PIMCO: Corporate Credit - Capitalising on Potential Disruption

A Q&A with Christian Stracke, global head of credit research & Adam Gubner, head of US corporate special situations at PIMCO

Record corporate leverage and challenging macroeconomic factors are combining to create a compelling investment environment for managers with flexible capital. Christian Stracke and Adam Gubner explain why.

Why is the credit market compelling right now?

Stracke: There are three key reasons. First, there is a limited supply of flexible capital. Second, there are global macro headwinds. And third, we are seeing a significant increase in corporate leverage. The market is increasingly fragile against a backdrop of rising rates, higher inflation, and slowing growth – this supports an increasing demand for that flexible capital.

Can you explain the need for flexible capital?

Gubner: Demand for private credit is growing from a variety of factors. Assets under management in the private debt space reached a 20-year high of $1.2trn in 2021 from $50bn in 2001. The sheer growth of the market means borrowers often have a greater certainty of execution, while the private market is often more flexible for the customised financing terms required to meet certain unique borrower needs.

To date, we’ve had an enormous supply of capital serving loans to well-performing middle market companies. This has served to exponentially fuel the private credit market, but few of these managers offer flexible capital to borrowers such as second liens (also called junior debt), junior capital, and even preferred equity. These are often part of the solutions PIMCO provides to borrowers.

At PIMCO, given our size, we focus on larger companies where a significant commitment is required to meet the financing needs. PIMCO recently provided the entire preferred equity investment to a large family-owned infrastructure company with short line (small- or mid-sized) rail, port, and terminal assets throughout the United States and parts of Canada. These assets are critical to North American infrastructure, difficult to replace, and provide a significant amount of end-market and geographic diversity. Companies will increasingly require flexible capital solutions across their capital structures and will continue to be attracted to those managers that can commit the entire financing.

Why are global macro headwinds shaping demand for private capital?

Stracke: There are several macro headwinds that we see increasing the demand for private capital over the next few years. First, the Federal Reserve tightening monetary policy and reducing its balance sheet is restraining the supply of credit into the economy. Meanwhile, the economy is struggling with high inflation driven by higher input costs and rising labour costs, ultimately leading to pressure on margins – something that we have not seen yet, but expect to see during the next few years. That in turn will place stress on corporate income statements and make it more difficult for corporations to fund themselves from cash flows, meaning there will be a greater need for bespoke solutions in the private credit space. 

How much of a factor is rising corporate leverage?

Stracke: There is a high level of leverage out there in the corporate sector, in the United States and internationally – Federal Reserve statistics show that business debt as a percentage of GDP is at an all-time high in the U.S. at present, with the slight exception of the first and second quarter of 2020. Those leverage ratios and stock of debt on corporate balance sheets leave companies ill prepared for any downturn in the economy and pressure on margins.

Many of these highly levered balance sheets are positioned for growth and continued high margins. If we see disappointments in growth and declines in margins, that will put pressure on EBITDA. Meanwhile, of course, as the Fed is normalising monetary policy, interest rates are rising, and so companies that pay floating interest rate costs on their debt will see these costs go higher. Moreover, if at the same time you were to see EBITDA decline, it can tip the difference between a company experiencing a positive free cash flow and burning cash. When a company starts to burn cash, it can hit a wall in terms of the credit fundamentals, and it will start to look about for new solutions in terms of its financing needs.

Gubner: We see unprecedented demand for leverage developing now that we believe will disproportionately reward managers that can commit flexible capital and scale. As we have said, the demand for financing is influenced by three factors: record market size now across the public and private markets, which has reached $4trn – three times the size of the market at the beginning of the financial crisis. Companies now have record leverage just as we enter a cyclical period of rising rates and potential earnings declines. Finally, we believe that there is a lack of private capital to meet borrowers’ full capital structures, particularly for larger companies.