Countercyclical strategies

Summary

We believe that this could be an opportune time to initiate an allocation to uncorrelated, opportunistic credit strategies because:

• If markets were to enter a more decisively ‘risk off’ mood, traditionally defensive assets – government bonds, in particular – may not be able to protect portfolios if central banks choose not to cut interest rates because inflation remains persistently high.
• In that eventuality, investors may need genuinely countercyclical allocations, such as opportunistic credit strategies that have historically generated their strongest returns by being able to deploy capital astutely through downturns.
• The uncertainty around the depth and breadth of any risk-averse period – dependent on whether or not monetary policy can tame financing costs to help struggling businesses and fiscal authorities have already exhausted their firepower – may favour the most flexible managers, who can seize opportunities across geographies, sectors and capital structures.
• However, if well designed and structured, an opportunistic credit strategy may not even need public credit or equity markets to unfold; they may solely rely on the manager’s ability to source off-market transactions and benefit from being a liquidity provider at times when entire cohorts of borrowers witness funding gaps.
• This becomes especially pertinent as borrowers face a maturity wall, which will need to be refinanced regardless of economic conditions. This necessity, which will come while banks are still retrenching from lending and public markets remain volatile, means being a flexible liquidity provider can command extra premia.

Risk everywhere

The headwinds for risk assets haven’t yet blown markets off course in 2024, but they remain well known: a potential economic slowdown, equity valuations that could de-rate, inflation still above targets, geopolitical tensions worldwide, and financing costs that are high while maturity walls loom. On this latter point, finance directors face unprecedented uncertainty. Should they prioritise refinancing, at higher cost, or investing in their business? These materially higher refinancing costs could trigger stress throughout the economy. They have already triggered some notable, albeit relatively small, credit events in recent months.

Set against these concerns, however, are government bond yields around their highest levels since before the financial crisis. Investors may therefore take some comfort that their fixed-income allocations could mitigate any equity weakness, as interest rates and bond yields have plenty of scope to fall when recession strikes.

This would be a relatively welcome scenario for traditional 60/40 investors, stung by losses on both sides of their portfolio in 2022. However, it may be unwise to rely on it. The primary problem with the thesis is that it depends on central banks being willing and able to cut rates immediately. This may prove highly unlikely while inflation stays stubbornly above targets, and volatile oil prices suggest inflation’s downward trajectory may not be entirely smooth.

As the May 2024 minutes of the Federal Open Market Committee confirmed:

The Federal Open Market Committee’s latest projections reinforced the ‘higher for longer’ message, as the forecast Federal funds rate has been revised up for each of 2024 and 2025 over the past year (Figure 1). Rate cuts at the first sign of trouble are thus by no means guaranteed, which has negative implications for bondholders in at least the early stages of the next economic downturn.

Moreover, history indicates that when inflation is strong, equities and bonds become positively correlated (Figure 2). Bad news for stocks therefore becomes bad news for bonds.

Cash may offer a safer port in any such storm, and is especially tempting at the prevailing rates in money markets. However, it lacks the upside potential that investors may have counted on from government bonds in past crashes.

A countercyclical profile

So what else could investors consider?

One option may be opportunistic credit strategies, especially those focused on stressed, distressed and special situations, with the ability to invest flexibly but without legacy positions to manage through the initial emergency by acting as liquidity providers. Past experience is encouraging. Around the global financial crisis, the highest returns from private-debt managers in the distressed and special-situations categories were generated by the 2008 and 2009 vintages (Figure 3). The pattern makes intuitive sense too: distressed debt performed first, and then special situations became more apparent after the market trough.

Our own qualitative analysis supports the thesis

Based on a range of scenario analyses, given the upcoming maturity wall and a medium-term investment horizon, we believe the expected returns from a global multi-manager approach to such credit strategies increase progressively as the economic situation worsens. In our view, they could reach almost equity-like levels through a recessionary environment.

Even outside an economic downturn, the maturity wall poses considerable challenges for borrowers and create opportunities for opportunistic credit investors. As the OECD has noted:

The problems only become more acute if loans are included alongside bonds. Loans and bonds rated B- or lower worth $58.4 billion will mature this year, surging to $313 billion in 2028. Loans and revolving credit facilities account for most of this speculative debt, according to S&P Global, with loans representing the majority of the annual maturity growth until 2028.

