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Distressed debt and special situations

March 2021
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Distressed debt after Covid

Cracks in the corporate world have been papered over by central bank liquidity. But opportunities remain for distressed investors, and more could emerge once economic fundamentals exert themselves.

01

The great divide

Fiscal and monetary largesse have helped to lift nearly all corporate boats since the Covid crisis hit. But not quite all. 

Many companies will snap back once Covid restrictions are lifted and as patterns of economic demand return to normal. These are the firms with sound business models that simply required some help to get through the worst of the pandemic shock. Yet there are also industries for which even the easiest of financing terms and government rescue packages won’t be enough to plug the huge holes caused by a total collapse of revenue. 

For instance, there are large segments of the consumer sector that are struggling. Lockdowns and travel bans have inflicted grievous damage on the hospitality sector.
Then there are the energy companies that are still struggling following the collapse in oil prices and cyclical industries like airlines that have yet to see substantial recoveries in demand.

In some cases, market optimism has run ahead of fundamentals, failing to price in the poor underlying state of companies’ finances. That opens up opportunities for distressed debt investors. In some respects this is the inverse of what happened in the wake of the market meltdown in the spring of 2020, when corporate prospects were marked down so severely that unusually cheap investment opportunities opened up, particularly in firms' senior and secured debt.

Distressed and special situations portfolios can invest in any part of a company’s capital structure - they can take long and short positions in both credit and equity, and can also use instruments like options to take advantage of pricing anomalies in stressed companies even when overall default rates are very low. 

Because of this, they deliver the kind of payoff that investors increasingly value: returns that don’t correlate with those of the broader fixed income market and a way to diversify the risks contained in a traditional bond portfolio. 

02

Rating pains

The risk of bond defaults might be concentrated in certain industries for now, but as central banks start to normalise monetary policy, probably later this year, highly-indebted companies could start to struggle. We figure the majority of gains delivered by corporate bonds since the onset of the pandemic have stemmed from central bank stimulus. But liquidity injections don’t solve solvency issues.

With investors starved for yield, companies issuing bonds have found ready demand for securities offering even the most modest income uplift. The proportion of outstanding bonds rated CCC - just three notches above defaulted bonds - has grown as well, jumping 20 per cent in both the US and Europe since March 2020 in both the US and Europe (see Fig. 1).1

That’s a worry for investors, because historically 25 per cent to 30 per cent of these bonds default over a two to three year period from when they’re downgraded, according to Moody’s.

Fig. 1 - All you CCC
CCC-rated debt as a proportion of the high yield market (%, as at 31.03.2020 and 31.12.2020)
CCC-rated debt as a proportion of the high yield market
Source: ICE BaML Indices. Data as at 31.12.2020.

Another concern is that a growing number of companies are factoring in future expected cost savings or revenues into current earnings. For instance, a record 35 per cent of newly-issued loans were made with adjustments to earnings in 2019, compared to just 5 per cent in 2009.2  

At the same time, some 20 per cent of US companies have debt servicing costs that are higher were higher than current earnings. Among European companies, those proportions at 17 per cent in France, 15 per cent in Germany and 10 per cent in the UK as of the third quarter 2020.3

Meanwhile, around 80 per cent of leveraged loans European companies issued in 2019 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 

03

Warning signs

Unless there’s a dramatic economic recovery, many companies will find it hard to service those debts, even in this environment of ultra-low interest rates.

Corporate leverage, which had already been creeping up, jumped sharply with the Covid crisis. Leverage among US high yield companies – which is to say the ratio of debt to earnings – rose to more than 13 times during 2020 from around 5 times in 2019 (see Fig. 2).5 Even in Europe, where companies have in the past taken on relatively less debt, 15 per cent of high yield companies have leverage of more than 10 times.

Fig. 2 - Up, up and away
Average leverage of US high yield companies (times EBITDA earnings)
Average leverage of US high yield companies
Source: Deutsche Bank. Data as at 01.10.2020.
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.
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, especially so during times of market stress – something that was very apparent during 2020.  

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. 

 
05

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 distressed 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-type distressed 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.

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.

Successful investing in special situations demands a very active approach.

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. And as economies emerge from this trauma, there will be significant further upheavals associated. A combination of heavy corporate debt loads and incrementally less monetary and fiscal support will create the sort of turbulence that has opened up opportunities for investors in distressed assets and special situations to generate outsized returns. That these returns are typically uncorrelated with the major asset classes makes distressed and special situations investing particularly attractive additions to investors’ portfolios.