Distressed debt investors send out their own distress signal

WHEN distressed-debt investor Mudrick Capital Management bet on an aviation startup in December, it was a sign that opportunities have dried up in one of the most lucrative corners in finance.

Despite pandemic woes and market turmoil, investors that trawl for beaten-up credit are struggling to put a glut of money to work. The unused capital for buying under-water loans and bonds surged 58 per cent in the course of the pandemic to US$95 billion in 2021, according to investment-data company Preqin.

Crisis-fighting policies such as low-interest rates and state-backed financing are propping up troubled companies. That's unlikely to change soon even as central banks start to rein in the flow of money. With few battered securities to scour for nuggets of value, Mudrick Capital - a distressed veteran and a winner during the Reddit-fuelled trading frenzy last year - invested US$200 million in a convertible bond to facilitate the listing of Vertical Aerospace, a UK company that designs electric aircraft. "We are forced to get crafty just like everybody else," said Jason Mudrick, the firm's founder and chief investment officer. "There's not a lot of distress right now." Investors from Blackstone to Carlyle Group have broadened distressed-debt offerings to other asset classes or abandoned the strategy entirely. Oaktree Capital, long the world's biggest investor in the segment, rebranded its latest fund as "opportunistic" and gave it broader strategic scope. Anchorage Capital Group, one of the best-known distressed-debt investors, painted a dim picture for the future of out-of-luck securities when it shut its flagship hedge fund late last year.

In the US, nearly US$1 trillion of debt was trading hands at distressed prices at the height of the pandemic, according to data compiled by Bloomberg. As of Jan 28, that had plummeted to about US$65 billion.

It's a similar story in Europe. Last month, just 1 per cent of the bonds in the Bloomberg High Yield Euro Index were trading at less than 90 cents on the euro, compared with around 15 per cent in January 2019. The trading of distressed securities emerged as its own asset class in the 1980s in the US. Investors like Leon Black pursued "loan-to-own" strategies or hoarded unloved bonds betting that they would bounce back. Small investments in debt at bargain prices can spell huge gains for hedge funds and private equity firms, with some generating returns well above 20 per cent. But in a world of easy money, even strapped borrowers can secure credit lines.

The retreat looks surprising in the light of the success enjoyed by the asset class during the pandemic. Few other credit-focused strategies came close to matching the returns of distressed debt, but those returns are deceptive. As authorities pumped money into the economy to counter the fallout from the coronavirus pandemic, Covid-hit companies like Hertz Global Holdings and Europcar Mobility Group recovered quickly. While that juiced returns in distressed investments in the short term, future deals disappeared. The market has changed a lot since Greg Olafson, co-head of Goldman Sachs Asset Management's global private credit business, started working in distressed debt more than two decades ago. Now, more people are chasing fewer opportunities. "As soon as something breaks, everybody runs in and a solution can be found," he said in an interview with Bloomberg.

With the pandemic easing and interest rates set to rise around the world, there's chances that the market rebounds. But if it does, it will take time and may never return to its heyday. "It is not the end of distressed investing, but tradable distressed credit investing is going to be more episodic," Armen Panossian, head of performing credit at Oaktree, said in an interview. "The window of opportunity is getting shorter and shorter." With the Federal Reserve kicking off what is potentially the biggest and fastest tightening of global monetary policy in years, some corporate debt could become unsustainable and create opportunities for high-risk credit investors, according to Michail Zekyrgias, head of EMEA distressed and special situations at Bank of America.

That would open the door again for Mudrick to go back to picking through corporate wreckage, rather than funding experimental aviation companies.

"Distress is not dead," Mudrick said. "We're just at a cyclical low point." BLOOMBERG