In credit cycle downturns, two critical considerations for returns are the shape of the default curve (magnitude and duration) and the intensity of losses suffered.
We believe market participants are too focused on potential changes in / outlook for interest rates and are not focused enough on the effects the probable shape of the corporate default curve will have on credit portfolios.
We believe the market is underwriting credit losses in the next downturn similarly to the last downturn, i.e., a sharp but short duration increase in defaults with above average recovery rates.
In our view, the next downturn will include several industry-wide downgrades and credit concerns like 2000-2004. After an extended economic recovery with loose financing for corporates, coupled with secular changes to several business models, we would expect credit issues to emerge as growth slows and financing conditions tighten.
Therefore, we expect lower peak default rates for several years, with lower than average recovery rates as structurally challenged companies with high debt loads face restructuring.
In credit we find most attractive opportunities in sectors and structures with strong underlying credit characteristics and improving collateral values, with subordination to mitigate downside risks.