It has been a challenging year for distressed investors, with most portfolios in the red, according to market sources. But a weak return in one year is often a springboard to better returns the next. The question facing distressed players is whether the mix of historically high inflation, rising fed funds rates and a slowing economy can create buying opportunities in 2023, and if so, where.
Climbing walls
With 2022 almost in the books, the S&P 500 is off around 16%, with the Nasdaq down nearly twice that. Leveraged debt indices, while also losing ground, are faring much better. The ICE US high-yield index is off around 9% this year, while leveraged loans are down just 80 bps, per the Morningstar LSTA US Leveraged Loan Index.
For market-neutral strategies, through November the HFRI distressed/restructuring index is down 3.4% and the special situations index is off 4.9%. Reflecting the better side of market-neutral, the merger arb index is up 1.6%.
Distressed investors looking ahead to 2023 and beyond can check two key yardsticks to gauge the potential volume of upcoming distressed opportunities, namely the maturity walls for high-yield bonds and leveraged loans. A dovish Fed and the massive liquidity injection since 2020 drove down yields and enabled a wide swath of leveraged debt issuers to refinance, extending maturities while lowering the cost of capital.
In high yield, combined maturities for 2023 and 2024 total only around $115 billion. That’s not much. But then, omitting the potential impact of maturity-extending refinancings, 2025 has $171 billion coming due, followed by a series of $200+ billion maturity years.
The leveraged loan market maturity wall is equally height-challenged over the next two years, with $106 billion of loans in the Morningstar LSTA US Leveraged Loan Index coming due in that period. But as with high yield (and again assuming no refinancings), 2025 may offer a richer target set for distressed investors, with loan maturities in the index leaping to $203 billion, while 2026 and 2027 each hold roughly $240 billion of maturities.
Default landscape
An inverted US Treasury yield curve has historically been a warning sign of impending recession. The US 10-year Treasury yield has been below the 2-year yield since July, with the inversion exceeding 80 bps in December, a degree not seen since 1981. But while that screams recession, not everyone sees it that way.
Barclays expects a “mild” recession starting in 2023’s second quarter and lasting until year-end. On the other hand, Morgan Stanley projects no recession at all in its base case, saying “the US skirts a recession in 2023 but GDP growth remains muted well into 2024 as the cumulative effect of rate hikes becomes apparent.”
As for the economy’s effect on leveraged loans, Morgan Stanley’s base case is leveraged loan defaults at 2.5-3.0% and high-yield defaults reaching 4.0-4.5%. Barclays forecasts both leveraged loans and high yield reaching default rates of 5-6%. The investment bank believes that, following the debt market house-cleaning of the hyper-liquid pandemic, “the remaining universe is fundamentally in better shape and should help limit the extent of defaults in the near term.”
Although it would take a flurry of defaults for the leveraged loan market to reach even the low end of the investment bank predictions, if those numbers are attained there will be plenty of investment opportunities for distressed players. For perspective, the Morningstar LSTA US Leveraged Loan Index has around $109 billion in loans currently priced under the distressed horizon of 80 (as of Dec. 12), and its default rate was 0.73% at the end of November.
As for the US high-yield market, Barclays projects option-adjusted spreads (OAS) topping out at 700-750 bps in 2023’s first half, before tightening to 500-525 bps by year-end. On the other hand, without a recession, Morgan Stanley’s base case foresees high-yield spreads widening to only 575 bps by year-end 2023. The bank anticipates the worst of the earnings slowdown passing by the end of 2023’s first half as the Fed pivots to cutting rates.
Crystal ball
The distressed community harbors a range of expectations about a potential recession. One distressed investing veteran of multiple economic cycles sees the US entering a long-running recessionary period akin to 1974-1981. He expects Jerome Powell’s Fed to take its foot off the brakes too soon, lowering the fed funds rate and allowing inflation to rise again. With a resurgence of unions and the current tight employment picture, he believes that could ignite a classic wage-price spiral.
If he’s right, the Fed would launch a new round of tightening, but he fears that the central bank may not keep rates high enough for long enough this second time around, either. He projects a tightening/loosening cycle driving high yield’s OAS to 1,000 bps at its worst.
Seeing a less extreme outcome are a trio of asset managers. Agreeing with Morgan Stanley is portfolio manager Chris Paryse at family office Foxhill Capital, who does not see the US entering recession during this rate-rise period. Rather, he anticipates a slow-growth domestic economy for a few years. “Dicier credits will have problems, and there will be some distress out there, but not a flood,” he said, translating that view into a high-yield market that gets no worse than an OAS of roughly 600 bps.
Jeremy Burton, portfolio manager at asset manager PineBridge Investments LLC, anticipates a “headline recession ahead,” which he expects will be “mild,” but he does not see a “deep or sustained slowdown.” He projects default rates for both leveraged loans and high yield going no higher than 4%.
Also expecting a mild recession is Capital Four US CEO and portfolio manager Jim Wiant. He sees the default cycle in both bonds and loans being “benign” and not reaching above 3-4% in this down cycle. He notes that the combination of many companies having adequate liquidity, and the propensity for banks to execute amend-and-extend transactions, is likely to keep default statistics low. But he cautioned that if the fundamental macro environment doesn’t improve, three to four years from now it could prove tough for markets.
