The investing environment for troubled and bankrupt companies is not expected to be very different in the second half of 2024 than it was in the first half, despite possible economic warning signs from the recent US equity market sell-off and rally in US Treasuries, according to distressed investors LCD canvassed recently.
At the same time, the process of investing in those companies — how restructurings are getting done — is undergoing a shift, the investors noted. That shift is taking distressed players away from a milieu where they often operated individually, to one where cooperation is a touchstone.
Before taking a close look at how the restructuring process is changing, reviewing the current distressed opportunity set will place the changes into context.
Split personality
The leveraged loan and bond markets have revealed a split personality in 2024’s first half. Credit spreads have been very tight for better-rated issuers, namely those in the B ratings categories and better, as the US economy has shown surprising strength, with US GDP rising at a 1.4% annual rate in 2024’s first quarter and at a 2.8% rate (the “advance” estimate) in the second quarter.
In particular, S&P Global has been reporting its US high-yield corporate bond BB index trading at an option-adjusted spread (OAS) in the mid-to-high-100s bps range (with a recent spike above 200 bps), with the B index OAS roughly 100 bps wider than that.
At the same time, S&P reported issuers rated CCC+ and below posting an OAS in the 800 bps range, as many of them have struggled with high interest rates and a vacillating consumer. In fact, operationally at 2024’s first quarter, 47% of CCC issuers had under 1x interest coverage (excluding EBITDA add-backs as per Bixby Analytics, according to Barclays).
As a result, market participants are executing a growing number of liability management exercises, or LMEs, which have pushed the Morningstar LSTA US Leveraged Loan Index trailing-12-month default rate that includes distressed exchanges to 4.02% at July 31, from 0.78% in July 2022 (though currently at a 2024 low).
By comparison, the default rate excluding distressed exchanges rose to just 1.45% as of July 31 (also a 2024 low), from 0.43% in July 2022. The US leveraged loan distress ratio was 4.41% by amount in July.
The bond market is also showing a moderate amount of stress. The distressed subset of the Morningstar US High-Yield Bond Index — a compilation of data encompassing bonds marked at an option-adjusted spread of 1,000 basis points or more — reveals bond investors having roughly the same opportunity set at July 31 as existed at the start of 2024, which is 40% smaller than in the spring of 2023. The subset's distress ratio was 5.88% at July 31, with $78 billion in distressed paper.
Back half
Turning to the economy, recent conversations with distressed portfolio managers have yielded a relatively consistent response that the US economy, while struggling in parts, and despite recent weakness in equities, is generally performing well. For the past two years and seemingly according to nearly everyone, a US recession has been just over the horizon. But it has, so far, failed to materialize, and consensus within the distressed community lately is that a recession is not likely to arrive in the near term.
But it isn’t all smooth sailing. Randy Raisman, portfolio manager at Marathon Asset Management, notes that “we are seeing cracks in the consumer and retailers are hiccupping,” citing Nike, Walgreens and H&M, among others, having recently reported weakness or guided down financial forecasts. Nonetheless, he believes the economy will remain relatively strong through the rest of the year.
Allan Schweitzer, a portfolio manager at Beach Point Capital Management, concurred, saying that while he sees small signs of weakness in retail and airline traffic, “we can’t draw a line from here to a high probability of recession.”
While Peter Cecchini, Principal and head of research at Axonic Capital, had also taken a US recession off his radar for the first half of 2024, he sees warning signs on the horizon. He notes that employment statistics have been slowing, specifically pointing to initial and continuing unemployment claims, which recently rose to 249,000 and above 1.8 million, respectively. For Cecchini, 300,000 initial jobless claims will signal recession is imminent.
He also points to data revealing depleted consumer savings and rising delinquencies. Still, he doesn’t see recession in the cards until possibly late 2024.
Presidential possibilities
This November the US will send a new president to the White House. “It’s hard to ignore it,” Jonathan Barzideh, a portfolio manager at Canyon Partners, said about the potential impact of the election process and outcome. He thinks fiscal incentives might “pull forward the economy from next year,” thereby potentially making the 2025 economy more difficult.
But while an important milestone in the second half of this year, Barzideh does not see the election ultimately playing much of a factor in the distressed opportunity set.
Other portfolio managers see the election roughly the same way. More than one distressed portfolio manager noted that a Republican win would likely result in less government regulation, which could be good for the economy’s growth prospects.
But a stronger economy might stoke inflation and leave interest rates higher rather than lower, some portfolio managers say. A reinvigorated trade war with China could also be problematic.
“Tariffs are inherently inflationary, and that might influence [the Fed’s] rate actions,” said Jeremy Burton, managing director and portfolio manager at PineBridge Investments. A weaker US dollar could also renew inflation concerns.
Co-op city
Interest rates have been elevated since the US Federal Reserve’s Federal Open Market Committee began raising them in 2022 in response to the highest inflation readings in 40 years. While inflation has subsequently subsided and is now approaching the Fed’s 2% target, the interest rate regime has caused damage.
Dan Zwirn, CEO and chief investment officer of Arena Investors, expects that “interest rates and inflation will both remain elevated over upcoming years,” and he foresees those factors driving company valuations lower and real estate cap rates higher.
Zwirn believes interest rates will remain at these higher levels regardless of which candidate wins the November presidential election.
