Each cycle of distressed debt investing is different. During the Global Financial Crisis (GFC), many viable companies faced liquidity crises. Prior to that, when the tech bubble burst in the early ’80s, companies like Global Crossing, Nortel, and Lucent applied excessive leverage and faced inadequate demand, forcing them to restructure and even go into liquidation. I needed it.
For 14 years after the global financial crisis, US federal funds and Canadian government rates remained unusually low, hovering around 1% plus or minus. In this era, every financial transaction, be it a corporate acquisition or refinancing, produced paper at historically low interest rates. Currently, much of the corporate debt at these tiers is not easily refinanced in a higher interest rate regime. Clearly, this is bad news for the original owner of the newspaper. But for investors looking for attractive, uncorrelated returns in listed stressed-distressed credit, it could be very good news.
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In fact, amid speculation about what the central bank will do next, investors cannot ignore how far bond prices have fallen. For companies under stress, price volatility is increasing, creating additional opportunities for credit market investors.
Since 2008, central banks have been quick buyers of bonds and other securities to strengthen markets during periods of high volatility. One of the outcomes of this quantitative easing (QE) regime is that distressed bond investors should be prepared to seize opportunities in whatever sector they arise.
Now may be the ideal time to lean into a debt obligation full of stress and anguish. The quality of companies facing credit stress has never been higher, and in some sectors safety margins have not been as good in recent decades. According to Howard Marks, CFA co-founder of Oaktree Capital, we are in a “catastrophic” environment with nominally rising interest rates, “Buyers are less enthusiastic and holders are less happy.”
Businesses experience credit stress for a variety of reasons. It may be a classic case of having too much debt. It could be the result of improper acquisitions or reckless debt-funded share buybacks. Perhaps management’s forecasts were too optimistic, and earnings and cash flow were disappointing. In moments like these, carrying forward debt may no longer be an option, making debt service even more difficult in a rising interest rate environment. Investors start calculating the probability of default or sale, and the price of the bond goes down.
Utilities and REITs are among the sectors often financed by bond issuances. Nonetheless, when it comes to stressed credit issues and bad credit, we recommend that you stay sector agnostic. After all, such investments are inherently idiosyncratic, and whatever your industry, buying good quality bonds at 50 cents on the dollar is always a good idea. Not so long ago, in 2015 and 2016, the energy sector experienced droughts, and in 2018, the homebuilding industry experienced a drought. There will always be points of stress in different areas at different times.
Today, traditionally defensive sectors can offer a wealth of value. For example, healthcare and telecommunications tend to be resilient in this regard. why? Because people are far more likely to cancel a Maui trip than an iPhone, and if given a choice between a hip replacement and a Winnebago, they’d choose the former. So the top lines in these sectors still tend to be very strong. Nonetheless, we are currently in a recession and rising labor costs are squeezing profit margins.
Small and medium-sized markets in the issuing market are also worth exploring. These may offer less competition and better risk/reward scenarios as larger distressed credit funds cannot invest in companies of this size. After all, size is the enemy of returns. At some point the biggest money becomes the market and can no longer generate alpha. Smaller, more agile investors are therefore well-positioned to jump on and capitalize on this opportunity.
Overall, the current environment may be the best environment for credit investors in at least a generation. Unlike equity investors, they prioritize capital, and even in the worst-case scenario, investors who hold the upper tiers of their capital structure will realize value, sometimes abundant value.
Nevertheless, credit investors should remain risk-focused rather than return-focused and seek to identify investments with the most attractive risk/reward ratios.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of the CFA Institute or the author’s employer.
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