Distressed debt investors are anticipating opportunities across numerous sectors in 2024. But that optimism comes after the US economy showed surprising strength this year, yielding a less lucrative target set than distressed players had expected.
At the end of 2022, investors saw in their rear-view mirrors a bear market that seemed to portend anything from a mild to a severe recession in 2023.
The inaccuracy of that crystal ball is now clear. GDP in this year’s first three quarters rose by 2.2%, 2.1% and 5.2%, respectively, as inflation declined by nearly two-thirds from its peak. Meanwhile, major equity and credit indices have soared.
So far in 2023, the S&P 500 is up 20% and the Nasdaq has returned a stunning 38%. In credit markets, the Morningstar US High-Yield Bond Index is up 10.2%, while the Morningstar LSTA US Leveraged Loan Index has gained 11.9% (all performance data as of Dec. 8).
On the other hand, distressed investors have earned 4.99% through November, as per Hedge Fund Research’s HFRI Distressed/Restructuring Index.
Burning money
The reason for this year’s strong economic performance is not hard to identify. “The US economy in 2023 held up much better than expected, despite headwinds, in large part because of a resilient consumer,” said Jim Wiant, CEO of asset manager Capital Four US.
In fact, consumers not only spent in 2023 like they had money to burn, but they may still have significant dry powder. Following the US Bureau of Economic Analysis’ September Comprehensive Update of the National Economic Accounts data release, analysts reported that more than $1 trillion in savings may remain in consumer hands.
Given that the US consumer makes up around 70% of GDP, with that firepower, a post-pandemic recession may never arrive. On the other hand, that spending could stoke inflation, or at least prevent it from falling toward the Federal Reserve’s stated 2% goal. That, in turn, could entice the Fed to keep the fed funds target rate elevated, forestalling a now widely expected dovish pivot early in 2024.
Falling coverage
While equity and credit indices rallied this year, US Treasuries slumped, with both short and long yields climbing and in turn eroding interest coverage (notably, a furious fourth-quarter rally has trimmed yields significantly).
In fact, the Morningstar LSTA US Leveraged Loan Index’s interest coverage fell to its tightest level since early in the pandemic.
Diminishing interest coverage suggests new distressed opportunities. To that end, the leveraged loan default rate rose to 1.75% by amount over the summer before drifting back to 1.48% in November, as per LCD. Looking ahead, S&P Global Ratings predicts that the Morningstar LSTA US Leveraged Loan default rate could reach 2.75% by June 2024. (Note: the Morningstar LSTA loan default rate does not include below-par buybacks and exchange offers).
S&P noted that the trailing 12-month US speculative-grade corporate default rate spiked to 4.07% in September, after bottoming at 1.28% in April 2022. Still, the S&P speculative-grade default rate is below the roughly 6.6% rate at year-end 2020 and well under the 10%-plus rates of the prior three recessions.
Distressed investors can also use debt maturity walls to indicate potential opportunities coming down the tracks. Half of the loan debt due in the next few years is rated B-minus or lower. And in the years ahead, the Morningstar US High-Yield Bond Index’s maturity wall climbs steadily, with $107 billion coming due in 2025, $174 billion in 2026 and a peak in 2029 at just over $260 billion.
Relatively weak high-yield issuance for the past two years heightens concern about meeting the demands of such a wall. High-yield debt issuance exceeded $200 billion annually most years during the decade between the Global Financial Crisis and the pandemic, as well as for two years in the midst of the pandemic.
But in 2022 and 2023, annual high-yield issuance has been well below $200 billion, and if the shallow pace continues, the bond market’s future ability to absorb and refinance maturing debt may be problematic.
Moneyball
With default rates rising, investors may be “just at the bottom of the first inning” in repricing risk, said Dan Zwirn, CEO and chief investment officer of Arena Investors. He noted that debt-financed acquisitions over the past few years have been at too-high multiples and financed with too much leverage. With interest coverage now falling, “the unwinding of that leverage is just beginning,” he said.