The challenge, inevitably, is timing. Figure 3 highlights that investing too early or too late in this space, while still producing positive returns in absolute terms, is less optimal than allocating at the nadir of a crisis.

A potential solution may lie in strategies with a drawdown structure, whereby managers only call capital from investors when they are ready to deploy it. The call rate is discretionary, allowing the manager to pace deployment according to the environment; this should help to maximise upside capture in an acute market correction.

It is in this regard that the aforementioned high cash rates could make it a particularly opportune moment for such drawdown strategies. In essence, an investor can commit to the strategy and continue to receive the cash yield until the manager determines that it is the right time to act; for maximum efficiency, it is important to ensure that fees are only levied on invested capital, not committed capital. 

Flex appeal

Given this specific market environment, manager flexibility is likely to be crucial along several dimensions:

1. Being able to operate across the boundaries of public and private markets should allow managers both to buy the bonds and loans of issuers that are in distress and then capitalise on their recovery, and to provide private financing to companies in need. Indeed, the lines between private and public credits are blurring; large groups that traditionally issued corporate bonds are now looking to private transactions, for reasons such as minimising syndication costs and risks, the speed and certainty of execution, or avoiding publicity. Equally, investment banks are hiring private-market specialists to facilitate such transactions.

> This advantage was particularly apparent in 2020. Although the Covid-induced crash was relatively brief due to coordinated monetary and fiscal interventions, flexible managers were able to act quickly as the price of public credits fell and implement more efficient capital deployment.

> The potential for rapid dislocations in public credit markets is exacerbated by the decline in liquidity since the global financial crisis. Investment banks have retreated from proprietary trading and their broker desks hold lower inventories; both were formerly the oil that made the bond trading machines run smoothly. Their absence raises gap risk – the chances of a bond price suddenly collapsing on bad news – which in turn creates opportunities for agile managers.

2. Being able to use a wide technical skillset across this public/private boundary should aid capital appreciation in distressed and special situations; this could include financial and/or operational restructuring, providing capital solutions that are more innovative than syndicated public lenders can match, and experience across niche areas of alternative credit (such as consumer loans or asset-backed financing) as traditional banks retreat from the market (Figure 4).

3. Amid the maelstrom of old and new market and economic concerns – monetary and fiscal, corporate and geopolitical – multi-strategy approaches (and therefore potential multi-asset exposures) can expand the investment universe, helping to diversify away idiosyncratic risks and open a wider opportunity set.

> The value of working across traditional asset or sector boundaries has been evident this year in real-estate markets. With distress emerging at overleveraged developers from China to Germany and Canada, credit managers with the right skillsets can ultimately take possession of the asset through an enforcement process via their initial debt positions.

4. Strategies able to deploy capital with a clean slate, without needing to attend to legacy investments struggling in the downturn, may have a relative advantage; this could also favour drawdown structures, compared with investors trying to benefit from the same recovery dynamics through open-ended funds.

In our view, a diversified fund of funds approach across the sub-components of opportunistic credit investing may help investors to tap each of these dynamics without having to build their own portfolio of niche managers. In an ever-more atomised and bespoke credit market, multi-manager solutions can harvest the full spectrum of alpha potential.

If this is done with a drawdown structure, moreover, the underlying managers can benefit to a fuller extent from the asset-liability mismatches across the credit market. Drawdown arrangements can help managers to size transactions appropriately without incurring shorter-term liquidity drags.

Conclusion

If risk appetite wanes, traditional bonds may not mitigate losses from stocks if central banks keep interest rates high as they fight potentially persistently high inflation. Cash allocations may help with capital preservation, but money markets are unlikely to give the performance that fixed income did in the past.

Opportunistic credit managers with drawdown structures, however, may help investors balance immediate downside mitigation (by letting them stay in cash) and future upside potential (by acting as a liquidity provider when other financial markets are withdrawing capital). This latter characteristic is how such managers have historically been able to command equity-like returns with limited downside embedded in the financing terms.

On the other hand, waiting to commit to distressed and special-situation debt until the signs of market distress become evident may mean missing the dislocation opportunities with the best risk-adjusted outlook (in addition to missing the opportunity to allocate to top-tier managers who may have already primed positions ahead of the expected downturn).

Opportunities with this degree of optionality tend to be rare in markets.