Distressed still not de-stressed
As in equity markets, Caroline Hay finds that the big bounce in distressed debt and leveraged loans since the lows of last winter raises as many questions as answers
Like other asset classes, leveraged loans experienced its most shocking period as 2008 drew to a close. "After the highs of late June 2007, we started to detect the first signs of concern," recalls Matthew Craston, co-head of leveraged loans at European Capital Management (ECM), "and the market took a few lurches downward. It seemed to recover over the next few months, until the Lehman collapse when leveraged loans, along with every other credit class, got caught in the ferocious downswing, and landed at an appallingly low base."
Of course, as with credit, the near-panic selling pushed loans too far down. "By the end of 2008, and as we entered 2009, both [leveraged] loans and the high yield (HY) markets reached a massively oversold position and presented a really compelling opportunity," agrees James Shanahan of JP Morgan Asset Management. Investment grade (IG) and then HY had already started to rally and loans followed in early
January. "These market rallies got serious legs, and sharply accelerated, on the back of the equity market rallies in mid-March," recalls Shanahan.
The opportunity set in distressed debt (DD) is described by Shanahan as "an organic subset of HY and leveraged loans (LL)". He points out that no company goes out to issue DD - something usually goes wrong to upset its plans, whether that be a market adjustment, a cyclical development, or just a case of a good business finding itself with too much bank debt. "So the company's bonds trade a discount, often really deep, with very high yields and in some cases, but not all, the company actually defaults on its payments."
As Mark Unferth, head of distressed strategies at CQS, puts it: "In many cases, good companies have inappropriate capital structures, and over the last few years there was a clear mismatch between capital structure and underlying business models."
In Europe, using CCC-rated bonds as a reasonable proxy for distressed debt, these assets lost more than 60% of their value from the highs of July 2007 through February 2009. However, like its near relatives, HY and LL (where spreads have gone from peaks of 2,200 basis points back to about 750), distressed debt has since soared. With values having recovered so much, are there any good opportunities still left?
"The very easy money, most of the beta, is probably behind us," affirms Shanahan. "We're clearly now seeking to add alpha by careful security selection and analysis; it's more about emerging tactical opportunities. Our outlook is very much like that of a contrarian value-oriented equity investor. We're buying assets, in fact debt claims against assets, that are trading at a discount to current value."
For Iain Burnett, co-head of distressed debt at BlueBay, 2009 may well have seen market prices recover, but he remains unconvinced that all is well. "In our view, we are far from the end of the banking sector shrinking in size and recognising losses," he says."In the years leading up to the crisis, bank balance sheets experienced phenomenal growth fuelled by short-term debt and largely invested in poorly understood assets. We do not feel that the bank lending market is fully functioning in our particular section of the corporate market and argue that we could have to endure several years before the banks have ‘recovered' and are in a position to lend to the same extent again."
This state of affairs denies companies a critical source of funding, and paints a bleak picture for much of corporate Europe: "The IG market has recovered," says Burnett, "and HY has a better feel, but relatively few corporates have access to these markets. Much of corporate Europe is starved of debt capital right now and is responding by cutting costs squeezing working capital and reducing capex. These businesses will face a big challenge to fund growth when macro-economic conditions improve."
Unferth agrees: "While 2009 has been a banner year for credit generally and particularly for distressed debt, we expect large, looming bank loan maturities starting late next year will present further opportunities," he says. "Market perception of a double-dip recession could also result in less accommodating markets for refinancing and a substantial increase in corporate defaults."
ECM's Craston believes that although leveraged loan returns are unlikely to post future returns anything like 2009's 40%, he believes that there are good returns to be had in 2010. However, he remains cautious. "In much the same way that the collapse was clearly overdone, I would contend that the sharp rally is also overdone," he says. "[Leveraged loans] is essentially a credit market that has arisen from private equity investment, 90% of which was LBOs, so most of it is extremely sensitive to the business environment, and we would argue that the jury is still out as to just how strong a recovery we will end up experiencing."
In Europe, in 2009, loan issuance diminished in significance, particularly at the top end of the sub-investment grade sector (BB), and it has been overtaken by HY issuance. "I believe that this [BB rating] is as ‘low' as the HY market will go, and I, personally, do not foresee greatly increased issuance of HY bonds rated B+ or B-," says Craston. The move has actually benefited loans, as much of this issuance has been used to repay loans at par, he continues. He explains that the secondary market in loans has experienced a positive effect from the demise of CLO issuance as reinvested monies, not permitted to purchase bonds, have turned to the secondary loans market for investment.
Although both leveraged loans and distressed debt have exhibited close correlations to other credit markets over the past 18 months or so, investment managers are not suggesting that this will continue to be a feature. "We have an event-driven approach," says Roman Zururtuza, head of European distressed and special situations at Gruss Asset Management. "Distressed investing is about buying undervalued securities - normally deeply discounted bonds and loans - in companies undergoing difficulties, with a view to benefiting from financial restructuring, operational turnaround or a liquidation. To the extent possible, we hedge out market and other risks which affect our investment. Hence our risk and our returns tend to be associated with the restructuring catalyst, rather than the business cycle."
One hot topic is the so-called ‘wall of refinancings', the huge glut of deals completed between 2005 and 2007, which are coming up for refinancing and restructuring between 2011 and 2014. "Now that we are in the downturn, it becomes a lot clearer to see what deals are not going to work," says Burnett. "2009 has seen many restructurings agreed involving covenant resets or repayment deferrals, with the aim of postponing write-downs until a later date. Like putting a sticking plaster on a gaping wound. "
Burnett believes that the distressed debt market is entering a period of huge opportunity. He says: "We are long-term investors, looking out two-to-three years and we want to put in proper capital structures; buying distressed debt is essentially a de-leveraging transaction which, in today's hugely leveraged world makes good sense."
The managers at Gruss believe that markets could remain volatile with higher effective default rates and lower recoveries than in previous cycles. Zurutuza and his colleagues are, however, prepared to be patient, especially in Europe where restructuring activity has been low thus far. They believe that there will be plenty of restructurings and that when they come, the rewards for the careful and the diligent will be high.