By Hedge Fund Solutions Group
Wider credit spreads and potentially higher default rates set the stage for the largest distressed opportunity since 2009.
Distressed investing can take several forms. The classic distressed investor buys debt instruments in companies going through bankruptcy and seeks to optimize their recovery on that debt. However, it’s just as common today to buy debt trading at distressed levels which are driven not by the financial position of the issuer but rather by forced or motivated sellers (e.g., a bank having to sell assets for regulatory reasons). In either case, it appears that we are in the early stages of a new, relatively narrow distressed cycle, which could potentially become broader and more extended, depending on the economic climate. In this article, we provide our outlook for both traditional distressed and more niche credit strategies, and assess the opportunities managers may seek to exploit in the current environment.
Assessing the Trajectory and Breadth of the Cycle
The past year has been difficult for the U.S. high yield credit markets, to say the least. The -6.6% the Barclays High Yield Credit Index returned over the 12 months ended January 2016 is the third worst rolling 12-month return (outside of a recession) the index has seen in over 30 years. (The other two occurred during the midst of the 2002 market crash.) High yield spreads, which are approximately 750 basis points (bps) over U.S. Treasuries, are in the 90th percentile of periods excluding recession over the past 30 years.1 Over $400 billion of high yield bonds now trade below $90,2 and the average price of a bond in the Credit Suisse High Yield Index is $82.96, down from $105 in June 2014. According to the J.P. Morgan High Yield Index, as of February 29, 2016, the implied default rate for 2016 was 8.4%, or 5.7% excluding energy.
Figure 1.1: U.S. High Yield Bond Spreads Have Widened Substantially
Source: Bloomberg, data through March 31, 2016. Barclays U.S. Corporate High Yield Index yield-to-worst minus 10-year Treasury yield.
Whether or not a meaningful uptick in actual corporate bankruptcy filings will materialize, it is undeniable that, from a pricing standpoint, the next distressed cycle has already commenced. At a minimum, current price levels suggest a near- to medium-term opportunity set for stressed/credit investors. Will this collapse in bond prices and increase in spreads be followed up by a spate of defaults, presaging a much longer-tailed, multiyear distressed cycle? The answer to this question is less obvious. Our team’s current expectation is that default rates will increase in 2016, although likely not to the implied levels mentioned above.
What is harder to conclude with certainty is whether we are entering a 2002 or a 2008 type default cycle. While a global recession or an extended tightening of credit could trigger a larger, more widespread default cycle, for now we believe that distressed supply will be sector-specific. More particularly, there are likely to be ample balance sheet restructurings in the energy/commodities sectors, with some select opportunities across other industries in secular decline, most notably traditional brick and mortar retail. Outside of these sectors, barring a major change to the macro backdrop, we believe there will be select distressed opportunities but not necessarily a widespread distressed cycle.
It is important to emphasize again that even if a major distressed cycle does not come to fruition, the recent price moves, which have been fairly indiscriminate, are producing compelling opportunities in stressed names as well as in capital structure arbitrage.
Energy: Focal Point of Current Potential
Pain is certainly being felt and will continue to be felt across the energy sector. Oil has dropped by over 50% from approximately $100 per barrel, while natural gas prices have fallen 70% over the past three years. This is reflective of both current supply/demand imbalances and worries about future global growth. Even if prices were to rise materially from here, many companies would still be just at or below their cost of production, leading many to significantly cut production or liquidate altogether. Credit Suisse has estimated that, at $50 per barrel for crude and $3 per mcfe (thousand cubic feet equivalent) for natural gas, energy defaults could reach 30% by 2017. Market prices certainly reflect these draconian scenarios. Of the $437 billion (bn) in high yield bonds trading below $90, 37% are within the energy sector.3 The average yield-to-worst (YTW) of U.S. high yield energy credits is 17.1%, while the average YTW for independent E&P and oilfield services are 21.4% and 25.3%, respectively.4
Figure 1.2: Energy High Yield Has Come Under Particular Pressure
U.S. Corporate High Yield Energy Bond Performance
Source: Bloomberg, data through March 31, 2016. Bloomberg High Yield Corporate Bond Energy Index.