Although market chatter has recently included the possibility that the US Federal Reserve may soon reduce its fed funds target rate by as much as 50 bps, the current relatively high interest rate regime is causing dislocation. Canyon’s Barzideh said “we haven’t seen a target-rich environment like this in quite a while.”
But Barzideh took his view a step further, noting that the entire distressed investing landscape is changing. “LMEs certainly add a level to the 3D chessboard when we approach a distressed investment and consider how our rights and priorities may change during a case and how we can prevent that.”
Along with other distressed investors, Barzideh noted the rising use of cooperation agreements — “co-ops” — among distressed investors, along with an increasing participation rate by lenders in some large capital structures. The Canyon portfolio manager is also seeing co-ops of longer duration, with some remaining in place for years, even through the maturity date of the underlying debt issuance. He believes their value is to show sponsors and management that the lenders “are a unified front, now and forever.”
Barzideh expounded on the advantages of co-ops, ticking off benefits including raising the chance of a creditor-friendly outcome for the troubled company, improving trading levels and tempering some of “the left tail risk of getting run over” by an aggressive LME and sponsor.
In fact, Barzideh is seeing within the current collection of distressed situations classic “good company, bad balance sheet” investments, but with the added dynamic of investors needing to strategize how to avoid damage from a sponsor-driven LME.
Echoing Barzideh’s focus on co-ops is Zoltan Donovan, managing director and head of restructuring & special situations at First Eagle Alternative Credit. He said that co-ops “have become particularly prevalent over the last 12-18 months.” He commented that, whereas in the past, the five-to-ten largest lenders used to work individually to maximize recoveries and minimize conflict, “now there is more hand-to-hand combat within the lender community.”
Donovan noted that “tiered co-ops” are a particular flavor of cooperation agreements, where early signers can benefit from improved economics and can have more influence in the restructuring process than later signers, which may improve their outcomes. “It pays to be early,” he said.
Donovan also sees sponsor sophistication rising. “Sponsor aggression has grown over the past few years,” he said, as they have deployed LMEs as a way to “stay in the game,” namely maintaining their control of the troubled portfolio company by giving up as little equity as possible, while garnering new capital and extending the operating runway by pushing out maturities.
Putting a point on it, Beach Point’s Schweitzer said that LMEs “have redefined the landscape for distressed investing.” He adds that the array of outcomes and their economic impact on each debt instrument are greater than they have ever been.
Schweitzer said that, along with the usual fundamental analysis, the questions facing investors now are who is the sponsor, who are my fellow creditors and what are the range of LMEs that might be deployed. He noted that “locking arms with fellow creditors can help mitigate what the sponsor can do and potential creditor-on-creditor violence.”
Adding to all parties’ motivation for utilizing LMEs rather than seeking bankruptcy protection is the rising cost of court-supervised processes. “Financial and legal advisor costs are bleeding out of restructuring processes and are having a detrimental effect on recoveries,” Schweitzer said. He adds that reorganizations are generally disruptive to management teams, and when negotiations falter, managements often seek “a smooth transition of ownership to creditors in a less disruptive manner” that can preserve value.
Sectors
Regardless of their view of the economy and the changes in how restructurings are unfolding, distressed investors continue to find places to put money to work. They noted that the sectors with the most opportunities do not necessarily correlate with the economy.
Rather, in some cases, multiples have come down because of sector-specific reasons, leaving those sectors overleveraged.
Zwirn of Arena Investors said, “We are seeing an increasingly large [distressed] opportunity set, though not necessarily just bonds and bank debt.”
Along with the usual suspects, Zwirn cites European real estate, litigation finance, energy lending, US commercial real estate bridge loans and asset-based lending as places where he is putting money to work.
One sector in everyone’s gunsights is media/telecom, “the lowlight of the past couple of years,” according to PineBridge’s Burton.
Marathon’s Raisman concurs, noting that telecom saw significant debt issuance between 2019 and 2021, as valuations rose. Now these companies are saddled with bloated debt levels while valuations have declined.
Schweitzer from Beach Point sees the market bifurcated between the low-probability-of-default relative value investments, and distressed investments with near-term maturities as catalysts. Across sectors, telecom, software, and other tech-enabled companies are on his short list of opportunities, while he sees greater vulnerability in healthcare services and building products.
On the other hand, he noted that as dispersion increases, he is less focused on taking broad sector-level views and more focused on idiosyncratic risk, such as looking at which companies overborrowed during the 2020-2021 issuance binge.
Marathon’s Raisman notes that another factor impacting the distressed opportunity set is destocking of the inventory build that occurred as demand spiked during the Covid-19 pandemic.
Canyon’s Barzideh has been looking for and finding investments in packaging, chemicals and other industrials. He has also found investable opportunities in crypto-industry liquidations, as well as in businesses that have emerged from destocking periods.
In real estate, Barzideh said that, while Canyon is generally staying away from Class B office buildings, the firm is seeing things to do in real estate otherwise, particularly in multi-family.
Barzideh points out that many issuers in the business services, healthcare and tech spaces, among others, have cap structures designed for zero interest rates, and they may at some point become interesting. But as of yet, he and Canyon do not see much to do there.
Along the same lines, First Eagle’s Donovan has been avoiding healthcare because it has “stroke of the pen risk,” meaning that legislation or reimbursement changes can come along any time and make a formerly great investment into a distressed one.
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