Distressed Debt Outlook: Distressed players seek opportunities as recession fears fadeAugust 15, 2023
With equity markets sailing back toward all-time highs first reached in late 2021 and high-yield option-adjusted spreads now around 400 basis points, distressed debt investors are left wondering whether the future is as opportunity-rich as they believed it would be. As recently as last December, many distressed and credit players expected to see a weakening US economy and lower asset prices this year.
But warning signs remain. They include a decades-high fed funds rate, slipping interest rate coverage, and rising default rates. Yield curve inversion has been a historically reliable canary in the coal mine, and the curve has been inverted for over a year. Yet markets rally on.
The fed funds rate hasn’t been above 5.25% since the 1990s, but that level is now the lower bound of the Federal Reserve’s target rate. Despite Fed chair Jerome Powell’s expectations, these historically high rates have so far failed to slow the consumer, the economy or the rise in asset prices, while core inflation remains more than twice the Fed's preferred level.
But the impact of rate hikes is usually delayed. A current market risk is that the Fed continues raising rates until it sees concrete proof of a slowdown or until inflation nears its 2% target, at which point the Fed may have gone too far, with unwelcome results for the economy and markets.
Another concern for investors is the impact of rising rates on interest coverage. Leveraged loan interest coverage topped 5.5x in 2022. But with short-term rates climbing and earnings projections falling, it has since tumbled.
Equally troubling, and with a riskier starting point, is the private credit market’s interest coverage ratio. At some 2x or less, it's roughly just half the ratio in the speculative-grade debt markets, and its downward trend is perhaps even more worrisome.
The steadily rising default rates for high-yield bonds and leveraged loans also demand investor attention. S&P Global Ratings projects the US speculative grade corporate default rate could reach 4.25% by March 2024, up from 2.5% at March of this year. Europe’s default rate is projected to rise to 3.6% by next March, from 2.8% this March.
The ratings agency also sees the US leveraged loan default rate creeping up to 2.5% by next March, from 1.6% this March.
LCD data show that as of the end of July, the leveraged loan default rate was 1.75% by amount outstanding and 2.03% by issuer count.
Credit investors anticipate much the same thing. Steven Oh, global head of credit and fixed income and head of leveraged finance at asset manager PineBridge Investments, sees corporate earnings declining, driving bond and loan default rates upward to peaks in the high-2% to mid-3% range.
Jim Wiant, CEO of asset manager Capital Four US, sees the US corporate bond default rate reaching the low-3% area and the loan default rate topping out near 4%, both sometime in 2024. While those numbers are not the double-digit levels encountered during the Global Financial Crisis, they convey trouble ahead.
Wiant added that, in his view, the default rate isn’t as indicative of conditions as in years past, because of investor creativity in solving balance sheet issues that is pushing out defaults or eliminating them entirely. He also noted that this creativity is to the disadvantage of existing bonds and loans; when those situations do crater, recoveries for existing lenders are generally lower than what they've historically been.
Finally, the yield curve inversion, a longtime reliable recession warning sign, is approaching its danger zone. LCD research shows that since 1978, the average lag period between the first day the US Treasury 2-year/10-year curve inverts and the start of a recession is 15 months, though previously the lag has been as long as twice that.
This October will mark 15 months from the curve’s sustained inversion in July 2022. So the clock attached to this warning flag is ticking loudly.
One sign of impending distress that is not yet flashing red is the maturity wall. Combined, the leveraged loan and high-yield markets face roughly $270 billion in maturities in 2025 and $400 billion in 2026.
PineBridge’s Oh believes these “small” near-term maturity walls effectively offset worry about corporate refinancing. He sees debt rated CCC+ and lower potentially having trouble refinancing but believes that the maturity wall’s relatively small size bolsters his constructive view of credit markets for the remainder of 2023.
However, the wall’s medium-term message may not be as sanguine. The $400 billion maturity bulge in 2026 brings 2025 into focus because maturities become current one year from their due date, and because leveraged loans often contain springing maturities that may move up the maturity date. So, while the leveraged debt market maturity wall is not an immediate trouble spot, it's on dangerous ground.
Making some sense
While the everything rally is a surprise to some, reasons for it are not hard to find. Speaking of the market bounce since the low-ticks of late 2022, Dan Zwirn, CEO and chief investment officer of Arena Investors, said that “these things don’t go in a straight line.”
Beyond the normal daily tug-of-war between buyers and sellers, Zwirn also sees structural impediments to lower prices that are creating “resistance to downside price discovery.” The resistance, he says, comes in part from the bullishness of retail investors, and in part from the resistance of institutional investors to sell and recognize losses, their reasons notwithstanding.
Zwirn also points to regulatory factors preventing market declines. He notes, for instance, that some European sovereign debt cannot be shorted in the derivatives market without a corresponding cash long position against it. Additionally, certain countries continue to have outright short-selling bans in place.
The combined impact of these roadblocks is to hamstring investors’ ability to express an outright negative view, which limits downside pressure on what might otherwise be vulnerable stocks and bonds, Zwirn said.
A more recent driver of debt and equity markets is the trend to revising 2023 recession expectations. While some analysts continue to anticipate some sort of GDP decline in the last six months of the year, others are now looking further out or have stopped looking entirely, leaving bullish investors with room to operate.
