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Distressed debt investing in the time of covid

July 2020

Prepared for distressing times

Cracks in the corporate world have been papered over by central bank liquidity. But as economic fundamentals exert themselves, opportunities will open for distressed debt investors.

01

The great divide

A battle is being fought between central bank liquidity and economic reality. You can see it in the vast gap between corporate fundamentals and the price at which companies’ bonds and stocks trade.

It’s a disparity that will continue to open the richest seam of opportunities for distressed debt and special situations investors since at least the global financial crisis a decade ago. Indeed, it is when the economic clouds darken that distressed securities prove their worth. 

And there’s the added advantage that these strategies are uncorrelated with the major asset classes, a characteristic that’s never been more crucial to helping limit portfolio risk than during these uncertain times.

Many companies were already under strain before Covid hit. This weakness came to the fore in March as the pandemic caused governments to impose drastic and economically-damaging measures to forestall the health crisis.

Symptoms of market distress were quickly alleviated by unprecedented emergency fiscal and monetary measures – not least some USD25 trillion in global central bank liquidity, which included direct measures like purchases of corporate credit in the US and Europe.

But unless these interventions return economies to robust health, they won’t have eradicated the corporate sector’s underlying vulnerabilities. They are merely distorting the market and prolonging the time it will take companies to return to health.

02

Weakness coming into the pandemic

The corporate bond market started the year in an even more fragile state than in 2008. US and European companies below investment grade were leveraged 4 to 5 times, even on their own flattering terms1 [Fig. 1] – in the US, for instance, some 25 per cent of 2019 reported earnings were “adjusted” for special factors compared to just 14 per cent in 20132. Looking through this very aggressive accounting makes it clear that actual leverage was around a third higher still in some cases. At the same time, some 16 per cent of US companies were zombies, which is to say they were unable to cover their interest expenses from earnings.3

Meanwhile, around 80 per cent of the debt European companies issued last year was Cov-lite – which is to say with minimal protections for bondholders. In 2011, all the region’s corporate debt was issued with traditional covenants.4

Fig. 1 -  All leveraged up
US high yield leverage - debt as a proportion of earnings before interest, tax, depreciation and amortisation
US high yield leverage

Source: Deutsche Bank research, Bloomberg. Data as at 02.07.2020

So when the pandemic’s fallout started, companies with already fragile balance sheets were hit hard. March saw a surge in the proportion of corporate debt classed as distressed, with spreads of 1000 basis points above risk-free assets and prices of less than 80 cents on the dollar. In both US and Europe the distressed ratios hit close to 40 per cent – their highest since the global financial crisis.5

But when central banks opened their taps, investors reacted quickly. Where there were significant outflows from the US and European high yield markets in March and April, inflows since then have been even bigger.

For instance, a net USD25 billion of new money has poured into the US credit market so far this year. This, in turn, has triggered a massive increase in the issuance of new bonds. In the US, the second quarter saw a new record for high yield issuance, which is now USD218 billion to date, up 60 per cent from the same period last year and already in excess of the total for 2018. Yields have as a result come tumbling down, and the proportion of high yield corporate debt classed as distressed dropped sharply on both sides of the Atlantic – to just 15 per cent in Europe by the start of June.

Fig. 2 - Spreading out
Percentage of US and European high yield bonds with spreads above 1000 basis points
Percentage of US and European high yield bonds

Source: Deutsche Bank research. As at 01.06.2020

03

Warning signs

We think this sharp bounce back has been largely technical in nature and, despite vast amounts of central bank support, many parts of the corporate sector remain fragile. We expect already high leverage levels to rise further still. Unless there’s a dramatic economic recovery, companies will find it hard to service those debts, even in this environment of ultra-low interest rates.


Fig. 3 - CCC level
Number of bonds rated CCC and below in the US and Europe in January and June 2020
Number of bonds rated CCC

Source: ICE BaML Indices, Bloomberg. Data as at 08.07.2020

So far this year, some USD150 billion of US and EUR55 billion of European investment grade credit have been downgraded to high yield6. And within the high yield market, the proportion of US CCC-rated bonds has increased from 10 per cent in March to around 13 per cent now7. The rule of thumb is that a third of CCC-rated companies default over the subsequent three years.

The ratings pressure will continue.  We should expect further increases in the number of fallen angels and further increases in the proportion of CCC-rated credit with companies reporting rising leverage and increasing cash burn as weak revenues fail to keep up with expenses.

