Hello, and welcome to Unlocking Markets, the RBC podcast. This is the place where we will be looking to bring you experts across the firm providing opinions on markets, global policy, sustainability, and macroeconomics, and how these feed into your investment decisions. I'm David Horsburgh, BlueBay Head of Client Solutions, and today I'm going to be talking to Adam Phillips, Managing Director and BlueBay Head of Developed Markets Special Situations at RBC GAM. Today, we will delve into the unusual challenges corporates and consumers are facing the direction of defaults and where the opportunities may lie across multiple sectors and countries for special situations. Welcome, Adam. And thanks for joining us, would be great to start off with hearing a bit about your background and why you joined BlueBay.

David, thanks for having me. Yeah, my background is pretty simple, really, it's just over three decades of special situations or distressed experience. I've been at BlueBay for three years, running the developed markets special situations team. Prior to that, I was CIO of Marathon Asset Management. And I also ran Lehman's European high yield and distressed business in the early 2000s.

Great, I think that will provide some good insight into the history of the market and definitely some interesting observations around what's happening today. We have a lot to get through today. So, should we just dive in? You know, given the length of that track record, am I right in thinking if defaults meaningfully pick up this time around this for your fourth major fault cycle?

Actually, to be honest, I think it's arguably my sixth if you take into account 1998 in Asia, 2000, 2001, 2008, the Covid period, and now it's probably six, of course, there was some mini-cycles in between those dates as well. Yet, the market set, the opportunity set is very rich at the moment. I mean, the reality is there are a lot of companies out there that took advantage of very easy money, at very low rates and, frankly, borrow too much money. And those companies probably went into Covid more levered than had historically been the case and certainly came out the back end of Covid having borrowed yet more money, so came out the back end with too much leverage and/or unsustainable balance sheets.

Well I guess, never a dull moment in markets. But you know, given what you're seeing or what you've just referenced in terms of increased lending? Are you seeing a meaningful uptick in terms of the opportunity set as the weeks and months go on? And probably just drawing on, you know, some of that past experience? What does that experience bring to the table here? And how might this time be different to some of these previous cycles?

Yes. So I spend a lot of my life really talking about a perfect storm of issues that corporates have experienced. As I said a minute ago, lots of corporates went into Covid, with more leverage than perhaps historically had been the case and had to borrow more money to get through Covid. And then were confronted with a whole subset of other issues, supply disruptions, commodity inflation, then feeding through to other forms of inflation, including wage inflation, higher interest rates, war on the edge of Europe, etc. So a whole catalogue of issues. Defaults are undoubtedly creeping higher, but from a very low base, we frankly expect defaults to increase substantially over the next two years. But although we don't necessarily think that defaults are going to end up at anywhere near 10% or 12% per annum as they did during the GFC. But it is worth noting that the high yield bond market and the leveraged loan market, which are our core markets, are twice the size that they were during the back end of the GFC. So, in fact, in terms of volumes of defaults, we might end up in a similar place.

I think it's a very peculiar market at the moment, you talk about these sorts of stresses hitting and, at the same time, defaults picking up at a relatively slow pace, but likely to do so, maybe increase in terms of pace going forward. What is the disconnect here? Right now, we see spreads at very tight levels on the back of the shocks, and defaults may be creeping up in the future, but actually, the market as a whole hasn't really seemed to react to that. Where do you think this disconnect is?

I would say that the high yield market, in historic terms, is trading relatively tight for this point of the cycle. I think if you talk to our high yield colleagues, they will say that that's partly a consequence of the fact that the high yield market is much higher quality, there is a much higher constituent of double B's than the was the end of the GFC. So, there is, in their minds, there's probably a reason why spreads are tighter than they have been at this point of the cycle in previous cycles. But that doesn't detract from the fact that, as I said a minute ago, it's a very big market, if you take into account the US and the European high yield leveraged loan market, you're talking about three and a half trillion dollars of debt. So, within that, there is clearly a lot of dispersion. And frankly, a lot of triple C's in there. So, notwithstanding the fact that the overall market is potentially trading relatively tight, there is a lot of dispersion, there are a lot of names in the 40s, 50s, 60s and 70s where we can get involved.

There has been some talk in the market about companies delaying refinancing in the face of higher rates and macro uncertainty. People talk about a maturity wall in 2024 and 25. In your opinion, will this be the real stress test for markets?

Yes, I think that's one of the stresses that's coming down the pipe. For instance, we are doing a lot of work on European real estate, and certainly, the impending maturity wall is a real issue for lots of large and small real estate companies across Europe. Currently, the real estate market is locked up. And really the outcome focusing just on that specific market is, can those companies sell assets because, as I said, the market is currently locked up, what are valuations going to look like over the next couple of years, are the bank's going to step in and help these companies to refinance their balance sheets? So that's just one example really, of where the maturity wall is, is very relevant. And I think time will tell, obviously, as to whether that maturity wall unlocks itself as it has done in the past.

Just moving on to a bit about where you're focused at the moment. I know that you and the team are focused on deals in the mid-market. Are you able to just explain a bit about what that is? And why in your view, this is a sweet spot, especially given the environment you've just described?

