty to execution, and the private market is often more flexible for customized financing terms required to meet certain unique borrower needs.
Text on screen: Adam Gubner, Portfolio Manager, Head of U.S. Corporate Special Situations
To date, we’ve had enormous supply of capital serving loans to well performing middle market companies. This has served to exponentially fuel the private credit market, but few of these managers offer flexible capital to borrowers such as second liens, junior capital, and even preferred equity are often part of the solution we provide to borrowers.
Images on screen: PIMCO trade floor
At PIMCO, given our size, we focus on larger size companies where the significant commitment is required to meet the financing needs.
PIMCO recently provided the entire $700 million preferred equity investment to a large family owned infrastructure company with short line rail, port, and terminal assets throughout the United States and parts of Canada.
Images on screen: Shipping ports, cargo ships and rail transport
The company’s assets are critical to North American infrastructure, difficult to replace, and provide significant amount of end market and geographic diversity.
Companies will increasingly require flexible capital solutions across their capital structures and will continue to be attracted to those managers that can commit the entire financing.
Text on screen: 2. Global macro headwinds
Images on screen: PIMCO trade floor
Stracke: The second reason that we see the increasing demand for private capital over the next few years are the macro headwinds that we see out there in the economy, and there are several. The Federal Reserve tightening monetary policy, reducing its balance sheet is restraining the supply of credit into the economy.
Meanwhile, of course, the economy is struggling with high inflation driven by higher input costs, higher labor costs, leading to ultimately pressure on margin, something that we haven’t seen yet but we do expect to see over the next few years. That in turn will stress corporate income statements and make it more difficult for corporations to fund themselves out of their cash flow, meaning that there will be more need for more bespoke solutions in the private credit space.
Text on screen: 3. Increase in corporate leverage
Images on screen: PIMCO trade floor
The third reason that we see an increased demand for private credit is simply the high level of leverage out there in the corporate sector in the United States and internationally. In the United States right now, business debt as a percent of GDP is at an all-time high, with the slight exception of the first and second quarter of 2020, looking at Federal Reserve statistics.
FULL PAGE GRAPHIC: TITLE – Companies across sectors have increased leverage significantly over the last decade. The bar chart shows company debt/EBITDA (earnings before interest, taxes, depreciation, and amortization), which has grown substantially in 2021 compared to 2009 for several sectors: Computers & Electronics, Healthcare, Services & Leasing, Media, Chemicals, and Manufacturing & Machinery.
Those leverage ratios, this stock of debt and then the leverage ratios on corporate balance sheets, leave companies ill prepared for any downturn in the economy and any downturn in margins. Many of these highly levered balance sheets are levered for growth. They’re levered for growth and continued high margins. If we see disappointments in terms of growth, if we see declines in margins, that will put pressure on EBITDA.
Images on screen: The Federal Reserve
Meanwhile, of course, as the Fed is normalizing monetary policy, interest rates are going higher, and so companies that pay floating rate interest costs on their debt will see their interest costs go higher.
And if you were to see at the same time EBITDA decline, it makes the difference between a company having a positive free cash flow and burning cash. When you get into burning cash, then you start to hit a wall in terms of your credit fundamentals, and you start to look about for new solutions in terms of your financing needs.
Gubner: We see an unprecedented demand for leverage developing now that we believe will disproportionately reward managers that can commit flexible capital and scale.
Text on screen: TITLE – The demand for financing is influenced by three factors:, BULLETS – Record market size in public and private markets, Record leverage, Lack of flexible capital
The demand for financing influenced by three factors: record market size now across the public and private markets, $4 trillion, which represents three times the size of the market at the beginning of the financial crisis.
Companies now have record leverage, just as we enter a cyclical period of rising rates and potential earnings declines.
Finally, we believe that there is a lack of private capital to meet borrowers’ full capital structures and particularly for larger companies.
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EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization
All investments contain risk and may lose value. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in distressed companies (both debt and equity) is speculative and may be subject to greater levels of credit, issuer and liquidity risks, and the repayment of default obligations contains significant uncertainties; such companies may be engaged in restructurings or bankruptcy proceedings.
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