With each passing day more and more analysts are hiking their estimates. Goldman Sachs, for example, has recently upped their recession odds to 35% over the next 2 years. The recent negative GDP print is also making investors increasingly nervous.
These rising recession estimates are linked to a growing skepticism of the Fed being able to achieve a smooth landing. 11 of 14 tightening cycles in the US post-WW2 were followed by a recession within 2 years (though only 8 of them can be rightly attributed to the Fed).
This week we take a look at three different weak macro periods, two recessions – the GFC and COVID periods as well as the energy crash of 2015 which hammered the energy and natural resource sectors and caused a slowdown in activity but was not technically a recession.
These three periods are shown below in the chart of the High Yield corporate bond credit spreads.
The key question on the mind of many BDC investors is how will the sector fare over the next recession? And while the real answer is unknowable we can get some sense of a possible answer by looking to the past. Specifically, we plot how the individual BDCs performed over the 2015 Energy Crash (x-axis) and the COVID Shock (y-axis) in the chart below. The green square highlights those companies that delivered a 10% Total NAV return (unannualized) over both periods. Keep in mind that not all BDCs were trading publicly in 2015 so this analysis will leave quite a few out.
For completeness here are the numbers for the GFC period as well. Again, unfortunately, either many BDCs were not trading then and/or the data is not readily available.
A few caveats are in order.
First, the next recession may not at all look like the previous recessions. After all, the last three weak macro periods of the GFC, energy crash and COVID crash were very different. The GFC arose because of the housing crash, lax regulatory standards and clever financial engineering that created seemingly safe assets out of residential mortgages as well as weakness in the bank sector due to large holdings of residential MBS assets on the balance sheet combined with an overreliance on short-term repo financing.
The Energy crash was not technically a recession although GDP in 2015 did drop significantly and moved below 2%. This period was characterized by one of the largest drops in the oil price on the back of shale oversupply followed by a sharp deceleration in oil exporting economies. Global energy and natural resource default rate hit more than 20%.
The COVID crash is well familiar to investors. A self-induced slowdown across global economies was matched with a large fiscal stimulus in developed economies. And even though unemployment spiked briefly household incomes held up well and there were relatively few corporate defaults.
The next recession could look very different from these and may impact BDCs more heavily.
Second, as investors are well aware, past performance is not indicative of future results so BDCs that held in well in the past may not do so in the future. That said, BDCs do tend to feature a fairly high serial correlation. In short, strong performers tend to remain strong and weak tend to remain weak. This is not surprising and has to do with the quality of the underwriting, borrower support and workout processes. These characteristics are “sticky” and replicable over time than the typical public market trading “alpha” of a given management house in our view. If this is correct, we would expect BDCs with a stronger through-the-cycle profile will remain more resilient over the next recession as well.
Thanks for reading.
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