The COVID-19 pandemic and resulting global shutdown of major parts of the economy, many of which remain closed, have created considerable distress in credit markets. By late March, the amount of US distressed debt had quadrupled to nearly $1 trillion, reaching the highest level since the 2008 financial crisis. Governments acted swiftly with an unparalleled level of fiscal and monetary stimulus to blunt the impact of the shutdowns and to support struggling consumers and businesses. This stimulus, particularly from the US Federal Reserve and its relentless efforts to support credit markets, has mitigated the potential depth of the credit distress. However, despite these efforts, large parts of the markets remain distressed and we believe they are facing a much longer recovery and possibly a permanent disruption in their long-term growth. Some of the heaviest hit sectors, including Energy, Retail and Transportation, have seen much needed improvement since the trough of the crisis in late March and early April but they continue to struggle with dampened growth prospects, high fixed costs and considerable debt loads. We believe that many of the indicators we follow continue to signal that distressed credit markets are trading at an attractive entry point. With equity markets having rebounded sharply during the crisis and investment grade credit providing meagre returns in a near zero-rate environment, investing in distressed credit could be an excellent opportunity.
The complexities of investing in distressed debt
Unlike equity or even corporate bond markets, identifying, analyzing and executing on distressed credit opportunities requires a unique set of resources. When a company is undergoing a bankruptcy process, the flow of information tends to dry up and trying to talk with management becomes considerably challenging. It can be vital to have a subscription to a news flow service that is specific to court and legal actions on North American bankruptcies. In addition, having access to a pool of credit analysts covering various sectors of the credit market, including specialists in distressed credits, can also help with the analysis of an investment opportunity. Even after identifying an attractive distressed debt investment, acquiring the security can be challenging as a particular issue with the right seniority or other coverage criteria may be small and tightly held. Leveraging a large network of broker dealers who can provide information flow, ideas, inventory and trade execution at competitive spreads becomes essential. Important to investing in distressed debt is an experienced and well-resourced back-office. Processing securities through a reorganization, settling a term loan trade and executing on various legal agreements as part of a restructuring are among the processes critical to investing in distressed credit. Finally, legal representation is also crucial when investing in distressed credit with representation generally required in each jurisdiction where a credit investment is held through a bankruptcy process.
Identifying favourable opportunities in capital structures
The travel sector has been one of the hardest hit with a collapse in passenger airline traffic globally. Air Canada is no exception with Q2 revenue down 90% and Q3 revenue expected to be down by more than 70% from last year. Searching through the company’s capital structure, we identified an interesting opportunity in the company’s enhanced equipment trust certificates or EETC’s which are pass-through trusts directly secured by the aircrafts in the company’s fleet. In the event of liquidation or default, these securities would be at the top of the capital structure. The pass-through trust A and B still maintain investment grade rating, despite Air Canada’s credit rating deteriorating to BB- with a negative outlook. The trust B was trading in the high 80’s in June implying around a 13% yield, a premium to where various issues of subordinated debt were trading at the time.
Playing out various scenarios, the risk to reward in these pass-through trusts appears compelling. There has been a lot of excitement in the equities and junior securities of airlines and there is a lot of optimism already priced in. Meaning there’s considerable risk in these securities if airline traffic doesn’t improve as expected or it deteriorates further due to circumstances like a second wave of COVID cases. While there have been a few airline bailouts in various countries, there is no certainty as to how a bailout could look for Air Canada. In June, the Quebec government announced a potential bailout of another hard-hit Quebec-based company, Cirque du Soleil, but in the form of a loan to recapitalize the company which would result in its equity being wiped out. An optimal strategy when navigating distressed debt markets where there is considerable uncertainty is to be positioned within the capital structure where you have a higher probability of a better outcome while still getting a great return.
Taking advantage of market dislocations
The energy sector has been among the hardest hit sectors in the current crisis, with oil prices cratering to negative levels as global oil demand collapsed without a corresponding reduction in supply or sufficient storage capacity for the glut of new inventory. While production curtailments, reductions in capital spending and efforts by OPEC to cut supply have moved the market closer to equilibrium, the sector remains oversupplied with troublesome 2nd and 3rd order effects and oil prices are still below all-in sustaining costs for the majority of North American producers. With energy among the most levered sectors and representing a significant portion of total high yield debt and new debt issuance over the past few years, the sector is highly distressed but also provides a plethora of potential opportunities.
We owned a small equity position of Athabasca Oil Corporation, a Canadian small-cap oil producer in the Pender Small Cap Opportunities and Pender Value Funds. While the company had high costs and concentrated assets, our investment thesis was predicated on the catalyst-rich nature of the business with several catalysts available in the capital structure, asset base and ownership, any of which could unlock value. As oil prices collapsed our thesis was negated and we decided to exit our equity position. But as we looked through the capital structure, we identified an opportunity in the company’s 2022 notes which we switched into. The notes are the most senior and are the only issue outstanding for the company, and we noticed they had become materially dislocated during the oil price rout in late March and early April. At our largest accumulation, the notes were trading at a severely distressed level in the teens as expressed in dollar terms, with the market value of the debt well below the cash value of the company. We viewed this as unsustainable as the company had sufficient liquidity to survive the price environment for an intermediate period, with significantly higher asset value than what was being reflected in the market. While still distressed, the notes have appreciated multiple times from that level, far outpacing the modest recovery in the equity. In periods of severe distress rare opportunities with higher upside and lower downside can be found, but a good fundamental understanding of the business and quick execution are critical to capitalize on these opportunities.
Complexity and inefficiencies provide opportunity
The idiosyncratic nature of investing in distressed debt with unique considerations not only for a specific issuer, but for each specific issue from that issuer across the capital structure, makes it challenging. But these challenges also result in a less efficient market, particularly for smaller issuers, facilitating the potential to gain an analytical edge and higher risk-adjusted returns. Our focus on bottom-up fundamental analysis, staying within our circle of competence, having flexible and nimble mandates and having the in-house, back-office and external resources to identify, analyze and execute on an investment are critical. We are in a unique and challenging time with many unknowns and businesses will have to restructure to adapt but we have a high level of conviction that if history is any indication of the future, the prospects for distressed debt are bright.
Amar Pandya, CFA
July 24, 2020