The Covid-19 pandemic has led to an economic downturn worse than the global financial crisis. The response from governments and central banks has been dramatic in both fiscal and monetary terms.
Global government Debt/GDP is expected to exceed 100% in 2020 for the first time in history. Central banks have cut rates, resulting in negative real yields, and in many cases, negative nominal yields.
The policy response has led to a “borrowers’ market” in the public debt markets.
Borrowers are raising record volumes of debt at record low yields. In data compiled by Bloomberg US high-yield issuance in June surpassed the prior monthly record set in September 2013. In early August, Ball Corporation established a new record by issuing a 10-year junk-bond at sub 3% and the deal was upsized from US$1bn to US$1.3bn. The US high-yield index is delivering 5.4% and its European counterpart 4.1%. It is counterintuitive that during the worst economic crisis in living memory, and possibly in centuries, highly levered companies are borrowing more than ever at the lowest rates ever.
High leverage is typically resolved by growth, inflation or default. In recent months there has been much discussion on which letter of the alphabet would best describe the curve of a post Covid-19 economic recovery. A “V” for rapid rebound, a “W” for double dip following a second wave, a “U” for slow rebound etc. These characterisations assume that all sectors in the economy move up or down together. They thereby fail to allow for two important lessons of Covid-19. Firstly, its impact is not uniform across the economy: there is a huge dispersion across sectors (compare online retail to theatres). Secondly, Covid-19 has accelerated trends and this acceleration will survive the pandemic (e.g. working from home). We should prepare for a “K-shaped” recovery in which some sectors and borrowers perform well while others either fail to recover or see an acceleration in an underlying long-term trend of relative decline.
Against this backdrop of economic shock, uncertain growth and segmental dispersion the public fixed income markets offer low yields, and a pricing mechanism driven by monetary policy. It is no wonder that industry surveys report investors maintaining or increasing allocations to alternative assets, in particular to private debt.
Private debt now offers the last refuge for yield. It is a market where returns are based on risk/reward and are determined through bilateral negotiations between borrower and lender. Private debt typically offers lower duration and shorter maturities than public markets. Moreover, it offers greater flexibility with respect to segment allocation. In the public markets, the index tracking funds were designed for a pre-Covid world where inclusion in an index may be a function of factors such as credit rating, governing law or currency, but rarely a function of industry segment.
Private debt is not a homogeneous asset class.
There are very diverse strategies including direct lending, SME financing, receivables financing etc. Investors allocating to private debt should consider a third lesson of Covid-19; companies with pre-existing vulnerabilities will have those vulnerabilities exacerbated by the pandemic. When allocating to private debt, investors should try to identify those strategies, segments and borrowers that are more resilient to Covid-19. We see as vulnerable those borrowers who are highly levered, and who are reliant on consumer spending or on a swift return to pre-Covid normality. We prefer those borrowers who have more resilience, including those who are less levered, in B2B and who provide defensive goods or services.
