Given the problems in Europe, distressed debt would appear to be all the rage, writes Joel Kranc. But waiting out events might prove to be even more lucrative
Global contagion. Crisis. Fallout. Apocalypse. There is no end to the adjectives being used to describe the situation that the euro-zone currently finds itself in - with little relief in sight.
Towards the end of 2011, leaders from the 17 key euro-zone countries gathered together to fend off any break-up of the union and provide assurances to markets that progress would be made in shoring up funding for countries in need. Despite the UK’s decision not to sign on, other leaders agreed to widen EU treaty changes that would penalise countries for missing the debt-to-GDP ratio of 3%. Markets wondered if this was the action needed to head off major economic meltdown, or if it was merely another stopgap. Coupled with that is a global economy that has barely recovered from the 2008-09 credit crisis and signs of slowdowns in China and other parts of Asia.
Where is the opportunity?
It is under that dark cloud, the lack of available funding for many companies in need, as well as the desire of banks to remove their unwanted debt from their balance sheets, that offers an opportunity for asset managers willing to take a chance on the euro-zone might have opened up.
Diana Monteith, a senior analyst responsible for convertible bonds and distressed debt at Loomis, Sayles & Co, says that there are opportunities within the distressed debt market whether the euro remains intact or not.
“Our view is that the euro will survive,” she says. “But if it doesn’t, by definition, there is going to be a massive amount of opportunity. If it stays together, what we’ve seen is a step forward, two steps back. It’s difficult for Europe to quickly come up with a solution and often the market will like what is said for a day or two and then pull back. That environment makes it difficult for companies to finance or refinance existing debt. So that kind of volatility can often create opportunity.”
Loomis, according to Monteith, is comfortable investing in CCC bonds. Others agree, and feel the timing is right for distressed debt investing.
“We believe it’s a tremendous time to be thinking about it and indeed committing capital to the space,” says Damien Miller, portfolio manager with Alcentra, a specialist in sub-investment grade US and European loans and bonds. “Compared to where we were nine months ago, or a year ago, you have a scenario where debt that was issued at par is now trading at 70 and sometimes lower. You’ve had a huge re-pricing of credit that has been driven for a variety of reasons.”
But the volatility of the situation in response to everyday headlines makes it difficult for investors - even of distressed debt - to know when the timing is right.
To raise or not to raise?
It is not clear, even with the perceived amount of opportunity available in the distressed debt market that a lot of capital is currently being raised. Some in the industry believe capital is too difficult and expensive to raise, given the complexities of the market.
“I think everybody is struggling right now to raise any capital because the markets have gotten so confusing people are not willing to put capital at risk when there is a tail event which could be bigger than Lehman,” says Scott Gibb, managing director with hedge fund firm Cube Capital.
He adds that even in the post 2008 environment, only about 15-30 funds were launched dealing with European credit and distressed debt. “A lot of them were launched with stringent terms - two-year locks, two-year rolling locks - quarterly gating, things like that, because these guys thought they were going to need time to work out what it was they were going to be able to buy from these banks.”
In other words, investors in the distressed space still wanted time and assurances for their trouble - something they are likely to want in the current environment as well.
For those not sitting on the sidelines, the opportunities appear to be both on the periphery as well as in the core countries of the euro-zone. Obviously, countries such as Greece, Spain, Portugal and others have generated the most headlines and have had to address their economic woes more publically than others. But opportunities might not necessarily lie in the geography or region.
Monteith says it is not based on geography but, rather, on market cap. “Some of the bigger companies that have issued a lot of debt are the most buyable, and those are some of the companies that have been hit the hardest,” she adds.
She also notes that some of it is technical. “If you have a company that is investment grade but falls out of the investment grade index - you’ve got a lot of forced selling and you’ll see a lot of opportunities there. You’re also seeing banks selling whole loans in the secondary market and that can create opportunities.”
One of the issues that has perhaps been a problem for investors outside of Europe is the lack of coherent insolvency policies throughout Europe. Unlike the US, European countries have a patchwork of bankruptcy laws and regulations that make investing in distressed debt and high yield offerings difficult.
Says Gibb: “Each market is different and you have to know how creditors are treated in each country. If you are to successfully navigate playing distressed in Germany, France, Spain, UK, the Netherlands and Sweden, it’s not that you can’t do it, it’s the fact that you have to understand the system to be able to price whether it’s a good or bad distressed opportunity to play.”
To others, like Miller, the complexity of the environment itself creates a further opportunity for investors. He says the lack of a “clean” structure like that in the US can be a negative to some because they are not confident about the rules of engagement.
“I think that’s a positive because it adds an additional layer of complexity and that additional layer of complexity helps to cause assets to become more mispriced than they otherwise would be in the US,” adds Miller. “It’s that mispricing of assets, because of the more complicated nature, that makes for, in our opinion, a potentially more attractive investment proposition.”
Back to the future
All the steps taken thus far by the euro-zone countries and central banks worldwide have done little to curb the fears of investors. Small steps have been taken that result in short rallies and longer-term down cycles. Amid this, investors seeking to make gains on the backs of distressed debt and high-yield credit are looking for the opportune time. Some believe it is now, while others are waiting.
Unfortunately there are no crystal balls to predict the next milestone or event. One thing is certain, however - banks are no longer are interested in financing companies and those companies are in need of available cash. The companies in Europe that need private funding for their financing will have no choice but to continue to pay handsomely for that privilege.