Investment Actions

David Trucano
on opportunistic credit

Jan 23, 2017

Opportunistic credit investing is about providing capital to borrowers who have a financing need they cannot meet elsewhere, whether at a bank or in liquid capital markets. Borrowers typically find themselves in this position because they are facing financial stress or some other special situation that requires a creative financing solution. Opportunistic investors accept and manage the risks that come with such complexity and illiquidity, and in exchange target a return on capital that’s well in excess of those offered in publicly-traded credit markets.

Aren’t there fewer of these idiosyncratic investment opportunities, given the broad availability of public credit in recent years? In fact, the reverse is true. More high yield borrowers are tapping public capital markets than ever before (see chart below). This inevitably means that a larger number of companies is likely to face unexpected developments, including potential defaults, when expected growth doesn’t materialize or impending maturities can’t be addressed through traditional refinancing activity. Borrowers are likely to encounter more surprises now that the era of low rates and suppressed volatility appears to be giving way to one of reflation and greater dispersion among industry sectors and individual companies.

David Trucano, lead portfolio manager for BlackRock’s Credit Alpha and Global Credit Opportunities funds, discusses the evolution of opportunistic credit and its relevance in the current climate.

Growing opportunity

Global high yield and leveraged loans outstanding

Growing opportunity

Source for total high yield and leveraged loan debt outstanding and pricing of performing loans: Standard and Poor’s LCD and Bank of America Merrill Lynch, as of November 2016. Source of distressed levels: Standard and Poor’s LCD and S&P/LSTA Leveraged Loan Index & Merrill Lynch, as of November 2016. S&P LSTA Index Distressed level is the estimated amount of performing loans trading below 80. Merrill Lynch High Yield Index Distressed level is the estimated amount of performing high-yield bonds out yielding Treasuries by 1,000 basis points or more. Source of default: J.P. Morgan default rate/amount estimated annually.

What accounts for the current interest in opportunistic credit strategies?

We see two factors at work. One is a greater emphasis on credit investing in general because of the low-rate world we’ve been living in. Within that larger credit universe, there is a wide swath of opportunity that fits between traded markets and what I would call traditional direct lending strategies. These are companies or projects that need credit to finance what is often a turnaround story or a business plan that hasn’t met expectations. This is the traditional sweet spot for opportunistic strategies. It's more challenging for traditional private lenders to provide financing in these situations because you have to negotiate structure, work with different constituents with different interests, and think in terms of what, ultimately, a recovery may look like in a downside scenario. You also have to be willing to take principal-loss risk, which most traditional lending strategies try not to accept. As opportunistic investors, we’re often willing to take that risk based on what we believe the underlying equity would be worth in downside scenarios, and our understanding of how we’d be protected by contractual rights and priorities.

Regulatory issues are particularly important. Before the Volcker rule and other post-crisis regulations, investment banks were very active in these financings. But since then, they’ve largely withdrawn from private markets or distressed situations, opening up a bigger white space in which investors can participate. And even though there’s now talk in Washington of rolling back some of these rules, I don’t see the broker-dealers returning in a big way. Business models have adjusted, significant human and intellectual capital has moved elsewhere, and corporate issuers are increasingly looking for platforms that can invest in different ways, and at scale, at all stages of the business cycle.

What’s your view of the current credit cycle, and how is it shaping your strategy?

You can’t time the cycle—you just try to be ready for what might happen next. We’ve been in a long, drawn-out expansionary credit cycle that was driven mostly by monetary policy, but now we’re looking ahead to the potential for rising interest rates and an acceleration of growth. A lot of investors stretched into yield assets because the returns on Treasuries and investment grade were so low. Many aren’t natural owners of high yield and bank loans, and will switch back if returns improve in more traditional markets. We think this will produce more volatility and price swings as capital markets open and close with greater severity and industry groups go in and out of favor. Lower trading volumes and lower dealer inventories in high yield will probably accentuate these movements.

A turn in the credit cycle usually starts with markets rejecting one or several credit sectors and then losing confidence more broadly in leveraged finance markets. We expect that will happen the next time as well. But if rates are still relatively low when this cycle turns, we expect the recovery period will be longer than in previous cycles, because central banks today have less room to cut rates and stimulate demand for risk assets. Previous cycle recoveries appeared “U” or “V” shaped, as we saw in 2002-2003 and 2008-2009. We think it’s likely that the next recessionary environment will be deeper and longer. As a result, opportunistic investors will have to hold assets longer to maximize recoveries.

While cycles are important, you also have to keep in mind how idiosyncratic these situations are. They develop because something goes wrong for a borrower and, ultimately, its creditors. But that failure may be the result of a secular trend, such as a technological change that undermines a business model and necessitates a change that needs to be financed.

What are some other things you need to consider when investing in opportunistic credit?

At the top of the list, I would put an ability to deal with ambiguity and to feel comfortable structuring investments that create downside protection. I’d also add an ability to move quickly to capitalize on general institutional inertia. Often, the best transactions occur at extremes—when you can move quickly and when you exhibit significant patience. And, of course, you need a discerning mind to prioritize potential opportunities because how you spend your time becomes increasingly valuable.

If you’re starting from scratch and trying to understand the industry and build a model, you’re going to find it very difficult to understand the specifics of a potential deal. Whereas, if you’re a part of a global credit platform, and you have colleagues who have been following the industry and the company over time or across several credit cycles, you can get up to speed more quickly. You also need the access, resources and expertise to do really deep-dive due diligence. It’s more like a private equity approach than traditional credit analysis: you’re looking at management, markets, suppliers, customers, competitive position and more. You also need to price the whole capital stack because if you're wrong or if you're pricing something to default and you want to get a better return, you will need to have a view of what the entire enterprise is worth, regardless of how it has been capitalized.

Structuring know-how and patient capital are significant competitive advantages in opportunistic strategies. Our experience investing in credit opportunities and the scale of capital we employ allows us to have a say in the structure of the transaction and on the terms of the security and covenants we negotiate. That gives us an ability to protect ourselves on the downside and the potential to earn an upside commensurate with the risk we’re accepting.

Finally, I would stress the importance of relationships and reputation in securing deal-flow. Being part of an organization that is able to come up with different ways to help a creditor finance itself across a cycle creates more context and sharpens investment decisions. It can also make you a more attractive potential partner for a management team or incumbent investors who are looking to solve a problem and return to more traditional financing markets over time or once a storm has passed. Many borrowers find themselves under considerable time pressure when they’re looking to non-traditional sources of capital, and they need to find somebody they can trust.

David Trucano
Managing Director, lead portfolio manager for BlackRock’s Credit Alpha and Global Opportunities team