Opportunity Knocks: Investing in Dislocation

Tight lending standards and rising yields, along with concern about an approaching turn in the business cycle, have put opportunistic credit in the spotlight. But what, exactly, does opportunistic credit mean? Here’s how we look at it—and what we think it may offer investors.

It may be helpful to think of opportunistic credit as an investment in dislocation. Put simply, it’s a strategy that seeks to capitalize on periodic disruptions across public and private credit markets that can cause assets to become mispriced. The nature of these dislocations can vary widely—some can persist while others are fleeting—and managers’ ability to generate returns depends on being able to identify them.

In public markets, dislocations tend to be cyclical in nature and can cause investors to paint an entire asset class with a broad brush. Should rising interest rates spark a sudden widening in high-yield corporate bond spreads, for instance, traditional mutual fund or exchange-traded fund managers may have to exit less liquid positions and reduce overall market exposure in a hurry to limit losses and maintain daily liquidity.

An opportunistic credit investor who can hold semi-liquid and illiquid assets might decide to step in and buy bonds at a discount from those desperate to sell, then wait for prices to rebound. Those who do this well, in our view, can increase their chances of delivering excess return relative to traditional public market credit investments by tapping into illiquidity premia that generally aren’t available to traditional credit investors.

On the private side, dislocations typically take more time to develop and can last longer, potentially creating more enduring return opportunities. For example, large US banks have steadily reduced many types of consumer and commercial lending since the global financial crisis, leaving mid-sized regional banks to fill the gap.

But originating and holding those loans to maturity has become more difficult today for these smaller banks. Many of them are wrestling with a steady decline in deposits, a rising cost of capital (Display), exposure to troubled commercial real estate investments and a thick book of loans originated at yesterday’s low rates.

The Many Challenges Facing Small Banks