The next five years hold immense potential for investing in distressed credits
Published on June 23, 2024Last updated 6 hours ago3 minutes of reading
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Although it appears that we are at a time where a market downturn may be imminent, small and medium-sized businesses could still excel.Photo by Michael M. Santiago/Getty Images
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By Parul Garg
High-yield credit spreads fell to their lowest level in a decade at 3.05 percent this quarter, reflecting reduced demand for credit risk compensation, demonstrating market confidence in risk weak credit ahead, but this optimism leaves little room for safety margins.
Credit spreads are a premium offered to investors to compensate for the risks associated with bankruptcy, and despite robust economic indicators and continued inflation concerns, the market as a whole fails to adequately compensate for these risks. , thereby providing limited opportunities for risk-adjusted returns.
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The situation reminds us of Benjamin Graham's observation: You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are correct.
Current market sentiment suggests investors believe interest rates may have peaked, but there are growing indications that the U.S. Federal Reserve will extend its high rates to combat the inflation since it targets a level of 2 percent.
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Large-cap equity markets are nearing all-time highs, largely driven by optimism over artificial intelligence, leading to inflated valuations and shrinking risk premiums, particularly in large-cap U.S. stocks now renamed the Magnificent Five and in the high yield indices.
However, concerns are emerging on various fronts and could potentially spill over into broader markets: political discontent in North America, Europe and elsewhere; skyrocketing public debts; ongoing military conflicts (including those involving great powers) in Ukraine, Haiti, parts of Africa and the Middle East; and divergent views on the societal impact of AI.
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Predicting market developments is always difficult and, therefore, unreliable. Changes often happen quickly, catching many people off guard with their scale and impact.
Although it appears that we are at a time where a market downturn may be imminent, small and medium-sized businesses could still excel. Their attractive valuations, combined with continued earnings growth, position them favorably, despite the market's greatest shortage of capital.
As Warren Buffett said, Size killed us. For a while, we had an abundance of candidates to evaluate. If I missed one and missed a lot, another one always came along. Those days are long behind us.
Berkshire Hathaway Inc. is a US$905 billion company. To improve performance, he would have to buy a gigantic company. The same competition for assets applies to private credit giants, like Oaktree Capital Management Inc., which, by necessity, cannot consider the secondary market made up of small and mid-sized companies due to liquidity constraints.
On the other hand, size is an important advantage for smaller funds, which are less dependent on credit cycles and have a much broader opportunity set of small and mid-sized capital structures. These could include unrated credits with attractive spreads that are often overlooked by indices and large companies.
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Smaller companies with simple capital structures can have significant return potential and growth catalysts. For example, in the distressed sector, it is possible to identify opportunities with spreads above 1,000 basis points. Similarly, stressed asset spreads exceed 600 basis points.
Today, sectors facing capital shortages and that have fallen out of favor with investors include healthcare, biotechnology, electric vehicles and cannabis. Looking ahead, we believe the next five years hold immense potential for investing in distressed and distressed credits.
Parul Garg is a portfolio manager at Pender Credit Opportunities Fund I.
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