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  • Erigo Capital Partners

Credit Market Dislocation: An Investment Opportunity

Without question, the investment environment is challenging. But through preparation and by taking a targeted approach, investors can realize significant returns in the event of a credit market dislocation.

Consider the facts:

  • The probability of a US recession is now 60% according to Bloomberg’s latest monthly survey of economists, up from 50% in September and double what it was six months ago. The Fed tightening to combat inflation and declining business and consumer confidence are clear headwinds to growth, resulting in falling asset prices.

  • Rising yields and wider credit spreads have resulted in many fixed income securities now offering among the highest all-in yields since the global financial crisis. Pricing is likely to get even more interesting with the onset of a financial dislocation event, given continued central bank tightening, the increased probability of recession, and the expected impact on market volatility.

This scenario will lead, most likely, to a correlated decline in pricing across all credit markets. We could, however, see a very different dislocation than what we experienced during the Great Financial Crisis.

Consumers, for example, are in much better shape now. Residential mortgage securities and consumer ABS benefit from a tight labor market, low household debt service, and a high level of housing equity. The ratio of consumer net debt to disposable income has gone from 0.6x in 2007 to zero today and unemployment numbers remain strong. Furthermore, the GFC experience has resulted in residential and consumer-related securities becoming more structurally robust and loss resistant.

The corporate sector is more vulnerable under deteriorating economic conditions. Corporate debt has risen significantly, making companies even more exposed to ongoing supply chain risk and compressed margins in a recessionary climate. With rising corporate leverage, increased financing costs, margin compression, and lack of bond holder covenant protection, there’s a good chance of increasing default risk in corporate credit markets.

So how do you play this opportunity?

Traditional distressed debt strategies can underperform based on their focus of buying businesses that are unhealthy with a high risk of bankruptcy. A better solution is to buy good assets at distressed prices, which could be found in the securitized product market under dislocated conditions.

Despite being more fundamentally sound, securitized products are among the most illiquid and volatile investments in a market sell-off, and this can be a source of opportunity through a potential dislocation event. As an asset class, securitized credit is prone to periods of significant price decline because of limited dealer balance sheet support, complexity of structure, and the leveraged nature of mezzanine and subordinate securities.

Investing at market bottoms is challenging from a behavioral standpoint. It is difficult to time market entrance and exit relying solely on judgment. Establishing a rules-based approach where price triggers are utilized to establish entry points can help astute investors stay patient amidst the chaos. Raising capital commitments now and using triggers to guide capital commitment overcome two issues: the behavioral tendency to avoid investing at market bottoms and the impracticality of raising capital when the dislocation event occurs. The most effective price triggers should reference benchmark securities/indices in which the price levels are synonymous with earning high returns based on historical data.

The use of business cycle indicators or price triggers to increase risk exposure during previous economic crises has consistently led to high returns during recovery periods*.

*Source: Verdad



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