George Hicks
In my more than 30 years in this business I have invested through many credit cycles. Some cycles have been in geographies, some in industries and then there are big systemic cycles like we saw in 1991, 2001 and 2008. Now we are clearly in one again, and at the start of a recession. None of these cycles have been the same, they evolve over multiple stages, and while some things are clear now, others will emerge over time. Clarity only comes with hindsight. For that reason, we rely on Värde’s deep expertise in credit that we’ve developed over the past 26 years, and we rely on the strength of our global platform to enable us to pivot to the opportunities where we see the best relative value.
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. In our view, we expect this will be as bad, or worse than, the Global Financial Crisis of 2008-09 (GFC).
The GFC, though, was about the fragility of the financial system at that point in time. This has been a physical disruption, a sudden stop, and there remains an open question on 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.
Our view is that monetary intervention has been critical in keeping even basic markets like treasuries functioning.
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 modeling.
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 saw dislocation in asset classes and even in the same capital structures – equity and credit telling very different things, for example. There was a big technical play that revolves around forced selling, a proper dislocation due to the unwinding of leverage positions. The mismatch between assets and liabilities is playing a big role – and all as the intermediaries and banks were no longer acting as a significant cushion and have been themselves dealing with physical disruption.
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 out of this, including in large amounts of credit previously and fairly considered safe. 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. The paths 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, in our view 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 to put 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 mispricings 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 start winds 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 specializations 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 RMBS, and homebuilding 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 take 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 characterized 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 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.
Strength of the business
George Hicks
We believe there is never a precise template for how any credit cycle of this magnitude plays out. We bring to bear our deep experience investing through many cycles to guide us on the best approach through each stage. We have always taken a rigorous approach to risk management, with a strong framework in place to review and assess deals.
We have ample resources with more than 100 investment professionals around the globe, including CIOs in the US, UK and Singapore.
We have always been big believers in investing in our business, building the right infrastructure and having back-up plans to deal with any crisis. While no one could have anticipated the events of recent weeks, we benefit from our experience working seamlessly across time zones and our ability to stay connected to address the operational challenges in this new environment.
With more than 300 people working across three offices in the US, five in Asia and five in Europe, all our business functions in-house, and trading operations in each region, we were well prepared to adapt and respond to ensure there was no disruption to our operations.
Responding in the right way
Ilfryn Carstairs
We are also committed to responding to this global crisis in the right way – carefully looking after our people, being good and responsible counterparties, and giving back to our local communities.
With a strong, established culture, we have fostered a significant sense of community in the firm over many years. In recent times, we’ve had to adapt to make sure we keep that sense of community alive while we all work from home. We are learning as we go on to some extent, but we are trying to put an emphasis on mental health and wellness and on keeping connections while we are physically apart. This includes heavy use of video meetings as well as social gatherings like virtual lunches and such.
We’ve also had a terrific philanthropic response targeted at our local communities and actively finding ways for our employees to volunteer remotely as well.
This is a very sobering period for us. We feel very fortunate that we have a platform with the strength, resilience and expertise to work on behalf of our investors in these times.
Commentary
Issue 148
Värde Views: Phases Of A Credit Cycle
A map of what’s to come
Excerpts from a webcast
Originally published in the April | May 2020 issue