Rising corporate debt is concerning investors. Index-eligible USD corporate bond volumes are up 150% since the financial crisis, and the lower-rated BBB segment has increased as a proportion of the investment grade (IG) total. BBB-rated credits now account for 60% of the USD IG index (ex-financials).
We do not see corporate debt rising out of control and precipitating an imminent crisis as there are a lot of mitigating factors, such as very low funding costs. But we expect corporate defaults to rise moderately as the cycle progresses, from current rates of 1.5% and 0.2% for US and EUR high yield, respectively to 3% and 2% over the next 12 months.
While this could drag on some credit investors' returns, it also presents opportunities. In our latest private markets education series, we outline some of the advantages of distressed debt (DD) strategies:
- It provides a counter-cyclical element to your portfolio. The opportunity set for DD is typically counter cyclical, with lower corporate earnings growth and higher debt, interest and default rates supporting the strategies.
- It can offer alpha. The strategies aim to monetize investments and extract maximum asset value by normalizing firm profitability, restructuring or liquidating assets. They add idiosyncratic exposure to companies or assets not often traded on public markets. While they are more illiquid than hedge fund DD strategies, private managers can extract differentiated value by adding time and complexity to the reorganization process, with equity exposure potentially enhancing returns.
- It can increase returns with relatively low volatility. The DD median vintage year internal rate of return (IRR) from 1997 to 2014 is 9.1%. The standard deviation of vintage year IRR is 5.7% over the same time frame.So we believe this asset class can be an attractive part of balanced portfolios. For more detail, see our publication Distressed Debt, along with our broader series on private markets.