Jay Weinberger, managing director in Houlihan Lokey’s financial restructuring group, also believes there is worse ahead for the economy and markets, noting that the US hasn’t yet seen a significant rise in layoffs, a classic leading indicator of an economy turning south. He adds that what uptick in layoffs we have seen is concentrated away from the low end of the wage scale.
Some investors believe the amount of damage the markets might sustain in an economic slowdown may not be that great. Jeremy Burton, managing director and portfolio manager at PineBridge Investments, foresees that “default rates are very unlikely to spike like in 2008-2009,” and that corporations will likely be spared unmanageable shocks to their operations.
Burton noted that while the US high-yield market has been shrinking over the past couple of years, he believes the market’s credit quality remains “pretty reasonable.” Combining those factors with the liquidity sloshing around the markets leads Burton to expect that, as the US high-yield option-adjusted spreads push above 400 basis points, “bids will fill in for risk,” keeping OAS from rising too much above that level.
Jeff Jacob, partner & opportunistic portfolio manager at global credit manager Marathon Asset Management, is slightly less bullish. “High yield will hang in at 500-over or less,” he said recently, noting that given current Treasury yields, “all-in yields in the high-yield market will put a floor on bond prices.”
Allan Schweitzer, portfolio manager at Beach Point Capital Management, concurs. Although he anticipates the US economy slipping into recession in 2024’s second quarter, Schweitzer believes US high yield is of generally higher quality, compared to past recessions. Coupling that with an elevated absolute yield would mean OAS will be tighter than in other cycles, he said, adding that today’s yields provide “equity-like returns,” which will attract capital.
As a result, Schweitzer projects that at worst the OAS will reach “550-600, but not much wider,” as low underlying dollar prices entice investors to jump in.
Switching the focus to leveraged loans, investors are less sanguine. Marathon’s Jacob foresees a possibility that leveraged loan spreads could go as wide as 675 bps, while the default rate — including distressed exchanges — could reach 4% (he sees a 3%-3.5% default rate for high yield).
Morgan Stanley is slightly more bearish on leveraged loans, projecting that the default rate will rise to 4.75% in 2024. On the other hand, Bank of America is more bullish about the loan defaults, seeing a peak of 3.5% in 2024.
Fielder’s choice
Canyon Partners investment partner Jonathan Barzideh notes that in the current market, distressed situations are generally not being caused by sector-specific factors such as declining energy prices or patient volumes. Rather, he sees them being caused by the “macro stressor from the Federal Reserve because of elevated rates,” adding that many companies do not have enough liquidity runway to survive these rates. A large percentage of today’s corporate balance sheets were designed for a zero-fed-funds environment, he noted.
In fact, Barzideh sees the US today as a “tale of two economies.” He cited on one hand the “revenge-spending economy” where consumers caught up on purchases and travel that they missed during Covid. On the other hand, he pointed to the “old economy” composed of industrial, packaging and chemical companies, which he says may have already been in recession for a year as they wrestled with destocking, labor shortages, supply chain issues and reduced volumes.
Also addressing higher rates, Capital Four’s Wiant notes that interest coverage is going to worsen in 2024 as hedges roll off and bond debt maturities are refinanced with higher-coupon paper, raising cash interest expense. The result, he expects, is “a narrower margin of error for many companies, even if they have healthy balance sheets and lots of cash.”
Drilling down, Wiant sees a “dispersion on outcomes” depending on whether companies meet market expectations or miss them. “Below the market’s relative surface calm, bonds are showing serious price dislocation in reaction to bad news,” he said. Wiant added that the wide range of winners and losers he expects to see within and across sectors is what makes the opportunity set so potentially attractive for at least the next few years.