Capital Four’s Wiant sees a “growth slowdown” in late 2023 or early 2024, “with some bumpiness, but not a hard landing.” He cited as support for his view the US consumer, who has been “more resilient than expected,” while US employment is holding up and consumer and business balance sheets “are in good shape.”
Taking a roughly similar line is PineBridge's Oh, who sees a recession arriving “in the first half of 2024, if it comes at all.” In his view, even if the economy experiences a textbook recession, “it is not going to feel like much of one,” because he foresees the US unemployment rate not lifting much further than the mid-to-high 4% range, from the current 3.6%.
“That’s far from conditions that would have a material negative effect,” he notes. Oh added that an important factor propping up the US employment picture is government healthcare and education hiring, making up for some weakness he sees in the private sector.
Despite the current strong headline employment data referenced by Oh, Houlihan Lokey Managing Director Tuck Hardie echoes Oh’s concern about the private sector. Hardie believes that, for some of the population, an economic slowdown may already be here.
He noted that with interest rates rising for car loans and credit cards, plus the dollar-shrinking impact of inflation, consumers may already feel as constrained as if a recession had already struck. He believes that consumer-focused businesses are not seeing “robust” activity, and that a slowdown is already beginning to cascade through the economy.
Along the same lines, Hardie sees the bottom third of businesses struggling to extend their balance sheets because lenders perceive that business risk has risen. Businesses that are suffering from an operating perspective are unable to get new capital, Hardie notes.
He cited recently bankrupt QualTek as an example, where he noted that prior to its filing under Chapter 11, investors had said they would not put in new money without a deleveraging transaction.
Despite his view that the US economy might tip into recession in 2024, Oh expects that for the rest of 2023, high yield’s option adjusted spread (OAS) will be “rangebound at 370-470 off,” with 550 bps off the curve as bad as things could get.
Meanwhile, Wiant is slightly more bullish on high yield, projecting modest tightening in high yield’s OAS over the balance of the year. “It may be bumpy,” he said, but ultimately demand for credit is going to prevent spreads from going much higher from where they are now. He added that, “with equity outperforming year-to-date and likely limited further fed funds rate hikes, we expect capital to flow toward credit, which appears attractive on a relative basis.”
More bearish is Peter Cecchini, director of research for asset manager Axonic Capital. He foresees a recession in late 2023 or early 2024, pushing default rates to near 8%. Commensurate with that level of defaults, he projects the high-yield OAS rising to 1,000 bps sometime in 2024.
Turning more granular for a view of investments for the remainder of 2023, one distressed market participant noted that he sees investors engaging in crypto-industry opportunities. He also sees real estate as a focus for distressed asset managers.
In particular, he said Chinese property companies have drawn attention from hedge funds. Domestically, he observes investors engaging not only in real estate debt, but for those with sufficiently large balance sheets, the physical buildings themselves.
PineBridge’s Oh is “cautious” on cyclical industrials, such as chemicals, as he believes investors are not currently being paid for the risk. Even a normally defensive sector like healthcare is too risky to invest from the top down, in his view. Rather, he recommends taking a company-specific, bottom-up approach to the sector.
Oh generally favors companies in the consumer, travel and leisure sectors. Theme parks and travel companies (such as cruise lines) also have good risk characteristics that should see them through a possible slowdown in the next year, he said.
Finally, Oh is constructive on energy, noting that while it has in the past been a “safe haven,” it currently trades too tight to be appealing. By extension, he would avoid energy service companies, pointing out that their clients — namely energy companies — have been disciplined in their spending, which has negatively impacted service company financials.
Houlihan’s Hardie sees aerospace and defense being relatively attractive as those companies are less affected by high interest rates and by inflation’s impact on wages and commodities, mostly because of the war in Ukraine.
On the other hand, Hardie considers any industry with an outsized labor component as risky. He also cited healthcare as an example, noting that it is at the intersection of two negative forces: wage inflation and government rate setting.
Wiant joined the chorus warning investors away from healthcare, noting more generally that he is avoiding sectors with “volatile cost inputs” where inflation — which he believes is “not necessarily beaten yet” — can do further damage. The auto, chemical and telecom sectors are also on his list of those he is steering clear of.
On the plus side, Wiant favors sectors that are “recession resistant and can pass through price increases.” He cited business services, software and consumer staples businesses that appeal to him. “In this market, we favor highly recurring and sticky contractual businesses with stable customer demand,” he said.
Arena’s Zwirn has been deploying a barbell strategy, putting cash to work in areas that attracted too much capital and now are priced more compellingly, as well as in distressed and special situation investments, namely in the debt of the “frothiest bubble recipients.”
Zwirn cites as examples growth companies that he has seen imploding since 2021, where he is seeking venture, “growth credit” and cash flow lending opportunities at one end, and on the other end providing funding to established companies with bad capital structures that are struggling to access capital to either refinance or reposition their business.
Regarding industries that may be especially vulnerable over the next six months, he took the opposite side of Wiant, citing enterprise software, business services and generally “businesses with high cash flow but low asset bases, because when things slow, they will as well, and they won’t have the stability or asset base necessary to bear a difficult restructuring or bankruptcy process.”
Axonic’s Cecchini sees transportation companies as very vulnerable in the current market environment. Trucking equities, in particular, are trading rich and not accounting for sector risks, he said.
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