In A Tale of Two Cities, Charles Dickens evokes the confusion, fear and excitement of revolutionary France, but we can borrow the novel’s
best-known passage – “best of times, worst of times, age of wisdom, age of foolishness” – and apply it, with far less literary fervor, to the stark
contrasts we see today in the corporate credit sector. It’s a tale of two markets. Many large or established companies that do not need credit to
effectively function are able to access it with relative ease and on favorable terms while, on a relative basis, many middle market businesses pay a
premium to borrow needed funds in illiquid markets, and by necessity they also offer terms more favorable to their creditors.
The middle market sector also tends to be less tethered to business and economic cycles, providing a more constant stream of opportunities for market
participants who can access them. There exists the potential to capture an illiquidity premium and also the potential to negotiate covenants through
structured investments – mechanisms presently absent for investors focused on larger companies. However, we do see early signs of excess even in the
middle market. Imbalances in these markets continue to build, like a Dickensian drama. We expect higher defaults and distressed exchanges in middle
market corporate debt. We also expect a marked increase in distressed opportunities for patient investors.
Demystifying a fractured middle market
Investors clamoring for yield in the near-zero-rate post-crisis environment are moving significant capital into the corporate bond and bank loan
markets. However, middle market companies tend to have more limited access to the capital markets: Most middle market companies are privately held, and
the few publicly traded companies are not well followed by equity analysts, resulting in limited visibility for these companies – and generally less
overall investor knowledge or interest.
PIMCO defines the middle market as companies with debt outstanding of less than $350 million. The middle market debt sector may be an attractive source
of higher returns in an overall low yield environment. However, the higher return potential comes with greater risks. A range of investors, including
dedicated lending funds, focuses on providing credit to the middle market, and we now see sharply higher leverage profiles in many of these companies –
increasing their already generally high vulnerability to economic or market shocks. Some creditors may allow riskier deal structures in exchange for
higher yield potential. Cheaper access to credit also tends to skew corporate management toward riskier decisions, misaligning the traditional
allocations of risk between shareholders and creditors.
The middle market still finds funding, of course, but there has been a profound shift in the providers of middle market debt since 2008 – private
lenders are increasingly replacing banks. Given losses from high default rates on loans during the crisis alongside sharply increased regulatory
capital constraints, the banks (when compared with historical standards) have de-risked and withdrawn capital to middle market companies. Special
purpose investing vehicles, such as collateralized loan obligations (CLOs) and business development companies (BDCs), are increasingly filling that
void left by the banks. As a percentage of institutional middle market loan volume, demand from these categories of investors has approached 2007
However, specialized vehicles may be less suited than commercial banks to hold the stressed and distressed debt that is often a component of middle
market investing. Many of these specialized structures are limited by their investment strategies, their targeted yield schemes and their covenants
against holding distressed debt, or they simply may not want to hold it. The behavior of managers of some of these specialized vehicles is rather
peculiar – more relationship-based and less arms-length in nature. Managers of such vehicles tend to “amend, extend and pretend” on covenant breaches
on the credit they provide: They have a higher likelihood of “playing ball” with companies and sponsors of companies. It is important to note that
these levered vehicles investing in levered companies are striving for yield. Leverage can amplify return, but also amplify losses, and therefore these
specialized investors may not want or be able to give up or disrupt their coupon stream – a typical result of a distressed debt restructuring. We
believe this behavior tends to underrepresent what otherwise would be higher default rates.
We believe the aggressive lending by these specialized vehicles alongside their limited ability to hold stressed debt creates potential for more
abundant supply of middle market debt for distressed investors than in previous distressed cycles.
Middle markets: higher default rates, yet comparable recovery rates versus larger companies
PIMCO’s experience has been that middle market companies experience more stress than larger companies, a trend likely to continue. Higher leverage can
play a role: Leverage profiles in the middle market have now exceeded 2007 (pre-crisis) and 1997 (pre-dotcom) levels, according to Leveraged Commentary
& Data (LCD). Figure 1 illustrates average leverage profiles [defined as Debt to EBITDA (earnings before interest, taxes depreciation and
Middle markets also tend to experience higher default rates, yet a recent study by Credit Suisse First Boston (CSFB) illustrates that their recovery
rates on balance are analogous to larger companies (see Figures 2 and 3). Although middle market companies can be more economically vulnerable due to
their size, there is relatively less complexity in understanding their financial health and a greater likelihood for investors to more effectively
exercise influence (such as through covenants and other control/governance features) and address potential problems more quickly when they arise. These
are key – yet often overlooked – features underlying middle market opportunities.
Stressed and distressed opportunities
We see the prospect for an increase in defaults and distressed exchanges over the secular horizon, particularly in the middle market. Indeed, pockets
of dislocation exist today in the retail, restaurant, gaming, shipping and mining industry verticals (notably in the coal market) as well as
infrastructure entities that were financed in the pre-2008 era. Also, the long-term stability of the European banking complex needs to be addressed, as
well as the secondary effects on credit availability.
