Every distressed debt investment cycle is different. During the Global Financial Crisis (GFC), many otherwise viable businesses faced a liquidity crunch. Previously, as the tech bubble burst in the early 2000s, Global Crossing, Nortel and Lucent, among others, applied too much leverage and, faced with insufficient demand, had to restructure or, in some cases, go into liquidation.
Over the 14-year post-GFC cycle, the US federal funds rate and the Government of Canada rate have remained exceptionally low, hovering around 1% or so. At that time, every financial transaction, whether it was a business acquisition or a refinancing, created paper at historically low rates. Today, in a higher rate regime, many of these layers of corporate debt cannot be easily refinanced. Obviously, this is bad news for the original owners of this newspaper. But it could be very good news for investors looking for attractive, uncorrelated returns in publicly traded distressed and distressed credit.
Indeed, amid speculation about what central banks will do next, investors cannot ignore how far bond prices have fallen. For struggling companies, price dislocation has increased, creating a growing opportunity for credit market investors.
Since 2008, central banks have been quick to buy bonds and other securities to support markets during periods of high volatility. One of the results of this quantitative easing (QE) regime is that distressed debt investors need to be ready and ready to seize opportunities in whatever sector they present themselves.
Now may be the perfect time to look into a stressed and struggling debt mandate. The quality of companies facing credit stress has never been higher and, in some sectors, the margins of safety have not been so favorable for decades. According to Howard Marks, CFA, co-founder of Oaktree Capital, we are in a “radical change” environment of nominally higher rates where “Buyers are not so impatient and holders are not so complacent.”
Businesses experience credit stress for a variety of reasons. This could be the classic case of excessive indebtedness. This could be the result of poor acquisition or ill-advised debt-financed share buybacks. Perhaps the managers’ forecasts were too optimistic and earnings and cash flow were disappointed. At such times, rolling over debt may no longer be an option, and in a rising rate environment, debt becomes harder to repay. Investors begin to calculate the probability of a default or a sale, and bond prices fall.
Utilities and REITs are among the sectors that are often financed through the issuance of debt securities. Nonetheless, sector agnosticism is advised when dealing with stressed and distressed credit. After all, such investments are idiosyncratic in nature, and regardless of the sector, buying a good quality bond at 50 cents on the dollar is always a good idea. Not so long ago, in 2015 and 2016, the energy sector experienced a drought, and in 2018 it was the turn of the residential construction industry. There will always be pockets of stress in different sectors at different times.
Today, traditionally defensive sectors can offer a rich vein of value. Health care and telecommunications, for example, have tended to resist in this regard. For what? Because people are far more likely to cancel their Maui vacation than their iPhone, and given the choice between a hip replacement and a Winnebago, they’ll opt for the former. Therefore, the best lines in these sectors tend to remain quite strong. However, we are in a recession and rising labor costs are squeezing margins.
The small and medium ends of the emissions market are also worth exploring. These may offer a better risk/return scenario with less competition since the largest distressed credit funds cannot invest in companies of this size. After all, size is the enemy of returns: at some point, the most important funds become the market and can no longer generate alpha. Smaller and more nimble investors are thus better placed to get started and capitalize on opportunities.
Overall, the current environment may be the best credit investors have seen in at least a generation. Unlike equity investors, they have priority in capital, and even in the worst case, those who hold the upper levels of the capital structure will realize value, sometimes abundant value.
Nevertheless, credit investors should remain more risk-oriented than return-oriented and strive to identify investments with the most attractive risk-reward ratios.
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All posts are the opinion of the author(s). As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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