In our view, energy companies can be ideal candidates for distressed investors seeking to generate alpha. They carry large amounts of hard assets and both the industry itself and individual company capital structures can be highly complex, leading to many inefficiencies and mis-pricings. Additionally, the total potential opportunity set within energy is large. High yield energy credit outstanding at market value is $131bn5 while there are 365 high yield energy issues. This does not even take into account the real potential for “fallen angels,” or investment grade energy credits being downgraded to junk status.
If one includes other commodity-related companies or second derivatives of energy companies (for example, a helicopter company that delivers supplies and labor to offshore rigs), the opportunity set grows even further. As we mention above, downward pressure on prices has been fairly indiscriminate, which has meant that even companies that are less exposed to lower commodity prices or whose business model includes servicing sectors outside of energy have been punished to a similar magnitude as those companies who depend on commodity prices more directly. This gives managers with the ability to understand these businesses a huge advantage as they can buy into securities at very attractive prices, with, in many instances, limited downside and significant upside.
Opportunities Outside of Energy
Elsewhere, the outlook for a larger supply of defaulted debt is more ambiguous. Fundamentals remain relatively supportive. Revenues of high yield issuers are still growing, albeit at a slower pace than in years past, while EBITDA margins have actually improved over the last few years.6 Leverage levels remain around the post-crisis average (~4.1x), and coverage ratios are the highest they have been since 2011 (~4.6x).7 The maturity wall is also fairly supportive. Only $52bn in high yield bonds and $17bn in leveraged loans are due in 2016, although those numbers rise to $98bn and $34bn in 2017 and $139bn and $85bn in 2018.8
On the other hand, several other indicators point to a more precarious position and possibly more forthcoming distressed opportunities. High yield new issuance has fallen precipitously over the last year, from approximately $400bn in each of 2013 and 2014 to approximately $100bn in 2015.9 Typically, a rise in default rates lags a decrease in new issuance by a few years. Deterioration in underwriting standards and fundamentals are also a leading indicator for rising defaults. According to S&P Capital IQ, covenant-lite loans as a fraction of total leveraged loan issuance reached a record high of 80% in the fall of2015. Last year, Standard & Poor’s issued the most downgrades in one year since 2009, while the number of downgrades in August and September 2015 were the most in a two-month stretch since May-June 2009.10 Meanwhile, S&P 500 and Russell 2000 earnings per share have been declining; the magnitude of the declines we have seen of late are usually only experienced during recessions, as last seen in 1990, 2001 and 2007.11
Major credit spread widening typically precedes distressed cycles as well. Regardless of whether the recent market turmoil leads into a full-fledged distressed cycle, credit spread widening and credit downgrades have led to technical pressure as mutual funds that are prohibited from owning defaulted securities and hedge funds coming under redemption pressure are forced to sell. This results in increasingly scarce liquidity, which often sparks an indiscriminate selloff of both good and bad investments. We seem to be in the midst of just such an environment. Keep in mind that trading volumes prior to this were already thinner than we have seen in previous cycles due to regulatory changes and banks limiting their market-making activity. Given the technical and fundamental pressure we have seen in certain sectors, distressed investors are focusing on two primary areas of opportunity: (1) bonds trading at stressed/distressed levels but which they believe are ultimately “money-good” and (2) stressed/distressed companies which they believe will be forced to undergo a restructuring and bankruptcy. A distressed manager’s ability to pick good and bad credits as well as good and bad industries is imperative at this point, particularly given our expectation that market volatility will remain elevated for the foreseeable future.
One sector in particular that we believe presents both long and short opportunities is retail ($38bn in high yield market value12). Traditional brick and mortar retailers have been suffering secular declines in their businesses for several years now as online retail platforms such as Amazon have continued to out-price them and gain market share. Many retailers with secularly declining business models have been sustained due to quantitative easing. As the recent credit spread widening has led to more discernment among credit investors regarding the quality of businesses they finance, we believe the underlying business issues many retailers have been facing will finally materialize in the form of lower prices across their capital structures. There will undoubtedly be some retailers with strong businesses who will survive, but we believe there will be many more who do not, presenting first a compelling short opportunity and then potentially a distressed opportunity on the long side.
