Distressed debt: Which sectors offer value?
The current environment may be the best that credit investors have seen in at least a generation
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 post-GFC, the US federal funds rate and Canada’s rate stayed exceptionally low, hovering around 1 per cent, 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 investors.
Since 2008, central banks have been quick to buy bonds and other securities to shore up markets in periods of high volatility. One outcome of this quantitative easing (QE) regime is that distressed debt investors must be ready to seize opportunities.
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. In some sectors, the margins of safety have not been this favourable in decades. Howard Marks, a chartered financial analyst and co-founder of Oaktree Capital, said that this is 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 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 real estate investment trusts 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; 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. Healthcare 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 surgery. Hence, the top lines in these sectors tend to remain quite strong. Nevertheless, we are in a recessionary period, and rising labour 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 capitalise 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 realise 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.
The writer is Pender’s stressed and distressed credit investing specialist