In the retail and restaurant sector, evolving consumer preferences and traffic trends, the growth of the internet and changes in disposable income
combined with operational and merchandising challenges has resulted in a decline in sales growth and margins for many traditional businesses. Although
retailers are acting to address these challenges of coping with their supply chain as well as property lease and labor costs, the fundamental viability
of some business models in the retail and restaurant sectors needs to be inspected.
While international casinos (e.g., in Asia) have witnessed solid growth over recent years, the U.S. casino sector has been saturated by an increase in
gaming licenses and competition. In addition, changes in consumer spending, changing consumer appetite for leisure activities and changes in government
regulation and taxation policies have adversely impacted the operations of numerous gaming companies. This is likely to lead to continued stress in the
Likewise, the continued overhang of the maritime order book combined with charter rate depression continues to weigh on multiple segments of the
shipping sector. As a result, shipping companies have experienced declines in cash flow that have resulted in covenant breaches, in both liquidity and
loan to value ratios. Also, one must be cognizant of the challenges of foreclosing on shipping collateral. Among other factors, the maritime industry
will experience stress from shifts in the supply/demand of transported goods, developments in seaborne trade patterns, labor inflation as well as
geopolitical volatility, regulation and compliance with international environmental and safety standards.
Declines in global GDP and subsequent demand destruction have resulted into substantially lower cash flows in the mining sector, due to the high fixed
costs. In particular, high leverage in the metallurgical (met) coal sector caused by merger and acquisition activity a few years back (or what PIMCO
refers to as “financial indiscipline” on the part of managers) at peak met coal prices per ton has led to recent bankruptcy filings. And, while the
shale revolution is a positive for certain sectors of the market, low natural gas prices (combined with MACTS regulation, or mercury and air toxic
standards, and bottlenecks in transportation) have negatively affected companies in the thermal coal space.
Infrastructure companies benefit from having assets (e.g., ports, roads, water treatment facilities) with long life cycles and may benefit from the
consistency and benefit of regulatory (e.g., concession) frameworks. However, there exist numerous entities in financial distress caused by the
inability of some of these companies to grow into their pre-2008 capital structures: Their debt is now coming due, a challenge for these companies, but
an opportunity for an investor who can be patient.
Even as investors move out along the risk spectrum and look toward distressed credit as a source of higher return potential in a low yield world, we
would caution them to focus on companies that will be able to withstand periods of economic inertia, to undertake careful valuation practices and to
strictly adhere to the absolute priority rule (in which senior creditors are paid in full before junior creditors). The tale of two credit markets is
an ongoing saga.
KEY CONSIDERATIONS FOR DISTRESSED CREDIT INVESTING
Distressed debt has historically provided low correlation to broad market indices and a diversification opportunity for investors. Within
the distressed debt sector, investments in middle market companies require comprehensive due diligence due to information asymmetries, as
well as the financial, legal, structuring and negotiation skills needed to harvest opportunities. A highly disciplined investment approach
and careful credit differentiation – incorporating both bottom-up and top-down analyses – is essential. Investors should be mindful of
various risks in this sector:
- Unintended consequences of accommodative central bank policies. While quantitative easing (QE) resulted in money flowing
into capital markets, it also likely distorted valuations and facilitated excessive risk-taking by some market participants. The long-term
effects of these experimental policies are unknown.
- Creditors’ rights. The bargaining power of companies (and equity holders) has largely overtaken that of creditors. The
recent record-high issuance of speculative grade debt has seen the return of pre-2008 instruments (e.g., covenant-lite loans,
payment-in-kind terms) that favor borrowers, while traditional covenant packages that help protect creditors (leverage and coverage
thresholds, restricted payments baskets, limits on dividends, limits on the incurrence of debt, and many more) have deteriorated.
- Managerial behavior and industry evolution. Creative destruction, a process by which industries evolve and companies
reconfigure to more effectively compete in a changing system, is important for the long-term functioning and growth of markets. Cheap
credit fosters risk taking and tends to skew capital allocation and budgeting decisions to lower returning projects, which may spur the
creative destruction that can lead to a potentially a more effective system. However, the extended low interest rate environment may be
encouraging more of this investment than in previous cycles and we believe this may lead to an extended period of overcapacity and further
imbalances in certain sectors of the market: The cycle is building and the seeds are being sown for the next distressed cycle.
- Liquidity and balance sheet examination. Cheap credit has prompted many larger companies to de-risk (somewhat) their
capital structures. However, many companies remain over-levered, with unfavorable cost structures, legacy liabilities and limited
flexibility to industry or economic changes. High leverage is a primary driver of distressed situations, as it reduces the margin of safety
for companies facing common operating challenges.
- Valuation elasticity. Valuations in high yield and bank loan markets are increasingly being stretched. While lower
discount rates are applied due to low prevailing interest rates, investors need rigorous valuation methods to properly evaluate expected
cash flow growth, which may revoke the effect of higher implied valuation multiples.
- Zone of insolvency and ability to influence. Companies may enter the “zone of insolvency” due to their liabilities
exceeding the fair value of their assets or due to their inability to pay debts as they come due. When this occurs, company directors have
duties to consider the interests of a corporation in its entirety, including creditors. Distressed investors in middle market companies
usually have more ability to address problems and potentially influence outcomes.