Investment opportunities can arise quickly in the public market, but they can also vanish just as fast.
With the stock market at an expensive valuation — just 8% below its all-time-high — stocks are tricky. Some suggest dollar cost averaging into stocks as volatility potentially rises in the near-term as coronavirus cases spike. Credit spreads are high, but they were higher last week.
But there’s an opportunity to add high yield to one’s portfolio in a very risk-managed way: using the private market.
Currently, U.S. high yield spreads are around 6%, according to St. Louis Fed data. This means the additional interest rate on a high yield bond is 6% more than on the safe 10-Year Treasury bond, as investors demand premium return for additional risk. UBS wealth management’s data shows low rated ‘B’ bonds (A’s are the highest grade) have spreads of around 6%.
Spreads were once at 11% as the U.S bear market hit hard, but the Federal Reserve walked in to buy corporate bonds to reduce the yield and enable companies to borrow and stay in business. In fact, the Fed expanded its credit facility this week, saying it will directly buy select high yield corporate bonds, adding juice to risk asset prices this week.
But the Fed has made it clear it’s mostly buying bonds of companies known as “fallen angels,” which had an investment grade credit rating pre-virus, but were forced into high yield status by the events triggered by the virus. That means companies who entered the crisis already-high debt burdens have been left to struggle and many are filing for bankruptcy. Small oil companies like Occidental (OXY) - Get Occidental Petroleum Corporation Report, much more levered than larger ones like Exxon Mobil (XOM) - Get Exxon Mobil Corporation Report, are experiencing very threatening issues to their capital structures. Oil producer Chesapeake Energy (CHK) - Get Chesapeake Energy Corporation Report installing for bankruptcy. Struggling retailers with poor online channels like JC Penney (JCP) - Get J. C. Penney Company, Inc. Report are also filing.
For those who have the capital and can stomach the risk, there’s a real opportunity, as UBS forecasts U.S high yield default rates should spike to 12% in the next year. Pre-COVID, default rates were humming at around 3% for several years and had spike to 14% during the 2008 financial crisis, unsurprisingly, as the Fed had taken longer to step in to clean up the mess. So far in 2020, default rates have reached around 6%.
Even before we dive into why private credit funds are able to realize a strong rate of return, let’s take a quick look at the facts:
"Historically, managers have been able to monetize on credit dislocations,” UBS’ team of alternative investment strategists wrote in their note, which contains a graph showing the strong correlation between rising default rates of leveraged loans and increased internal rate of return for distressed credit funds.
The advantages of investing in these funds, UBS points out, are aplenty. First off, the fund managers, flush with industry connections and expertise, can source deals easily and provide financing solutions to keep companies operational and still enjoy a high interest rate. Secondly, proven funds can enjoy access to capital when needed and then manage a distressed company through the bankruptcy process.
The point: access to this strategy might provide opportunity for a better deal than to simply buying a few bonds of a distressed public company and then hoping the bonds don’t completely fail and remain liquid.