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Aon Retirement and Investment Blog

Reassessing the Opportunity in Distressed Debt

Spiking corporate defaults and historically wide credit spreads served up a host of compelling opportunities for distressed debt managers in 2009 and 2010, producing robust double digit gains for investors. Since then, the default rate has dropped significantly, leaving investors with fewer opportunities to profit from restructurings, particularly in the U.S. At the same time, the distressed situations that arose in the wake of the global financial crisis are now closer to fruition. Many hedge funds with exposure to the Lehman Brothers liquidation, for instance, are choosing not to reinvest in the claims as they’re paid off through distributions.
While a relatively limited distressed opportunity set argues for more tempered return expectations, several factors unique to this cycle--such as an uneven economic recovery and continued bank deleveraging in Europe--continue to present compelling opportunities for managers with the expertise and resources to uncover them. 
Distressed outlook dimming…
Given today’s relatively benign corporate default environment, the distressed investment landscape appears less fertile than it did just a few years ago. Low interest rates and a healthy investor appetite for yield have allowed leveraged companies to refinance their debt and extend near-term maturities, resulting in far fewer defaults. According to Moody’s, the trailing 12-month global  speculative corporate default rate has hovered below 3% in recent years—down from a peak of 13% in 2009 and below long-term averages—and isn’t expected to rise materially in the near-term. In the U.S., high-yield and loan default rates increased in April (above 2% and 4%, respectively), due to the bankruptcy filing by Energy Futures (TXU), the largest high-yield default on record. But that event had been long-anticipated, and market observers don’t view it as a harbinger of increased default activity to come.
Meanwhile, investors have grown accustomed to accepting slimmer yield premiums for taking on more credit risk. By the end of June 2014, the average option-adjusted spread over Treasuries for high yield bonds tightened to less than 400 basis points, which is below historical norms. In absolute terms, the average yield on high yield debt once again reached all-time lows last seen in May 2013, with the yield to worst on the Barclays U.S. High Yield Bond Index dipping below 5%. With market volatility low and valuations tight by historical standards, distressed debt managers could also suffer setbacks if volatility picks up amid renewed risk aversion. Many distressed funds struggled for similar reasons during the Eurozone sovereign debt crisis’ escalation in 2011.
…but not snuffed out.
Despite these challenges, we think certain distressed debt managers are well equipped to continue to provide attractive returns in the current climate. Although the best time to invest in distressed debt is typically when defaults approach their peak, credit trouble in specific industries, sub-industries, and individual companies continues to crop up between larger cyclical default waves, a period that can last several years. The current environment favors managers with an established global presence and the skill to delve into complex capital structures and legal terms. Such traits give managers an advantage in sourcing investments and performing the detailed analysis required to be successful as more obvious opportunities become scarce.
Ripple effects from the credit crisis should also continue to provide fodder for distressed debt strategies. For instance, slow growth in the developed world could continue to put pressure on highly-leveraged companies that need to see stronger growth in order to maintain their capital structures. A couple of areas that have garnered some attention from distressed managers recently include the retail and energy sectors, where ongoing shifts in consumer behavior and the impact of the U.S. shale boom present headwinds for some companies. 
Regulatory changes in the U.S. and Europe have also made it costly for banks to hold less liquid or more complex loans, and many of these borrowers will need to refinance their debt in coming years. European banks have further to go to comply with regulatory requirements than their U.S. counterparts, and many have been shoring up their balance sheets in preparation for the European Central Bank’s Asset Quality Review, the results of which will be released in the fall of 2014. Many distressed debt managers have already begun to deploy capital in the region in light of a dearth of opportunities in the U.S.
In addition, remnants of investments left over from the credit crisis still hold prominent places in many distressed portfolios—whether liquidation claims or post-reorganization equities—suggesting those opportunities have not fully run their course. The Lehman Brothers liquidation in particular has continued to fuel distressed debt hedge fund returns in 2014, more than five years after the company filed for bankruptcy, as recovered proceeds continue to exceed initial expectations.
Granted, distressed debt funds can perform poorly in the late stage of the credit cycle, when credit and liquidity premiums increase dramatically. But while market leverage statistics and issuance trends have begun to deteriorate in recent years, they haven’t yet approached levels that preceded prior downturns. Managers that ply a more flexible approach can also dampen the impact of broader market moves, whether through their ability to identify truly catalyst-driven, idiosyncratic opportunities or utilize the flexibility to short individual credits, employ hedges, or raise cash to protect against market downdrafts.
 Miriam Sjoblom is a U.S.-based Senior Consultant in Hewitt EnnisKnupp’s Liquid Alternatives Group.

The information contained above is intended for general information purposes only and should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only. 

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