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Finding opportunities in stressed and distressed credit throughout the cycle
With debt default rates at exceptionally low levels on both sides of the Atlantic, investors might be forgiven for thinking that the market for distressed credit would be very subdued.
Written by
Galia Velimukhametova
Senior Investment Manager
But there are strategies that can find and take advantage of opportunities even in these environments, while also being well placed for when markets again come under stress.
This requires tactical agility, an active approach and an ability to make investments – both long and short - in all parts of the corporate capital structure. Default rates on high yield credit have collapsed to around 2 per cent in the US and 1 per cent in Europe, near their lows of the past decade, notwithstanding a small spike that occurred in the wake of the pandemic.
Default rates on high yield credit have collapsed to around 2% in the US and 1% in Europe, near their lows of the past decade.
Even so, below the surface, the undercurrents are turbulent. The number of zombie companies – those that can’t cover their annual debt servicing costs from earnings – is still high. At the same time, the proportion of debt that is issued with little or no covenant protection to lenders represents around 90 per cent of the European market. Net debt to earnings has been climbing for B- and CCC-rated companies, which is particularly worrying given that the earnings themselves are heavily adjusted.
This fragility is evident within the high yield market. Default rates might be low, but there’s a growing number of companies suffering financial stress – which is to say yield spreads on their bonds are above the 300 basis points, which is approximately the long-term average for the European index, but below what’s considered distressed at 1000 basis points. At the same time, the proportion of zombie companies compared to those able to service their debts from earnings has been growing across all regions.
There is already great dispersion among industry sectors with corporate default rate forecasts ranging widely between utilities, where defaults are all but unknown, at one end and hotels and media companies at the other.
This creates fertile ground for investors like us who can take short as well as long positions. For instance, we can sell stressed companies short in anticipation that they will become distressed or default. At that point we can buy them back on their restructuring prospects. And because we participate across the company’s capital structure, we can arbitrage between equity and debt as well as different tranches of its borrowing.
At this point in the credit cycle we are turning increasingly cautious. Market volatility is rising. Central banks are poised to drain some of the vast lakes of liquidity they’ve created since the pandemic. Fiscal transfers to households and companies are being wound down. Inflationary pressures are building, in part on the back of supply chain disruptions and rocketing commodity prices. And governments are taking aim at corporates – not just in China with its regulatory clampdowns on certain sectors like real estate, but elsewhere too. Meanwhile, Covid accelerated structural changes in the economy, speeding adoption of e-commerce, forcing technological efficiencies and prompting deglobalisation.
We expect these factors will make this a deeper distressed cycle than in the past. But we are also cautious about the decline in recovery rates1 during recent years – distressed companies will have to be evaluated with even more care in future. At the same time, it’s critical to seek out liquid assets – the pandemic made clear how damaging it can be to hold illiquid investment positions.
Deep fundamental credit work, careful risk and liquidity management, and active management across the capital structure with an ability to go both long and short allow us to find opportunities in the market for stressed and distressed debt throughout the cycle – both now when conditions appear quiet and as they turn less benign over the coming quarters.
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