Copyright (c) 2013 Kison Patel
The distressed high yield bond and leveraged loan markets are suffering from a lack of supply that will not likely improve in the near term, and distressed investors are on the new issue bandwagon. But these investors are not pulling back and are bullish on their return expectations and signs of future supply are at hand.
“Wherever those distressed opportunities are coming from, they will be fewer and further between because a lot of issuers have the ability in today’s market to find fresh capital to allow them to kick the can down the road,” said Robert Grien, managing director and head of the finance and restructuring advisory group for TM Capital.
The amount of rated distressed high yield bond debt on the market dropped to about $ 50 billion as of Jan. 15 from $ 62 billion as of Dec. 14, 2012, according to Standard & Poor’s. Distressed loan volume dropped to $ 22.5 billion in 2012 from $ 34.4 billion in 2011, according to the LSTA Trade Data Study.
The high yield bond distressed debt ratio was 8.1% as of Jan.15, a decrease from 9.7% as of Dec. 14, 2012. The distressed ratio—the percentage of speculative-grade bonds trading wider than 1,000 bps above the 10-year Treasury note—is now approximately half of what it was at this point last year, 15.3% reached in January 2012. While the current distressed ratio may be higher than pre-recession levels, S&P analysts note that it is significantly lower than the average since the end of the 2008 recession. The distress ratio has averaged 12.3% since the third quarter of 2009.
The number of corporate issuers that are distressed also decreased. As of Jan. 15, 99 S&P-rated companies had issues trading at distressed levels, a decrease from 118 in December.
The S&P/LSTA Leveraged Loan Index distressed ratio increased to 4.1% in December 2012 from 3.6% in November 2012. The corporate distressed ratio decreased to 9.7% from 11.4%.
And institutional investors may be holding on to their distressed securities longer and not putting them on the market due to pricing concerns, according to the president and founder of investment networking firm Fundology. He said that he works with a lot of commercial banks that are finding it more difficult to make the case for distressed debt. “The challenge with the distress debt you see is getting a good price for it. … For a community bank getting rid of a debt, it’s got to fall between 45-55% of note value. A lot of time what you’re seeing through distressed periods is a lot of lower-valued assets, especially with a lot of portfolios with institutional buyers you would get it a lot lower, down to 15% in some cases.”
Distressed debt has taken a backseat to the primary market, as many investors who would otherwise be buying distressed debt have found themselves spending more of their capital on the new issue market.
Law firm Bingham McCutchen, Debtwire North America, and Macquarie Capital published a 2013 distressed debt outlook that found a steep drop in the number of purely distressed players on the market, but steady faith in the returns of the asset class and clear determination on the part of investors to keep investing.
The survey, which polled 100 distressed debt investors in telephone interviews in November and December of 2012, found that only 15% of respondents described themselves as purely distressed debt investors, a drop from 50% of respondents in the 2010 survey.
Distressed investors have, in large part, directed their attention to other asset classes. “The days of the pure distressed player appear to be over,” Bill Govier, an attorney with Bingham McCutchen, said in the report. “Today’s investors are not afraid to mix things up, choosing not to focus on one particular strategy in a given year, but going after results on numerous fronts.”
But most of those surveyed expected to keep or increase their allocations to distressed debt, with 44% expecting to keep the same allocation to distressed debt and 42% planning to increase assets dedicated to distressed debt. Only 14% planned to decrease their distressed allocation. The largest segment of respondents said they were dedicating between 21% and 40% of their assets to distressed debt and 18% of respondents said their firms were dedicating between 41% and 60% of assets in distressed debt. At this point last year, 54% of respondents were putting less than 20% into distressed, and this year only 36% of respondents were putting 20% or less into high yield.
For return expectations, the feeling among distressed investors has improved over the last year. In the 2013 survey, 7% of respondents are targeting returns of greater than 20% for the year, whereas zero respondents had such targets last year. And 29% of investors said they are targeting returns of between 15.1% and 20%; 25% of respondents had that target for 2012.
And fewer distressed investors were planning on giving money back from their funds this year, with more opting to either raise new funds or remain constant.
And at some point, the new issue market is bound to cool down. “I’m confident that at some point the market will take a breather,” David Miller, a managing director with Macquarie Capital, said at a briefing. He noted that the recent rise in the ratio of downgrades to upgrades among speculative-grade companies reported by S&P is a sign that there could be more distressed assets coming to market in the not-too-distant future. “We do start to see some rumblings,” he said.
Miller said that the key sectors to watch for distressed debt are transportation, media and entertainment, consumer products, energy, aerospace and defense, financial services, and education and healthcare.
Some distressed investors are looking at Europe as a place for distressed deals as eurozone banks continue to shed distressed assets. “The corporate distressed high yield opportunities in the U.S. and Europe are few and far between today, so we are being patient and instead focusing on other asset classes where we see a better pipeline of deals. We are seeing an increasing supply of loan portfolios coming off the bank balance sheets, particularly in the European markets,” Jody Gunderson, senior managing director with CarVal Investors, said in an email. “We also see better value in corporate liquidations than in the distressed high yield market, especially in Europe.”
Gunderson is on the investment committee for CVI Credit Value Fund II, the $ 1.1 billion new distressed credit investment fund that CarVal Investors has raised. CarVal began raising the fund last March with a target of $ 1.5 billion and expects to raise or exceed that target amount and have a final close of the fund later this year. The fund invests in global distressed credit, taking advantage of opportunities that result from the ongoing deleveraging of financial institutions in Europe and elsewhere.
“We’ll be ready if the distressed ratio increases, but we wouldn’t count on it, particularly in the U.S. We don’t see the catalyst for a significant increase in the distressed ratio in the U.S. Europe could be a different story,” she added. “We are avoiding the pitfalls in the corporate distressed market in Europe and certainly there are plenty of catalysts that could result in better distressed opportunities down the road.”
Market observers point out however that distressed bonds are still very risky and like other junk bonds are susceptible to interest rate risk as well as default risk. Distressed issues have the lowest recovery prospects of speculative-grade securities. Among the current issues trading at distressed levels, 71% have S&P recovery ratings of ‘5’ or ‘6,’ meaning they have “negligible to modest” recovery prospects in the event of a default, according to S&P’s Jan. 25 Distressed Debt Monitor report. Also, about 60% of distressed issues are unsecured or subordinated. Of the 99 companies on S&P’s distressed list, 46% have either negative rating outlooks or ratings on CreditWatch with negative implications, and 49% have stable ratings and only 3% have positive rating outlooks.
“The bond market, with rates as low as they are, is already a dangerous place to play,” said John Riley, founder and chief investment strategist for Cornerstone Investment Services. “You could double rates from here, bonds could really get clobbered, and you’d still have halfway to go before you reach average.”