Classics
Shifting focus to the specific from the general, Houlihan Lokey managing director Surbhi Gupta sees a particularly attractive opportunity set in the middle market (which she generally defines as companies with less than around $1 billion in debt).
Gupta is watching leveraged companies in this space, especially those that were financed during an era of 5-6x — and higher — leverage multiples, experiencing stress as they attempt to withstand the multi-barreled onslaught of supply chain issues, inflation-driven costs, labor shortages, higher interest rates and constricted capital markets. While she noted that the middle-market troubles are “agnostic to sector,” Gupta said that TMT (technology, media and telecommunications), healthcare, and consumer/retail are prominently on the radar.
As busy as the middle market may be, the long-time distressed investing veteran mentioned earlier does not currently see much in the way of classic distressed opportunities. While he concedes that there are certainly challenged businesses, like movie theater chain AMC Entertainment, the market is devoid of the “good company bad balance sheet” situations that are classically the heart of distressed investing. He anticipates that changing in 2023.
While he’s waiting, one sector that he has been focusing on is crypto, a troubled arena where, he says, many others fear to tread. Jeff Marwil, head of the restructuring practice at law firm Proskauer Rose LLP, concurs about the opportunity, saying that “crypto has crept its way into the mainstream, and we expect more activity in that space to come.” However, Marwil currently sees crypto as more of an opportunity for lawyers than for financial advisors and investors, though he expects investors will warm up to the space over time.
PineBridge portfolio manager Burton believes that we have no comparable market to look back at for investment guidance. “We’ve never seen an environment like this, with low bond coupons, high inflation, and a slowing economy,” he said. Meanwhile, he too sees a relative lack of classic distressed investments in the market, which he believes is a result of the “mini flush-out” of weaker credits during the 2020 market swoon.
Coupling that downdraft with the refinancing wave that pushed out the high yield and leveraged loan maturity walls, there isn’t much raw material for deeply distressed investments to develop, Burton said. He also noted that during the high-yield OAS’s recent move into the high 500s, buyers came in, both quickly and in size, killing off the chance for distressed players to find many fresh ideas.
Convexity’s floor
Given the current lack of deeply distressed opportunities, Foxhill Capital’s Paryse has been seeking and finding stressed situations in the high-yield market. He has been identifying bonds trading over 10% from issuers that he deems unlikely to file for bankruptcy protection. He sees companies with debt trading in the 60s and 70s that are marked there simply because of the high convexity of their relatively low-coupon bonds, set when the market was issuing record amounts of paper near all-time-tight spreads.
Paryse anticipates that as longer-term yields stabilize or even decline over the next 12-18 months, he will profit from the coupon, and potentially from capital gains as yields descend. Supporting his strategy, Paryse said that low dollar price bonds have an inherent floor as long as credit quality doesn’t deteriorate, therefore limiting further price declines even if the market’s spread keeps rising.
Barclays said much the same thing, opining that “[bond] prices are unlikely to go well below implied recovery levels.”
Another market that has Paryse’s attention is private debt, which he said was originally attractive to buyers because of its yield proposition. But in the current rate regime, yields on higher-quality public high-yield debt is now in the same general zip code that private debt once inhabited.
Paryse believes that all things equal, investors are more likely to prefer public debt, forcing private debt yields higher to attract capital, and hamstringing current borrowers who need to refinance or restructure as their floating-rate debt becomes more expensive. He expects that will create opportunities to invest at favorable risk-rewards.
As for sectors, Paryse sees retail as a target, especially apparel and home goods companies. He also sees potential weakness in Western European industrial companies. He added that given the cost of energy in Europe, energy-intensive businesses there, such as paper/packaging and chemicals, could become distressed in 2023 and demand attention.
PineBridge’s Burton said he would overweight defensive sectors, such as healthcare. Food and beverage and software are other sectors he is considering. While he views the energy sector as having performed defensively this year, Burton said that its dependence on China generating sustained demand through 2023 raises questions about whether that will continue.
Opportunity knocks
Capital Four’s Wiant believes that there are opportunities in stressed high yield, since “in many sectors, the baby has been thrown out with the bathwater.” He explains that investors are not making distinctions within sectors, resulting in healthy companies being punished along with those actually deserving of harsh treatment.
He cited consumer-facing companies as an example, noting that companies producing discretionary products sold to lower-end consumers are faring worse operationally than companies catering to higher-end consumers, yet the markets are painting all of them with the same brush. He mentioned pet-product companies as a sector that offers opportunity, while he has been avoiding toy, apparel and home furnishings.
Proskauer lawyer Marwil has been seeing investor activity in the commercial real estate sector, especially office buildings. He thinks that class-A properties will end up being relatively safer investments, noting that class-B and C spaces may have valuation issues that could hurt the ultimate recovery to lenders.
Seeing opportunities in commercial real estate debt is Arena Investors LP CEO and chief investment officer Dan Zwirn. But like Marwil, Zwirn cautions that only the best of the class-A properties are worth digging into at this point.
On the liquid investing side, Zwirn has been trolling for opportunities among busted converts using equities and derivatives to improve the positions’ risk-rewards.
Zwirn also said his firm is investing in structured private convertibles and selectively buying or financing LP or GP interests in private equity and private debt investing partnerships in the secondary market.
