The opportunity set for distressed investments has morphed into the most fertile environment since 2008. The China slowdown that began in 2015 appears to have marked the beginning of a new distressed cycle, and a number of factors have contributed to today’s attractive distressed/stressed credit opportunity set. After years of record inflows into credit products, markets have started to digest the beginning of an interest rate hike cycle, resulting in significant credit outflows. In 2014 and 2015, the total net outflow from high-yield mutual funds was $24 billion and $17 billion, respectively.1 Furthermore, investor demand for yield resulted in an excess of capital chasing too few opportunities as evidenced by the growth in high-yield bond issuances. The high-yield debt market is 75% larger now than it was in 2008.2 Against this backdrop of easy credit, many companies that should have been worthy of only minimal leverage were able to raise significant amounts of debt (e.g., exploration and production and commodity sectors). The resultant losses from these “true junk” investments have added to risk aversion in all areas of the market, particularly in the first few months of 2016 when investors’ risk-off sentiment, coupled with deteriorating liquidity, exacerbated a sharp sell-off.
Despite the V-shaped recovery that began in mid-February, credit spreads in high-yield continue to look attractive, and default rates continue to rise. The par-weighted U.S. high-yield default rate increased to 3.68% in April from 3.18% at the end of March, and up from 1.53% as of April 2015.3 Year-to-date through April, 27 companies have defaulted on debt totaling $37.6 billion ($31.4 billion in bonds and $6.2 billion in loans), which is only $115 million less than the total default volume in FY 2015.4 To give this some context, defaults in Q1 2016 make up the fifth highest quarterly total on record (other difficult quarters include: Q1 2009, Q2 2009, Q2 2014 and Q4 2009). While commodity-related credits have been hit the hardest, the distressed credit opportunity has expanded into non-commodity industries, such as Gaming/Leisure and Information Technology (Chart 1). For institutional investors looking to add exposure to distressed credit, there seems to be no time like the present.
Distressed Universe of the Credit Suisse High-Yield Index
Source: Credit Suisse, CS Credit Strategy Monthly, as of 4/30/16.
Distressed Universe is defined as bonds rated CC or below.
Liquidity is another important consideration for investors in U.S. credit. Illiquidity was one of the unintended consequences of Basel III and the Volcker Rule provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These changing market and regulatory dynamics, such as the elimination of banks’ proprietary trading desks, have contributed to dislocation and pricing inefficiencies in the credit market. Liquidity has declined significantly because broker/dealers are forced to reconcile new regulations that have made market-making more difficult and less profitable. As a result, dealer inventories as a percentage of the high-yield debt market have declined steadily from 4% in the summer of 2007 to less than 0.3% currently.5 However, anecdotally, small-batch trading of $10 million to $20 million in bonds still works. In fact, $5 million trades are much easier to execute than before. The deteriorating liquidity in the credit market creates an asset/liability mismatch not only for many ‘40 Act and ETF products, but also for multi-billion-dollar hedge funds. For example, it would take at least three trades for a $5-billion high-yield mutual fund with 100 holdings to enter or exit a bond position.6 Therefore, portfolio managers are thinking twice and underwriting to a wider margin of safety before adding a new position. To cope with illiquidity, many large distressed-debt firms have launched drawdown-style funds with five-to-eight years of lock-up periods. This type of pseudo-private equity vehicle allows hedge fund managers to properly align and size distressed-for-control investments that require a longer investment horizon (versus the standard quarterly liquidity with 90-day notice) to maximize value. However, for institutional investors that prefer quarterly liquidity, their best bet would be to invest in credit through nimble hedge fund managers.
High-Yield Debt and Loans in Default
Source: Bloomberg and PAAMCO, as of 3/31/16.
The abundance of under-followed, middle-market distressed opportunities should encourage institutional investors to seek smaller hedge funds in order to take advantage of the current credit market dislocation. The bulk of stressed and distressed debt opportunities today reside within middle-market companies; 69% of all stressed high-yield issuances have a notional size of $500 million or less.7 Similarly, 63% of defaulted high-yield debt and loans have an issuance size of $500 million or less (Chart 2). As a result, large credit funds would run into sizing constraints when investing in a majority of these distressed situations. For example, a $2-billion credit fund would have significant difficulty accumulating a 5% position in a $300-million issuance because this fund would need to own 48% of the total issuance if bonds are trading at 70 cents. In a more distressed scenario, where bonds are trading at 20 cents, a $2-billion fund could only create a 3% position by owning the entire $300-million issuance. Furthermore, these middle-market trades usually flow through Tier 2 and Tier 3 dealers (e.g., Imperial Capital, Stonecastle Securities), which are less utilized by large multi-billion dollar hedge funds. Research coverage is also scarce with only one or two sell-side firms. Consequently, these middle-market credit names are usually under followed by large hedge funds and mutual funds, whereas the multi-billion dollar bankrupted credit structures, such as Caesars Entertainment Operating Company ($18 billion) and Energy Future Holdings (or TXU Corporation, $36 billion), are somewhat crowded.8 The risks in the latter are twofold. First, institutional investors’ credit hedge fund exposures may be less diversified than intended because several large hedge fund managers may own the same position names and thus have similar performance. Second, these exposures can be subject to mark-to-market losses from technical selling pressures if hedge funds were to be forced to exit positions to meet redemptions. Without proprietary desks or dealers stepping in, these bonds could hit “air pockets” and trade down 5-10 points per day for multiple days in the absence of any company-specific news. This is what happened in January and early February this year.
The elevated level of volatility in the high-yield bond market and the rise in the number of bankruptcies have expanded the opportunity set for the distressed hedge fund strategy. The speed and severity of the credit market sell-off in January and February highlighted some interesting points about the current, post-Dodd-Frank trading dynamics (e.g., lower trading volumes, wider bid/ask spreads, etc.). Ultimately, this type of trading environment provides attractive opportunities for event-driven credit portfolios that are relatively small and nimble. The current distressed cycle is more middle-market centric and therefore is better served by smaller hedge funds (i.e., under $1 billion in assets under management).
1Source: Lipper Fund Market Information.
2Source: Credit Suisse, CS Credit Strategy Monthly, as of 4/30/16.
3Source: J.P. Morgan, High-Yield Market Monitor, as of 4/30/16.
4Source: J.P. Morgan, High-Yield Market Monitor, as of 4/30/16.
5Source: Federal Reserve Bank of New York, Primary Dealer Statistics, as of 4/30/16.
6For illustration purposes: On average, a position for a $5 billion hedge fund with 100 positions is $50 million. Assuming the manager was able to trade two $20 million block trades, it would need to do another trade to accumulate $50 million in a bond.
7Source: Bloomberg, as of 3/31/16. Stressed credit is defined as having a YTM greater than 1,000 bps and trading under 90 cents.
8For example, Paulson & Co, Mason Capital Management, Soros Fund Management, Silver Point Capital, and Canyon Capital Advisors were the five largest hedge fund holders of the Caesars Entertainment Corporation equity, according to the Q1 2016 SEC Form 13-F filings.
Raina Dong, CFA is an Associate Director in Portfolio Management at PAAMCO. She serves as the Roundtable Head for the Distressed Debt strategy.
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