Every cycle when investing in distressed debt is different. During the worldwide financial crisis (GFC), many otherwise viable firms faced a liquidity crisis. Previously, when the tech bubble burst within the early hours, Global Crossing, Nortel and Lucent, amongst others, overleveraged and were forced to restructure or, in some cases, go into liquidation within the face of insufficient demand.
During the 14 years of the post-GFC cycle, the U.S. federal funds rate and the Canadian federal funds rate remained exceptionally low, hovering around 1%, give or take. During this time, every financial transaction, be it a company acquisition or a refinancing, resulted in historically low rates of interest. Now, much of this corporate debt can’t be easily refinanced in the next rate of interest system. This is clearly bad news for the unique owners of this newspaper. But it may very well be superb news for investors looking for attractive, non-correlated returns in publicly traded stressed and distressed bonds.
Indeed, amid speculation about what central banks will do next, investors cannot ignore how much bond prices have fallen. Price disruptions have increased for struggling firms, making a growing opportunity set for credit market investors.
Since 2008, central banks have been rapidly buying bonds and other securities to support markets during times of high volatility. One results of this quantitative easing (QE) is that investors in distressed debt have to be ready and willing to benefit from opportunities as they arise in every sector.
Companies suffer from credit constraints for various reasons. It may very well be a classic case of taking up an excessive amount of debt. It may very well be the results of a foul acquisition or ill-advised, debt-financed stock buybacks. Perhaps the managers’ forecasts were too optimistic and earnings and money flow were disappointing. In such moments, rolling over the debt may now not be an option, and in a rising rate of interest environment, servicing the debt becomes harder. Investors begin to calculate the probability of a default or sale, and the value of the bonds falls.
Utilities and REITs are among the many sectors which can be often financed through debt issuance. Still, industry agnosticism is advisable relating to stressed and non-performing loans. After all, such investments are inherently idiosyncratic, and whatever the industry, buying quality bond for 50 cents on the dollar is all the time idea. Not way back, in 2015 and 2016, the energy sector experienced a drought, and in 2018 it was the turn of the homebuilding industry. There will all the time be pockets of stress in several sectors and at different times.
Today, traditionally defensive sectors can offer a wealthy vein of value. Healthcare and telecommunications, for instance, have tended to be resilient on this regard. Why? Since persons are far more prone to cancel their Maui vacation than their iPhone, and given the selection between a hip alternative and a Winnebago, they’ll select the previous. Therefore, sales in these sectors are likely to remain quite strong. Nevertheless, we’re in a phase of recession and rising labor costs are reducing margins.
It can also be price exploring the small and medium ends of the emissions market. These may offer a greater risk-reward scenario with less competition because the larger distressed debt funds cannot spend money on firms of this size. Because size is the enemy of returns: in some unspecified time in the future the biggest funds turn into the market and may now not generate alpha. Smaller, more flexible investors are due to this fact higher capable of get in and benefit from the opportunities.
All in all, the present environment would be the best that credit investors have experienced in at the very least a generation. Unlike stock investors, they’ve capital priority, and even in a worst-case scenario, those holding the upper echelons within the capital structure will realize value – sometimes abundant value.
Still, credit investors should remain more risk-focused than return-focused and work to discover the investments with probably the most attractive risk-reward ratio.
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