The next five years hold immense potential for investing in stressed and distressed credits
By Parul Garg
High-yield credit spreads this quarter hit a decade-low of 3.05 per cent, reflecting reduced demand for compensation against credit risk, indicating the market’s confidence in low credit risk ahead, but this optimism leaves little room for margins of safety.
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 right.”
However, concerns are emerging across various fronts that could potentially spill over into broader markets: political discontent in North America, Europe and elsewhere; soaring government debts; ongoing military conflicts (including those involving major powers) in Ukraine, Haiti, parts of Africa and the Middle East; and competing views on the societal impact of AI.
Predicting market shifts is always challenging and, therefore, unreliable. Changes often swiftly occur, catching many off guard with their magnitude and impact.
While it seems that we are at a juncture where a market pullback may be imminent, small-to-mid-sized firms may excel regardless. Their attractive valuations, coupled with ongoing earnings growth, position them favourably, despite facing the highest capital scarcity in the market.
On the other hand, size is a significant asset for smaller funds that are less dependent on credit cycles and have a much larger opportunity set of small-to-mid-sized capital structures. These could include unrated credits with compelling spreads that are often overlooked by the indexes and larger firms.
Smaller companies with straightforward capital structures may present significant yield potential and catalysts for growth. For example, in the distressed sector, it is possible to identify opportunities with spreads surpassing 1,000 basis points. Similarly, there are spreads in stressed assets exceeding 600 basis points.
Parul Garg is a portfolio manager at Pender Credit Opportunities Fund I.