Yeah, absolutely. I think the first thing to say is that we go to where the stress is. And the reality is, we believe the most stressed part of the market is the mid-market. Companies are naturally less diversified by product and geography. They also have less access to the credit markets than they are obviously their bigger counterparts who over the past three years have tapped the credit markets for additional liquidity. Mid-market companies are much more reliant on the banks, and we know that the banks are tightening, lending standards and shying away from risk. So overall, we think there is just a lot more opportunity in the mid-market. The other point to mention is that most of the market participants, as in special situations and distressed market participants, hedge funds and asset managers have, frankly become huge over the past 10 years. And frankly, don't want to write less than $100 million tickets per deal, which leaves the market open for us in the mid-market sphere where we can write $20 to $30 million or euro tickets and not encounter any competition.

Just thinking about the types of deals that are coming across your desk at the moment. In your view, are they sharing any commonality across countries or sectors?

Yes, I think some are, so I think it's fair to say, as I mentioned a minute ago, that there are sectors like real estate that are very stressed and distressed in some instances. There are other stressed sectors, obviously, sectors that use a lot of energy, generally chemicals companies, paper and packaging, auto parts companies that use a lot of energy that for obvious reasons have suffered and are continuing to suffer. But generally, I think it's fair to say that the opportunity set is pretty broad based. We are seeing opportunities, as I said, in base industries, oil and gas, manufacturing, food, shipping, telecom, cinemas, retail, f&b (food and beverage), I mean, the list goes on, really. I would say that's a key differentiator, in this cycle from previous cycles, which tend to have focused sectors. I look back to 2000 - 2001, where there was a lot of telecom and cable, and obviously the dotcom blow up as well. Whereas this time round, I have to say, this feels more broad based.

I know you've talked in the past about changing demand trends, creating challenges for businesses, and Covid being a big catalyst for this. I guess the question is, do you like businesses that are in need of a pivot or a change in strategy.

I actually wouldn't necessarily say that. In fact, I would probably argue that if a company needs to change its strategy or do a full-blown operational restructuring, those are probably the harder investments. I think what we used to say was, ideally, special situations or distressed investments, the easiest investments were good business, bad balance sheet. And actually, I would say generally, there are fewer of those this time around. Most situations that we get involved in these days, not only need a financial restructuring, but they also need us to roll our sleeves up and get involved in an operational restructuring. So I think the answer to the question is no, we don't gravitate really, to companies that need to pivot or change their strategy. In fact, almost the opposite. You know, we ideally want to find a business that actually is a good business that is doing pretty well in the underlying business, it's just got the wrong cap structure.

In terms of the opportunities in the market and where you're spending a lot of time, do you find yourself, spending a lot of time on liquid or illiquid opportunities? I'd imagine the latter taking a lot more sort of effort and a lot more sort of focus from the team.

Well, frankly it's a bit of both. You know, clearly, there is as I hopefully have explained, there is a lot going on in the high yield bond market, leveraged loan market. And as a consequence, you know, those are generally more liquid investments. And, of course, liquidity is one of the key parameters we'll keep one of the key investment parameters for us. You know, if we're going to get involved in more illiquid situations, clearly, we want to be compensated for that. And, you know, when we can make 15 to 20% type returns in liquid investments. You know, as a rule of thumb, we're probably looking to make 25 to 30% type IRR for more illiquidity. So, clearly, we want to be compensated for that illiquidity,

In terms of the time needed to realise an investment thesis on some of those liquid names. Has that timeline increased at all at the moment? Or is it relatively in line with historic norms?

Yeah, I would say it's relatively in line with historic norms, I would say, on our existing, more liquid portfolio. Really, I suppose our time horizon is anything from three months to two years. Whereas, on more illiquid investments, you know, it might take two to five years to realise an investment. But I wouldn't say that that has generally changed dramatically in this cycle.

So just thinking about the market today versus some of the markets that you've lived through over the last couple of years. How is the market today different to say, the GFC or the dotcom bust? In your opinion?

Well, the first thing to say is that the market generally is bigger. And notwithstanding the fact the fact the fact is there are more participants, and of course, the advent of private debt has had an effect. So, you do get the private debt funds refinancing generally leveraged companies, whereas obviously, that was less prevalent 10 or 20 years ago? I'm not inclined to comment that much on private debt because actually, I genuinely think they are a bit of a black box in the sense that I would probably argue that intuitively, they've probably done a better job of underwriting their credits than potentially perhaps the banks have done, but without knowing individual portraits. It is difficult to know what's going to come out of the private debt market in terms of opportunity for special situations investors. But I'll get back to that point, you know, there are more participants and in a sense of the market is more dynamic. The other point to make, of course, is the point I made earlier is that a lot of the funds that are involved in special situations are much bigger than they were 15 years ago. And in a sense, that is an opportunity for us, as I explained earlier, because, you know, we're concentrated focused on smaller situations where there is less competition.

It sounds like there's a large amount to do in markets then at the moment. Thank you, Adam. We'll be back next month with another episode of Unlocking Markets. Good luck and goodbye, thank you very much.