Three key phases of major credit cycle: Map of what's to come

Wed, Jun 03, 2020

Ilfryn Carstairs


THE impact of Covid-19 - and the speed of its disruption to society and markets - is unprecedented. It is clear that we are at the start of a major, connected credit cycle. We expect this cycle will be as bad or worse than the Global Financial Crisis of 2008-09 (GFC).

The GFC was about the fragility of the financial system at that point in time. The current crisis is a physical disruption - a sudden stop - and there remains an open question about the depth of this event, which is driven by the open question around the duration of physical disruption. As we're still in the early stages, though, the range of potential outcomes remains wide.

We believe in many ways this is closer to an absolute black swan than what happened in the GFC based on the lack of time to adjust and the speed of escalation. This is important because it brings into focus downside scenarios that weren't considered even in the more draconian cases of prudent risk-taking. It goes beyond any downside case people were reasonably modelling.

The start of this cycle has also been much more significant than that of any previous recession, even a very deep one. The first order impact on over-levered credit is quite obvious - a quick impairment. It brings into play the deeper, second order of impact that can then cascade and create more systemic problems. Similar to what happened in the GFC, it creates a lot more impairment but also a lot more panic.

Panic feeds on itself, and panic took hold in markets. The consequences of this usually take a fair bit of time to manifest, and they're not easily fixed. That further informs our view that this is a very significant cycle.

We've been asked quite a bit about the impact of stimulus. Our view is that monetary intervention has been critical in keeping even basic markets like treasuries functioning. Fiscal stimulus came thick and fast and the level of urgency that policy makers have shown in heading off what could have been at least a temporary depression has been impressive in terms of the magnitude and speed at which it has come.

We note, though, that the stimulus in the early days of the cycle has been targeted at survival and tilted to places that need it most - both consumers and basic market functioning. We think more will be needed and that focus on survival will really need to continue.

Of course there will be some bailouts, but unfortunately for the world there will be huge impairments to deal with, including in large amounts of credit previously and fairly considered safe. The Troubled Asset Relief Program (TARP) stimulus came in early October 2008, and of course it was five months before the market bottomed, and the GFC opportunity ran for many years after.

We really don't think there is a silver bullet to avoid a large default cycle. It's more a question of how bad the impact is already and the paths from here, which will vary by industry and by country. Importantly, we believe the shape of the recovery will revolve around medical outcomes - whether a vaccine can be effectively developed and we get reliable testing to allow people to get back to work.

While significant uncertainty on the duration and depth of this cycle remains, we know that the cycle will evolve over multiple stages, and with three key phases.

Phase 1

The first phase is the "processing period" and it starts with maximum uncertainty and some chaos. Phase 1 can provide strong absolute returns with good downside protection, but that opportunity is quite short-lived relative to the length of the overall cycle. In this phase, investors have seen high quality credit with liquidity at prices where one could benefit from what we view as irrational dislocations in the market.

As we would expect in this early stage of the cycle, we cannot overstate the shift in the opportunity set in recent weeks. While some corners of the market are beginning to settle, markets remain dysfunctional, and prices in many places do not make sense, creating hugely compelling potential opportunities.

Our experience through crises of the past has taught us that there is no time to waste in putting money to work - in the right way - early on.

While the opportunity set may be enormous, we remain disciplined about where to focus our efforts and resources. What we do, and crucially what we don't do, are equally important aspects of investing in this environment.

HIGH QUALITY NAMES WITH DOWNSIDE PROTECTION

It might seem paradoxical, but the start of the crisis saw the most dramatic mis-pricings in the most senior parts of the capital structure - and in high quality, investment grade names. These were typically liquid blue chip companies with very large market caps - leaders in their sectors and, we believe, likely survivors of this cycle. The level of dislocation in markets also made it possible to hedge downside risk relatively cheaply.

Ultimately, we are not preoccupied with trying to identify the bottom of the cycle while the backdrop is still highly uncertain. In the early part of the cycle, there is an advantage to simply having cash on hand to transact with sellers who need liquidity.

As this more chaotic period starts to wind down, Phase 1 should move to more deep value opportunities where finding clear survivors in more impacted parts of the economy becomes a real credit selection exercise. Some restructuring opportunities may begin to make sense.

Phase 2

Phase 2 begins when the range of outcomes narrows, markets return to more functioning levels, and liquidity comes back. Narrower outcomes better enable us to discern between potential winners and losers.

This is when one would typically start to form stronger specialisations around more impacted areas and sectors, and credit selection is critical as large restructurings happen. Less liquid opportunities should start to emerge. For example, in the GFC, opportunities centered around financials, distressed Residential Mortgage-Backed Security (RMBS), and home-building lending platforms. As views on specific sectors become more clear and the market more fully processes, one can also expect to see opportunities emerge in the illiquid space, including more lending and those resulting from forced asset sales.

In certain markets that have taken more time to reprice, we expect these opportunities to evolve over the coming weeks and months as we head into Phase 2. While the structured credit market has seen some dislocation, it has yet to experience the same fundamental shift in pricing as the corporate market. It has pockets of very real default risk.

We expect to see more forced asset sales as we get deeper into the cycle, and rescue lending deals emerge. While those opportunities do exist today, in our view they are characterised by high levels of desperation and low-quality collateral. We believe those in need of cash will ultimately come to terms with prevailing levels of price and risk, and eventually begin offering up more high-quality assets.

The primary market will also have a role to play, with many firms facing a liquidity squeeze, and the quality of collateral will again be important.

Phase 3

The final phase is the aftermath. This can have a long tail that could last for anywhere from two to three years in developed markets and up to five to seven years in less developed markets.

This opportunity set is generally much less liquid and can include non-performing loans (NPLs), new money, and special situations lending. For example, countries like Spain and Italy were in crisis in 2009 but in our view, NPL opportunities only really emerged in 2014 and beyond. Phase 3 in this cycle may yet be many years away.

The writer is partner, co-chief executive officer and chief investment officer, Värde Partners

https://www.businesstimes.com.sg/wea...-whats-to-come