Also taking a broad approach — rather than a narrower, sector-based approach — is Beach Point investor Schweitzer. Looking widely at “2021-22-vintage LBO deals,” he noted that many LBOs reach their “peak risk” level in year three, given how debt covenants are structured and the amount of cash sponsors generally initially allocate to support their acquisition. “We’re coming into that time period now,” he said, expecting that 2024 is going to present opportunities from this investment class.
Ball four
Conversations with credit and distressed investors reveal that they are particularly focused on four sectors: healthcare, media-telecom, software and commercial real estate.
Healthcare, for instance, was generally disliked as an investment sector for 2024. PineBridge’s Burton pointed out that although there is now less labor inflation, companies face idiosyncratic risk from reimbursement rate changes.
Houlihan’s Weinberger also tagged the reimbursement issue as a problem for healthcare investors. He noted that physician rollups, and nursing home and rehabilitation center companies, are still seeing the negative impact of the spike in labor costs that have not been offset by rising reimbursements.
Yet some portfolio managers found reasons to like at least some parts of healthcare. Capital Four’s Wiant, for one, is “constructive” on the sector, pointing out that the sharp spike in labor cost trends that did such margin damage to healthcare companies in recent years is likely over, and those costs are now “normalizing,” producing a more favorable forward outlook.
Wiant especially liked hospitals, ambulatory surgery centers, nursing and post-acute care. On the flip side regarding healthcare, Wiant is avoiding radiology, anesthesiology and dialysis companies.
Triple play
Commercial real estate is another distressed sector on investor radars. Canyon’s Barzideh notes that $2.3 trillion of CRE debt is coming due over the next 4-5 years, yet he sees the sector being hit by three dynamics simultaneously.
First, higher borrowing rates are raising the cost of capital while rising cap rates are lowering valuations. Second, real estate is seeing changes in usage, with Barzideh noting how retail has been reorienting to take advantage of shifting consumer shopping patterns, and how some class-B office space might be entirely obsolete in some cities.
The third dynamic is migration patterns. Real estate is seeing negative impacts of people leaving high-tax areas and of people departing urban areas to seek more space.
Tangential to real estate, Capital Four’s Wiant has been avoiding stressed retail, as he sees lower recoveries in the sector. But he would make an exception for companies with especially strong brand names. He is particularly “wary of debt structures where value can be moved out and away from creditors.”
In another distressed sector, technology, Marathon’s Jacob likes that many software companies have recurring revenue streams and at least partial moats around their businesses.
On the other hand, Canyon’s Barzideh said that many software companies grew through rollup strategies and, given high initial multiples, were built for a zero-interest-rate environment, leaving them vulnerable in the current rate regime. They are also feeling “top-line pressure” in the softening US economy.
Putting a point on it, Beach Point’s Schweitzer noted that many software deals were structured with “high leverage and quirky financing that came with lots of adjustments.” He said Beach Point was being “thoughtful and smart” about how it steps into the distressed subset of the sector.
Another sector uniformly unloved is telecom. Houlihan’s Weinberger pointed out that it is wrestling with the “ripple effect” of consumer cord-cutting, other changing consumer preferences and higher interest rates, and there is therefore less money available for capital expenditures.
PineBridge’s Burton also cited the long-term secular trends running against media-telecom, noting that “[the sector] is not cyclical, and investors are questioning both their business models and their ability to refinance.
As for those with the nerve to step into Media/Telecom, Capital Four’s Wiant pointed out that multiples are descending, hurting potential recoveries, especially in broadcasting and cable.
Scanning for investing possibilities offshore, Arena’s Zwirn noted that he is seeing opportunities in non-performing loans and distressed lending in southern Europe and the UK, as well as new distressed situations emerging in Scandinavia and Germany.
In Asia, Zwirn has been avoiding well-publicized and politically sensitive situations emanating from China. He has, however, been finding opportunities away from public focus in China, as well as distressed and special situations in Korea, Japan and Southeast Asia.
Featured image by Jonathan Kitchen/Getty Images
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