Credit Markets Forging Ahead | Milken Institute Global Conference 2024

Macro Backdrop and Returns:

• Central bank tightening drove Treasury yields from 1.25% in early 2022 to ~4.5% currently, causing a >3x increase in yields.
• Five-year Treasuries and high-quality fixed income posted negative returns (~-5.5%) over the 2022–2023 period due to duration risk.
• High-yield bonds delivered holding period returns of ~2%, while bank loans generated ~12% returns by isolating credit risk from rate risk.
• Investment-grade credit suffered returns exceeding -10% due to high duration sensitivity to rising rates.
• Panelists anticipate a potential shift where falling rates and stable credit fundamentals could create a "tailwind" environment for the next 12 months.

Market Opportunities and Valuation:

• Current high-yield spreads (~300 bps) are considered tight but not overvalued given a historically low default rate environment.
• The high-yield market has contracted by nearly 20% in recent years, resulting in a portfolio quality higher than seen in the last 25 years.
• Higher base rates have attracted significant capital inflows, which panelists expect will further tighten spreads in the near term.
• Opportunities are identified in "esoteric" credit sectors and asset-based financing where private equity has retreated from the zero-rate era.

Texas Teachers Pension Plan (TRS) Strategy:

• TRS holds a $200B portfolio with 0% strategic allocation to credit; any credit exposure is purely opportunistic against equity or private equity benchmarks.
• The credit portfolio currently totals $7.5B, representing ~70% of the credit allocation, with a heavy focus on asset-based and regulatory capital relief transactions.
• Key investment targets include real estate construction loans and refinancing solutions for sponsors lacking exit markets.
• TRS recently exited $1.3B of senior direct lending to General Partners in 2021 to crystallize liquidity, a move made when market conditions were "normal" and before the current rate environment.

Private Credit vs. Syndicated Loan Markets:

• Broadly Syndicated Loan (BSL) issuance rebounded sharply in Q1 2024, reversing the private credit dominance seen in 2022.
• Private credit firms face a "dearth of M&A activity," with LBO volumes down 38% (2021–2022) and another 36% (2022–2023), reducing their primary source of deal flow.
• Private credit market share in leverage finance peaked at 24% in 2022 (excluding double-B) but is expected to normalize to the high single digits long-term.
• Private credit wins mandates through complexity, multi-jurisdictional support, and flexible capital commitment (e.g., delayed draw term loans) rather than just price.
• Liquidity in private credit is viewed as portfolio-level; while individual loans are illiquid, diversified secondary market transactions (stake sales) are increasingly feasible.
• CLO liability spreads remain tight, with AAA tranches trading near the 100th percentile of historical spread widths, suggesting further tightening pressure.

Distress and Liability Management Exercises (LMEs):

• Default rates hovered between 2.5% and 3% last year, though speakers note this is a "red herring" compared to loss rates.
• Panelists estimate that under traditional 10-year-old covenant structures, default rates would likely have been 10–15% due to interest coverage breaches from rate hikes.
• Current recovery rates for broadly syndicated loans have declined from historical ~$0.70/$1.00 to ~$0.40/$1.00.
• LMEs are increasingly characterized as "coercive exchanges" where sponsors monetize deep discounts in trading bonds to delever balance sheets without cash outlays.
• The "debt tycoon" dynamic, where dominant shareholders leverage loose covenants to extract value from creditors, is expected to persist despite reputational concerns.
• Co-op groups of creditors are forming faster to block aggressive LMEs, though ETFs and large owners with liquidity constraints sometimes remain unable to join these coalitions.

Covenant Erosion and Future Outlook:

• Borrowers are utilizing marketed EBITDA adjustments to flatter credit profiles, creating a widening gap between actual cash-flow-based leverage and reported leverage.
• Investors express concern over "non-pro rata up-tiering," where certain creditors receive preferential treatment, eroding trust in the capital structure.
• Panelists predict a future tightening of covenants and stricter documentation as a reaction to recent aggressive LMEs.
• The industry faces a choice between allowing distress to play out via bankruptcy (with lower recoveries) or facilitating LMEs that may not solve underlying solvency issues.
• Despite the "salty" sentiment toward opportunistic restructuring, successful mutual LMEs have occurred where companies faced imminent maturity walls without liquidity access.

Rapid-Fire Closing:

• In a humorous closing question regarding music rights investments, panelists selected Taylor Swift, Aerosmith, Pearl Jam, and Jimmy Buffett as hypothetical single-artist choices.