Citi-IESE Credit and Debt Markets Project

The amount of speculative-grade debt has risen sharply in recent years in both the U.S. and Europe due to a decade-long environment of low interest rates and elevated risk-taking. As a result, a combination of economic slowdown and higher interest rates poses significant challenges to the issuers of these debts in particular and the financial system in general given their comparatively higher probability of default or distress.

In prior business cycles, weak companies were largely forced to restructure as a result of actual or impending breaches in debt covenants. In the case of the latest debt market boom, unprecedented levels of financial leverage were coupled with looser creditor governance, as evidenced by the high prevalence of “covenant-lite” leveraged loans, which leave investors virtually powerless to react.

Understanding the workings and imperfections in the speculative grade financing market is thus of great importance, which will require deep expertise in leveraged loans, high-yield bonds, mezzanine financing, and direct lending.

Research topics include:

• Size and growth of the speculative-grade market and its submarkets, with emphasis on the roles played by SMEs in Corporate Europe
• Historic risk-return patterns of speculative-grade debt
• Cross-correlation with other asset classes
• Impact on issuers when moving from investment to noninvestment grade (“fallen angels”), with a particular focus on market inefficiencies and the role of rating agencies
• Corporate governance in distressed firms
• Investment strategies and characteristics
• Growing use of weaker standards such as “covenant-lite” loans and its implication to the resilience of speculative-grade market
• Implication of sudden “freezes” in HY issuance in 2022 to European corporates, especially SMEs
• Analysis of the liquidity mismatch in European speculative-grade market
• Analysis of maturity profile of European speculative-grade market and factors behind it
• Analysis of key players in the speculative-grade market with a focus on the growing role played by passive investors and the dominance of institutional investors (or lack of retail investors)
• Transparency of transactions (i.e., availability of trading data) and its implications to speculative-grade market

Bankruptcies fell sharply in OECD economies during the pandemic because of the array of COVID related support available to businesses, as well as imposed moratoria on bankruptcy filings. But these measures expired and financial conditions have tightened substantially since then. Therefore, the current economic downfall will likely bring an upturn in bankruptcies. Companies suffering losses will struggle to survive and many will fail. A well-functioning insolvency system is thus vital.

It supports vigorous economic recovery and limits creditor losses in insolvent companies, which is critical to promoting creditor recovery. It helps viable companies survive and continue to operate, safeguarding capital and jobs that would otherwise be lost. All this helps support healthy credit markets. Conversely, an ineffective framework can lead viable companies to collapse, with concomitant loss of capital and jobs. At the same time, insolvency systems should be designed to “flatten the curve” of the volume of firms subject to insolvency in a moment of time, because the accumulation amplifies the magnitude of losses.

European insolvency systems vary widely across member states and are considered less efficient than the U.S. Chapter 11 system. The divergences include, among others, the criteria to open an insolvency proceeding, ranking of creditors, valuation procedures and the role and level of participation of creditors in an insolvency proceeding. Improving and harmonizing the European restructuring and insolvency framework could help to achieve corporate revitalization and deeper credit markets, as well as encourage job creation, productivity growth, and faster recoveries.

From an investing perspective, given the lack of uniform and consistent procedures across Europe, understanding the different restructuring and insolvency frameworks and how to achieve the best outcome in any jurisdiction is critical to making sound investment decisions. Insolvency law affects the time to resolution and the time to recovery, and as a result, the value of distressed assets. Therefore, differences in country-specific insolvency laws impacts the losses associated to distressed assets.

From both policy and investment perspectives, understanding the legal framework and its implications, as well as the practical reality of restructuring in different jurisdictions, is paramount.

Research topics include:

• Effects of borrower rights, law enforcement, and legal procedures on the management of distressed assets and their market value
• Effects of different insolvency regimes on bank behavior and lending, as well as firms’ access to credit and their borrowing costs
• Relation between insolvency regimes and entrepreneurship
• Link between bankruptcy law and the resolution of non-performing loans
• Effects of borrower rights, law enforcement, and legal procedures on the probability of default (PD) and loss given default (LGD)
• Link between the legal framework and credit risk
• Lack of a common insolvency regime and its implication to credit supply to European SMEs

A genuine sustainable transition in capitalism will not be the result of cosmetic changes or repurposing of existing initiatives but will require more profound changes in corporate strategies, business models, financial approaches, investment practices, accounting rules, public policies, and consumer behavior.

Since 2008, a shift is underway from active toward passive investment funds, a growing industry dominated by a few big players that hold a significant proportion of stock in the world’s largest publicly traded companies. The ramifications of this combination of concentrated ownership and passive investment strategies is still not well understood. Important issues include the impact on corporate governance, capital allocation, the sustainability and stability of financial markets as well as the impact of climate change on credit risk.

Corporate governance. On the one hand, passive investors have little incentive to concern themselves with firm-level governance performance since their primary aim is to replicate a particular index. On the other hand, the concentration of corporate ownership may entail a re-concentration of corporate control.

Capital allocation. The increasing popularity of passive investing and exchange-traded funds has reduced liquidity and pricing in less liquid investments such as distressed assets, increasing their attractiveness.

ESG and credit markets. Large funds have taken a leading role in advancing corporate sustainability. Practical challenges include the implementation of a unified system to measure ESG drivers and incentive structures that boost ESG performance.

Climate change and credit risk. The impact of environmental risk on the cost of bank loans has received comparably little attention relative to financing through equity and bonds.

Specifically, how the banks’ loan pricing and their lending volumes to firms depends on the firms’ environmental performance as well as on the preferences of the banks’ stakeholders. Additionally, modelling the effect of climate change and natural disasters on credit risk is challenging (climate risk could affect firms by inducing physical disasters or by imposing the need to adapt to technological change). However, this quantification is critical to transmit environmental efforts across the entire economy through the banking process.

Research topics include:

• Drivers behind the heavy concentration in the funds sector
• Implications for industry competition and productivity
• Consequences of the role of large investors in debt monitoring
• Implications for correlation of returns and security-specific price information
• Aggregate investment fund flows and market price dynamics over the business cycle
• Effects on the sustainability of financial markets
• Effect of green (ESG) bonds on their issuers
• Impact of environmental risk on the cost of bank loans
• Impact of natural disasters on credit risk parameters