'Strategic bankruptcies' may accelerate the default process
By Scott Roberts, Co-Head of High Yield Investments and Senior Portfolio Manager. Posted on Invesco US Blog: Expert Investment Views.
Many market participants focus on default rates as an indicator of underlying health in the high yield market. In recent years, overall default activity has been below longer-term averages. Invesco Fixed Income's High Yield team, however, believes that's going to change in 2016. We see stress in several industries, most notably energy and metals and mining. We believe this stress will lead to a material increase in high yield defaults, likely into the 5% to 6% range. In our opinion, the majority of default activity will center on the aforementioned troubled sectors.
How 'strategic bankruptcies' may change the default picture
One reason we've increased our default expectations is our belief that a number of troubled companies have adopted a new way of think about filing for a formal bankruptcy. We think we are about to see a new trend where company management teams will debate the merits of a so-called "pre-emptive default" or "strategic bankruptcy." What's interesting about this process is that many stressed companies today may have 12 to 18 months of liquidity on hand, yet they may decide to file for Chapter 11 protection much sooner than some market participants had expected.
There are many moving parts and endless "what-if" questions to evaluate, but the process works as follows:
- Management teams internally recognize the severe balance sheet stress they face, the deep trading discount on the debt, and severe equity underperformance.
- If management teams believe they will retain their jobs during and post-restructuring, they are more likely to consider a pre-emptive bankruptcy in an effort to clean up their balance sheet and reset their capital structure.
- As part of the restructuring process, debt gets reduced, which allows the company to exit bankruptcy with a more appropriate capital structure.
- An important part of the process is the allocation of the new equity, most of which will be distributed to the old debt holders. In many cases, the management team will also get a small percentage of equity as an incentive to help grow the company post-restructuring.
Redefining 'winners' and 'losers'
We believe this new trend will allow the interests of different types of investors and management teams to come into alignment. As for who loses in these types of transactions? The current equity holders would likely be wiped out as the pre-restructuring equity gets canceled through the bankruptcy process.
Importantly though, we don't think investors should get overly pessimistic about rising defaults. This may sound counterintuitive, but default indicators are a lagging statistic. We would ask investors to recall what happened in the high yield market during 2008 and 2009. While defaults rapidly increased in 2009, the asset class generated its best-ever total return.
We do see value in many sectors of the high yield market today and think credit spreads are pricing in the potential for a US recession, which we view as unlikely. We note slowing global growth rates and manufacturing data in the US, but the service-oriented industries and US consumers continue to do well. In our opinion, nimble managers will potentially be able to generate attractive total returns in high yield in 2016.
Credit spread is the difference between Treasury securities and non-Treasury securities that are identical in all respects except for quality rating.
High yield bonds involve a greater risk of default or price changes due to changes in the issuer's credit quality. The values of high yield bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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Why high yield defaults may be heading higher by Invesco US Blog