Stuart Mathieson, Head of Barings’ Global Special Situations group, and Bryan High, Co-Portfolio Manager of the strategy, discuss how the macro environment is impacting their outlook, and where they're seeing distressed debt opportunities today.
Can you start by setting the stage for us, in terms of the macro landscape? From your perspective, how is the cycle affecting the behavior of high yield issuers, and what does that mean for the opportunity set in distressed investing?
When we look across the markets today, I would say it’s clear that we are in the late stages of the credit cycle, although we’ve been saying that for 12 months now. Fundamentals appear stable, and we’ve seen corporate earnings hold up reasonably well. But with the search for yield across the markets, we’ve also seen a rising number of aggressive structures with weaker covenants in the space, across both loans and high yield bonds.
One big change since the last cycle is that the markets have gotten significantly larger. For comparison purposes, if we look back at 2007, high yield credit markets were about $2.1 trillion—including both loans and bonds—and average pre-crisis default rates were roughly 2%. Today, the size of the markets is closer to $3.5 trillion, and average default rates are at a similar level. Overall, that’s a relatively low default rate, but inevitably it will increase—and given the larger size of the markets, even doubling that rate would add about $50 billion in distressed debt. So, the opportunity set is certainly there, in our opinion.
Distressed debt means different things to different people. Can you explain how you think about special situations and distressed debt investing from Barings’ perspective?
At Barings, we’re focused on corporate credit. So that includes North American and European broadly syndicated loans, high yield bonds and private credit. Each of those represents a portion of the large funnel of opportunities we consider when we’re looking to deploy capital across our platform. There are varying degrees of how we can do that, but overall our strategy falls into two buckets.
On one hand, we might take a non-control position—or what we call a high yielding investment—which is often on the back of a price dislocation in the market. This allows us to either invest in the loan or bond and clip a coupon along the way, or buy it at a discount, with the opportunity for capital appreciation.
On the other hand, we might take a control position—or what think of as an enterprise value investment opportunity. In some cases, a high yielding investment could morph into an enterprise value investment. But in most cases, we take a control position from the start, in anticipation of a specific catalyst that can lead to value creation through a restructuring process. This often results in us forgiving some debt in exchange for a majority equity stake.