As featured in the CFA Institute: Enterprising Investor, June 28, 2023
Each cycle in distressed debt investing is different. During the global financial crisis (GFC), many otherwise viable companies faced a liquidity crisis. Prior to that, as the tech bubble burst in the early aughts, Global Crossing, Nortel, and Lucent, among other firms, applied too much leverage and, in the face of insufficient demand, had to restructure or in some cases go into liquidation.
In the 14 years of the post-GFC cycle, the US federal funds rate and the Government of Canada rate stayed exceptionally low, hovering around 1%, plus or minus. During this era, every financial transaction, whether a business acquisition or refinancing, created paper at historically low rates. Now, in a higher rate regime, many of these layers of corporate debt cannot be easily refinanced. Clearly, this is bad news for the original owners of that paper. But it could be very good news for investors seeking attractive, non-correlated returns in publicly traded stressed and distressed credit.
Indeed, amid speculation about what central banks will do next, investors cannot ignore how far bond prices have dropped. For stressed companies, the price dislocation has increased, and that creates a growing opportunity set for credit market investors.
Since 2008, central banks have been quick to buy bonds and other securities to shore up the markets during periods of high volatility. One outcome of this quantitative easing (QE) regime is that distressed debt investors must be poised and ready to seize opportunities in whatever sector they arise.
Right now may be an ideal time to lean into a stressed and distressed debt mandate. The quality of companies experiencing credit stress has never been higher, and in some sectors the margins of safety have not been this favorable in decades. According to Howard Marks, CFA, co-founder of Oaktree Capital, we are in a “sea change” environment of nominally higher rates where “buyers are not so eager, and holders are not so complacent.”
Companies experience credit stress for a variety of reasons. It could be the classic case of taking on too much debt. It could be the result of a poor acquisition or ill-advised debt-funded share repurchases. Maybe the managers’ forecasts were overly optimistic and earnings and cash flow disappointed. In such moments, rolling over the debt may no longer be an option, and in a rising rate environment, the debt becomes harder to service. Investors begin calculating the probability of a default or sale, and the price of the bonds goes down.
Utilities and REITs are among the sectors that are often funded by debt issuance. Nevertheless, sector agnosticism is advisable when it comes to stressed and distressed credit. After all, such investments are idiosyncratic by nature, and whatever the industry, buying a good-quality bond for 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 homebuilding industry’s turn. There will always be pockets of stress in different sectors at different times.
Today, traditionally defensive sectors may offer a rich vein of value. Health care and telecommunications, for example, have tended to be resilient in this regard. Why? Because people are much more likely to cancel their Maui vacation than their iPhone, and given the choice between a hip replacement and a Winnebago, they will opt for the former. Hence, the top lines in these sectors tend to remain quite strong. Nevertheless, we are in a recessionary period, and rising labor costs are pinching margins.
The small and middle ends of the issue market are also worth exploring. These may offer a better risk/reward scenario with less competition since the larger distressed credit funds cannot invest in companies of this size. After all, size is the enemy of returns: At some point, the largest funds become the market and can no longer generate alpha. Smaller, more nimble investors are thus better positioned to jump in and capitalize on the opportunities.
All in all, the current environment may be the best that credit investors have seen in at least a generation. Unlike equity investors, they have capital priority, and even in a worst-case-scenario, those holding the higher tiers in the capital structure will realize value — sometimes abundant value.
Nevertheless, credit investors should stay more risk-focused than return-focused and work to identify those investments with the most appealing risk/reward ratios.