Companies’ financial difficulties will not ease even if monetary support continues. Investors can expect higher default rates over the next 12 months. We think they’ll reach around 6-7 per cent in Europe and 11-13 per cent in the US (the US figure is higher because energy companies – whose finances have been particularly hard hit by the economic slump – account for a bigger share of the market).

Sectors that were hit hardest by Covid are also likely to become some of the most interesting recovery stories over the coming months: transport, energy, leisure, consumer discretionary, gaming and retail, which was already troubled before the pandemic. Active, bottom up distressed and special situations strategies aren’t just looking for vulnerable companies, but also those that have suffered turbulent times and are now undervalued by the markets.

Hidden virtues

Key to a successful distressed and special situations strategy is an ability to respond quickly to changes in circumstances and to use a wide range of instruments. 

The Covid pandemic has heaped misfortune on many companies in vulnerable sectors and blinded investors to turnaround stories. Take the French container transportation and shipping company CMA CGM. A year ago we took a short position on its debt based on both a macro view – that the global market for shipping was slowing – and on idiosyncratic factors facing the company. Like that it was carrying excess debt, that it had overpaid on a large acquisition and that it was having trouble passing high costs onto customers. The company’s debt sold off while its credit default swaps rose.

But by October, we’d felt the selling had gone too far. We not only closed our positions, but went long. CMA CGM was hit by the general market volatility in March, but has since recovered well, a move that’s been reinforced by better-than-expected first quarter results and the agreement of a sale and leaseback scheme that shores up its balance sheet and we felt the company could withstand new regulatory standards better than other firms.

04

Decorrelation

Special situations and distressed debt investing – which entail the ability to either buy or short sell a company’s debt, according to circumstance – has the advantage of not being tied to the performance of wider markets. That matters for investors. Including assets whose returns follow a different path can reduce the risks in a portfolio. It can lower the volatility of returns and preserve capital when the economy slows or contracts.  

Strategies that focus on researching individual companies, getting to know them well and understanding when they’re at risk and when they’re undervalued, are best placed to generate attractive returns whatever the wider market may be doing. A lack of correlation with major asset classes can be a boon to minimising portfolio risk.

Historically, this style of investing has generated strong returns. Over the past 20 years, investing in distressed fixed income has achieved annual returns of 6.1 per cent against 5.1 per cent for global corporate and high yield bonds. We believe that a well-managed active strategy in this space has the ability to generate an even stronger performance. 

One reason for this is the asymmetric nature of credit. Normally trading corporate debt doesn’t offer much upside – a sudden improvement in a bond issuer’s credit ratings or falling government bond yields can give some uplift, but by and large most of the return comes in the form of regular interest payments. By contrast, if a bond issuer defaults, the hit to a fixed income portfolio can be heavy and long-lasting. Which is why shorting the fully-priced debt of companies running into problems can be so rewarding.

By the same token, the potential gains from buying and holding distressed debt can also be significant – not least because once companies go into default markets often underappreciate the true value of their debt securities, particularly when they don’t trade very often, which helps to drive the outcome in our favour. And at times like these, during heightened uncertainty and rising risks, investors have the opportunity to make outsized returns. 

Special attractions

Those qualities come with a cost: successful investing in special situations demands a very active approach, based on thorough analytical work. Risks can also be significant, not least because many of these bonds are illiquid. But focusing on the most liquid assets helps to minimise volatility and ensure an ability to exit the investment. It also means shorter holding periods – say 12 months for an absolute return approach compared to the 5 to 7 years for an average private equity fund. 

Tailoring the investments requires additional skill. It’s important to have an appropriate mix of short and long positions to ensure that the strategy is doing more than just capturing market effects. Shorts also help to develop ideas for what might be successful future long positions.

History tells us times like this are when the biggest opportunities for outsized returns emerge.

This style of investing has the further advantages of being less management intensive than private equity funds, and of using less leverage. On the other hand, having the flexibility to trade sovereign debt can help an investor’s liquidity profile.

In all, it’s a market where substantial experience is important, not just to develop the contacts and understand the sort of analysis needed but also to know which opportunities present themselves at different points of the business cycle. Those skills become even more relevant during once-a-generation events like the Covid crisis. History tells us times like this are when the biggest opportunities for outsized returns emerge. And we think the coming quarters will open up the best prospects for distressed and special situations investors since at least the global financial crisis. That these returns are typically uncorrellated with the major asset classes makes distressed and special situations investing particularly attractive additions to investors’ portfolios.