Credit Investors May Lose Four Years of Income in Next Downturn

Investors will probably see cumulative losses as steep as 19 percent in the next downturn in leveraged credit, with mark-to-market drawdowns that may run three times as large, according to Bank of America Corp. strategists.

Expected losses of 14 percent to 19 percent translate into 3.5 years to four years of lost income, credit strategists Oleg Melentyev and Eric Yu said in a BofA Global Research report Friday. “Understanding the pressure points is going to be key to navigating the cycle,” which has pressed beyond its typical span of eight years to a decade.

With the credit cycle now in its eleventh year, the strategists looked across high-yield bonds, loans, and private credit for looming losses in U.S. leveraged finance. While cumulative losses are permanent, damage from much larger drawdowns may be reversed, the strategists said.

For example, high-yield debt saw an average loss of 14.7 percent in the last two credit cycles, with average excess return drawdowns of 37.3 percent before investors’ appetite for riskier assets came back, according to the report. 

In the next credit cycle, investors should brace for drawdowns of 48 percent for loans, 37 percent for high-yield bonds, and 16.5 percent for investment-grade debt, the strategists said.

Within private debt, they estimated leverage levels are now at 5.8 times earnings before interest, taxes, depreciation and amortization — similar to leveraged loans. But the downturn will be harsher in private credit because the borrowers in that part of the market are smaller and less diversified, according to the report.

The strategists expect EBITDA will drop 30 percent in private credit, compared with a 25 percent decline for borrowers with high-yield bonds and leveraged loans. That may translate into higher defaults, they warned.

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A simple move into higher-quality credits may not be enough to mitigate risks in a downturn.

“Taking extremely tight higher-quality valuations into account, it actually makes more sense to have above-benchmark exposure to lower quality segments, while managing overall risk lower with a cash position,” the strategists said. “Loans are a particular standout in terms of their poor risk-return profile.”

The strategists expect an average recovery rate of 50 percent for loans during the next credit cycle, “a low level by historical standards” that they said reflects the prevalence of companies with debt financing consisting entirely of loans, loose debt covenants, and aggressive add-backs to EBITDA.