The number of high yield bonds and leveraged loans trading at distressed levels is on the rise.1 Although, that may not come as much of a surprise, given the current macro environment headlined by geopolitical turmoil, stubbornly high inflation, an energy crisis in Europe and a slowing global economy. A similar situation unfolded in 2020 as the COVID-19 pandemic was at its peak, but proved to be short-lived due to the abundant fiscal and monetary stimulus that was injected into the global economy.
However, signs that another distressed cycle could be underway are mounting, especially the longer it takes the Federal Reserve (Fed) and other central banks to rein in inflation. This isn’t great news for the economy, but it does excite distressed managers who have near-record levels of dry powder, as shown in this week’s chart.
Taking a step back, the distressed asset class has evolved markedly since it emerged over 30 years ago — when credit investors would purchase corporate bonds at severely depressed prices, betting they would bounce back. The investment universe has since grown to include other forms of debt such as bank loans, non-U.S. debt and real estate-related debt.
Distressed investing doesn’t just include debt either. Investors will often seek to invest further down the capital structure and some investors will employ a more hands-on strategy called “loan-to-own” — acquiring a distressed company’s debt with the goal of taking control through bankruptcy proceedings. The most meaningful growth in corporate debt occurred following the global financial crisis (GFC) of 2007-09, when countless non-banks (notably alternative asset managers) entered the origination space as traditional banks sought to reduce exposure, particularly to middle-market companies.
Although the private debt market comes in many flavors, a subset of the asset class will focus on distressed and special situations — and will often work closely with management of struggling borrowers to structure privately negotiated credit solutions through transactions such as debtor-in-possession financing and bridge loans.
All told, the amount of corporate debt in the U.S. and abroad has exploded since the GFC. According to data compiled by Oaktree Capital Management, the total amount of high yield bonds, BBB-rated bonds, leveraged loans and middle-market direct loans outstanding globally has risen to $12.2 trillion, more than four times the level in December 2007.2
Although default rates are still near long-term averages, signs of distress are becoming more apparent. S&P Global Ratings’ U.S. Distress Ratio, a measure of risk in the bond market that tends to anticipate movements in U.S. default rates, jumped from 4.3% in June to 9.2% in July, its highest level since October 2020.3 Rating agencies are taking notice as well. The ratio of downgrades to upgrades in the U.S. Leveraged Loan market has quadrupled to 2.28x for the rolling 3-month period ending Sept. 30, 2022, according to Leveraged Commentary & Data.4
Rates have risen this year at an extraordinary speed. The yield on the 10-year Treasury bond, which serves as a benchmark for borrowing rates, rose from 1.512% to start 2022 to a high of 4.234% as of Oct. 24, the highest level since 2008.5 Although it’s uncertain how high rates may climb, what is certain is that a growing list of struggling companies are now confronted with higher debt-servicing costs in the face of a worsening demand environment.
More downgrades and distress could force banks, collateralized loan obligations (CLOs), mutual funds and other institutions to sell. As referenced earlier, distressed companies are also likely to continue looking to the private market for rescue financing. This is all to say that the opportunity set for the distressed asset class could be substantial if the situation continues to deteriorate.
Key Takeaway
The investment universe has grown considerably over the past few decades but it has also become increasingly complex. Distressed investing can vary from a purely trading-oriented strategy to a longer-term, private equity-like approach of acquiring distressed companies, taking control and structuring a turnaround. There are also hybrid managers who have expertise across the spectrum, which affords them the ability to be more opportunistic.
In the event that we’re entering another distressed cycle, it seems there will be a lot of competition given the record level of dry powder available. It’s unclear how severe or prolonged the next cycle may be, so investors will need to perform thorough due diligence before selecting a manager and be willing to stomach the illiquidity that comes with investing in the asset class. I suspect that greater dispersion of returns will be generated by distressed managers than we’ve seen historically.
Sources:
1Source: The Economist- Distressed-Debt Investors are Preparing to Pounce; 9/1/22
2Source: OakTree- The Roundup: Top Takeaways From Oaktree's Quarterly Letters- 3Q2022; 9/27/22
3Source: S&P Global Ratings- Default, Transition, and Recovery: The U.S. Distress Ratio Accelerates To highest Level Since October 2020; 7/21/22
4Source: PitchBook- Leveraged loan default rate, distress ratio climb amid volatility; 10/4/22
5Source: CNBC- U.S. 10 Year Treasury; as of 11/1/22
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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