Credit markets face “tale of two cities”
Credit markets are becoming increasingly polarised, presenting both opportunities and risks that require discipline to navigate, warns AlbaCore Capital Group.
While the collapse of US auto parts company First Brands dominated headlines last year, the direct impact on the European syndicated loan market has been contained. Instead, investors should be wary of a growing bifurcation within the market, David Allen, managing partner and chief investment officer at the European alternative credit firm.
AlbaCore warned that while 55 per cent of the loan market is trading above par, the share trading below 90, typically viewed as a sign of stress, has risen to 11.3 per cent.
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The issue is not primarily company failures, the firm said, but the growing number of businesses that will soon need to refinance large amounts of debt. In the current environment, this could prove challenging and could eventually be reflected in the ratings of these companies being put down to CCC.
At the same time, most European loans are held by collateralised loan obligation (CLO) vehicles, whose investors tend to favour safer, higher-quality credits. As a result, weaker or more complex borrowers’ risk being left behind, widening the gap between strong and stressed names.
“As the proportion of constrained CLO buyers has increased it has contributed to structural weakness in demand for more complex or low rated credits,” Allen wrote.
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On one hand, the trend presents risks, Allen said, as it could put further technical pressure on these names as rating-sensitive CLOs may need to sell. Less desirable credits have the potential to drop off “far and fast”.
“In our existing portfolios, we are re-underwriting every name. Where we see borrowers with deteriorating credit profiles are not yet priced in, we are looking to proactively exit rather than risking the larger drop which could follow,” he said.
However, this dynamic also creates opportunities. “With leverage still elevated, these borrowers may struggle to obtain straight refinancing in the senior direct lending market, enabling opportunistic and capital solutions investors to step in,” he said.
Overall, Allen wrote that as financial markets are increasingly sending mixed signals, they’ve created a “tale of two cities” situation where investors can find evidence for both “optimism and caution”.
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