Bankruptcy wave opens up opportunities in distressed securities
Distressed securities, which include stocks, bonds or other debt instrument of companies going through financial or operating difficulty, form an investment niche because of the specialised knowledge required, and this looks increasingly appealing thanks to a number of factors.
Raw materials are plentiful
We have seen unprecedented levels of growth in US high yield issuance. The issuance seen between 2010 and 2015 is almost double that seen during the last credit cycle (2003 to 2009, see Figures 1 & 2 below).
Historically, periods of elevated high yield issuance have been followed by increased levels of assets entering into bankruptcy. The record recent levels of high yield issuance suggest that the raw materials required for another bankruptcy cycle are in place. In addition, over the first nine months of 2016, the assets going into bankruptcy were over 30% higher than any other full-year period since 2009.
Lower quality issuance has boomed
This high yield wave has been characterised by high levels of low quality issuance. During 2015 over 40% of high yield issuance was in B or CCC bonds. Typically, four years after issuance almost 25% of B instruments and 45% of CCC rated bonds have defaulted, according to Edward I. Altman of the NYU Salomon Center (31 December 2015).
Central bank policy and the low interest environment have meant that low quality issuance has been supported by investors’ hunt for yield. Firms have been successful in pushing out their maturity dates as a result of this backdrop, meaning that we are well past the four year mark for a number of these securities. Any kind of disruption to this market environment, such as a slowing credit market or even a moderate rise in interest rates, may have significant consequences for these lower quality instruments.
Huge wall of maturities coming due
Within the next five years, there is over $1.5 trillion worth of high yield bond and leveraged loans that will mature (see Figure 3). Even under the most benign market conditions, some proportion of this debt will need to be restructured, which will present plenty of good opportunities for investors in distressed securities. Add to that the potential for interest rates rises, where refinancing may become more of a challenge for highly leveraged firms, and there will be a wealth of opportunities in the distressed market.
The energy sector is leading the way
The energy sector is leading the rise in distressed securities. Although oil prices are on the rise, they are still at less than half their peak levels and many energy firms are experiencing distress due to unviable operating models at current price levels. Moreover, fluctuations in demand from China have created significant turmoil in other natural resources, mining and metals securities.
Over the last few years, the energy sector has grown to make up almost 20% of the high yield market in the US, with a market value of around $140 billion. As is typical for a fast-growing sector, capital has been allocated poorly into lower quality projects that had only made sense in a higher price environment. This presents a huge opportunity set for a distressed investor, as around half of that issuance ($70 billion) is either trading at stressed/distressed prices (below 70¢ on the dollar) or has already defaulted.
We expect the distressed opportunities in the energy sector to continue for at least the next year, but think the best prospects will gradually shift from the pre and mid-restructuring debt to the post-restructuring equities. We are seeing an increasing number of oil and gas companies emerge out of Chapter 11 bankruptcy with much-improved balance sheets and valuable oilfields. We also expect to see an increasing number of opportunities in the oilfield services sector, both in pre-restructuring debt and post-restructuring equity.
It’s not all about energy
The opportunity set is not confined to the energy sector. Even now, 75% of the debt trading below 50¢ on the dollar is from other sectors. Further to this, 70% of the Q3 2016 Chapter 11 bankruptcy filings have come from sectors outside of oil and gas. In particular, media, telecoms, commodities, retail and healthcare have all provided increasing distressed opportunities as the selloff in energy has reminded investors of the perils of investing in highly leveraged firms.
The impact of rising interest rates
Deeply distressed securities, many of which are already in default, are largely immune to interest rate movements. Moreover, rising interest rates have the potential to further increase the number of distressed opportunities in the market. This will happen in two ways. Firstly, troubled companies that have barely been able to make their interest payments, in this era of rock-bottom rates, will find it increasingly difficult to service their debt. Secondly, interest rate hikes are likely to create volatility and reduce investor confidence in the high yield bond market, making it more difficult for marginal companies to refinance.
How will this bankruptcy wave compare with previous cycles?
We do not expect the current bankruptcy wave to be as extreme as the sharp and short cycle we saw in 2008/2009 following the global financial crisis. We expect that it will be most similar to the 2000-2003 bankruptcy cycle, stretching over three and four years, with a more gradual but continuous stream of opportunities becoming available during that period. This will provide opportunities on both the long and short side as the cycle progresses.
The impact of Trump
While it is still too early to tell, the election seems to be having a positive impact on many distressed sectors including financial services, coal and construction, which could all benefit from deregulation and increased government spending on infrastructure. Other sectors, such as healthcare, could be negatively impacted and provide distressed investors short selling opportunities. It is also quite possible that volatility in the high yield markets may increase under the Trump administration, which would create additional gain potential in distressed securities.
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