Another area in which distressed investors are likely to find opportunities in the current environment is capital structure arbitrage. Just as volatility creates indiscriminate selloffs across asset classes and sectors, putting pressure on both good and bad companies and balance sheets, it can create indiscriminate selling within one company’s capital structure as well. An added benefit of capital structure arbitrage in such an environment is that it provides a natural hedge as an investor will typically go long one part of the capital structure and short another in roughly equal amounts, thereby limiting overall market exposure.
Structured/Niche Credit: Value from Noneconomic Price Declines
While corporate credit tends to be the focus of most stressed/distressed investors, from time to time, structured products can become stressed and offer compelling return opportunities for those funds capable of sourcing and analyzing these often complex instruments. Two such areas look particularly interesting to us today: CLO mezzanine debt and TruPS (trust-preferred security) CDOs. While these areas have their own unique attributes, the general attractiveness of both stems from the fact that the recent material price declines have been spurred largely by noneconomic motivations, most notably regulatory changes affecting banks.
For CLO mezzanine debt, yields have widened across the capital structure over the last year (see Figure 1.3). CLOs are typically structured such that a layer of equity serves as a buffer for the first ~10% of losses. In order for BBB or BB tranches to suffer principal losses, annual default rates would have to spike to 2009 levels and stay there until maturity of the CLO—a highly unlikely scenario in our estimation. Additionally, these debt tranches are floating rate and therefore are insulated from any potential rise in interest rates. While credit spread widening in the underlying loans of these structures explains some of the price drop in these securities, we believe much of the current pricing dynamic is better explained by the fact that ~40% of the holders of CLO mezzanine debt are nonpermanent capital (i.e., hedge funds) and banks that are under regulatory pressure to divest.
Figure 1.3: CLO Spreads Appear Particularly Compelling
|CLO Spreads & Yield to Maturity||Underlying Spreads|
|Ratings||CLO Spreads||Change since Jan. 2015||CLO Est. YTM||Leveraged Loans||High Yield|
Source: Greywolf Capital Management, data as of March 1, 2016. Spreads are relative to Treasuries and measured in basis points.
TruPS CDOs are the other structured credit instruments that we believe also offer an interesting risk/reward proposition over the coming one to two years. TruPS CDOs are tranched securitizations of bank preferred securities. These trust preferreds are hybrid securities that combine features of both equity and debt. They represent a relatively niche market of about $40 billion (notional) and are under-researched given that many of the issuing banks are small and/or do not have publicly traded equities. This disinclines most large institutional investors from participating and thereby creates some pricing inefficiencies. Much like CLO debt, this market has declined in price over the last 9-12 months owing to selling by hedge funds faced with investor redemptions and banks that now receive poor risk capital treatment for these securities under the new regulatory regime. At the same time, the fundamentals of the underlying banks making up these CDOs have improved markedly over the last several years. Net income and revenue are both up, and nonperforming loans are down. The number of banks on the FDIC’s “problem list” declined from 329 to 203 in the last year. Rating agencies upgraded over $25 billion of TruPS in 2015 alone. Further, a year ago there were 112 banks deferring interest on their TruPS and today there are 85.13
Overall, the volatility in global markets over the past year has created many opportunities across the credit markets. Within traditional distressed strategies, we believe there is a fairly large upcoming opportunity set throughout the energy complex, from drillers through ancillary services companies connected to the oil industry. Outside of energy, certain sectors, such as retail, should continue to experience secular declines and a concomitant rise in stressed/distressed situations. The recent volatility has also opened up opportunities to own credits trading at large discounts, which may ultimately be “money-good” or not need to restructure. Given the diversity of the opportunity set as well as the potential for ongoing volatility, we believe it is prudent to continue to concentrate on managers who use little to no leverage, focus on liquidity and downside protection, and have capital stability. Additionally, we believe managers who have a demonstrated ability to invest throughout the capital structure and to short will outperform more levered, long-biased managers focused solely on traditional distressed opportunities.
1Source: Goldman Sachs.
2Source: J.P. Morgan.
3Source: J.P. Morgan.
6Source: J.P. Morgan.
7Source: J.P. Morgan.
8Source: J.P. Morgan.
10Source: The Wall Street Journal.
11Source: Ellington Capital Management.
13Source: Hildene Capital.
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