We have entered a more volatile macroeconomic environment and, in turn, a more challenging investment landscape. However, in our view, market dislocation also gives rise to significant opportunities to generate attractive, and often outsized returns.

Many investors are now considering how they can adjust their credit allocation both to protect portfolios against a likely recession while still generating attractive and steady yields in a rising-rate environment.

During the initial wave of COVID-19 and more recently following Russia's invasion of Ukraine, European liquid debt markets, consisting of leveraged loans and high-yield bonds, faced increased challenges of wider spreads and volatility in secondary trading, with primary issuance effectively grinding to a halt.

While much public discourse focuses on the primary market, many investors are now arguing that dislocation in the secondary market presents an attractive buying opportunity, which could result in yields in excess of longer-term trends. For instance, between December 2021 and April 2022, yields in the European leveraged loan market rose to 4.4% from 3.4% (S&P LCD European Leveraged Loan Market index), while European high-yield bond yields increased to 5.4% from 3.1% (Bloomberg Pan-European High-Yield Total Return index).

These yields are reflective of high-quality credits being sold at significant discounts, mostly due to negative market sentiment, even though most of the issuers are still likely to meet their obligations. Additionally, the floating rate nature of most leveraged loans is viewed by many as attractive in a rising-rate environment.

Even in the fixed-rate market, buying opportunities exist for attractive credits where a refinancing or sale is expected in the short- to medium-term.

At the same time, with significant sell-offs in equity markets, investors are attempting to rebalance portfolios that have been over reliant on equities during the bull run of the past decade and are now reconsidering the role of credit strategies within their portfolios. In particular, pension funds will be assessing how they meet their long-term obligations to their members.

However, allocators to credit need to be cautious, as analysis of past periods of excess yields in the liquid market demonstrates that these are often in lockstep with elevated default rates and loss ratios. For example, during 2008-2009, when realized yields in the European leveraged loan market rose to circa 15% to 20%, the default rate peaked at 11%. Similarly, yields of circa 12% in 2012 were accompanied by a 7% default rate, according to the S&P LCD European Leveraged Loan Market index.

Excess yield is often representative of a reaction to a negative economic forecast, as opposed to structural upward repricing of the liquid markets. Taking advantage of this is contingent on the ability to accurately time the market and trade in and out of positions, which is notoriously difficult over long periods.

Average cumulative annual returns for these asset classes demonstrate this — for leveraged loans it is 4.5% (S&P LCD European Leveraged Loan Market index), while it is 6.4% for the high-yield bond market (Bloomberg Pan-European High-Yield Total Return index).

When comparing return expectations, investors with longer-term liabilities should focus on longer-term trends. The typical gross return profile of an equivalent strategy, such as direct lending, is between 6% to 8%, for example, a significant premium to even the current elevated public market yields. While private returns are hard to verify, a recent survey from Private Debt Investor found nearly 90% of private debt LPs expected returns to meet or exceed these benchmarks.

As well as comparing favorably on returns, we believe that direct lending also benefits from a more attractive risk-return profile.

Direct lenders typically conduct more detailed due diligence, negotiate terms bilaterally and examine specific parts of a borrower's business, rather than simply relying on publicly available materials. In our view, combined, this results in strong investor protections.

In contrast, the European leveraged loan market has become an overwhelmingly covenant-lite, or cov-lite, market — in 2021, 96% of leverage loan issuance was cov-lite (S&P LCD European Leveraged Loan Market index), compared to just 5% of loans originated in the private debt market, according to Proskauer's 2021 private credit market survey.

Covenants, which provide the lender with an ability to step in and renegotiate terms, force changes at a company and, if necessary, take enforcement action, are crucial in maximizing the share of the principal recovered in the event of a default (the recovery rate). This is illustrated by the cumulative recovery rate for covenanted loans in the U.S. between 2014 and 2020, which represented an 11% premium to cov-lite deals, as outlined in S&P's October 2020 paper "Settling for less: Covenant-lite loans have lower recoveries, higher event and pricing risks."

Like leveraged loans, direct lenders in the private debt market typically originate floating rate instruments with the additional benefit that a lender may engage directly with a challenged borrower to develop a bespoke solution. Again, this is an important feature in a rising-rate environment. In addition, the locked-up fund structure of the asset class promotes a long-term view, provides the ability to ride out volatility and reduces trading volatility risk.

Investors should seek credit strategies that primarily deliver stable returns over the long term, particularly during challenging periods with minimal trading risk.

While many will certainly benefit from trading in the current market, particularly when the sell-off bottoms out, many more will lose money. While perhaps somewhat of a cliche, the adage of "time in the market" vs. "timing the market" is likely to hold true.

Anthony Fobel is CEO of Arcmont Asset Management, a European private credit asset management firm headquartered in London. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.

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