Debt and equity markets experienced a battering in 2022’s first half unlike any since 2020’s pandemic-driven market swoon. The Nasdaq, S&P 500 and ICE BofA High Yield Index bottomed in June at 34%, 24% and 14% below their peaks, respectively, before rallying through July. Meanwhile, the number of leveraged loans trading lower than the distressed starting point of 80 cents on the dollar has roughly doubled in the past six months.
Distressed investors, who have watched a flood of capital drive valuations to record heights, see the weakness as finally creating investment opportunities, although what they see reflects their differing views on the severity of the current market dislocation and how long and how deep this current economic downdraft might run.
Tuck Hardie, managing director in the financial restructuring group at investment bank Houlihan Lokey, sees a number of challenges facing the U.S. economy over at least the next quarter. To begin, he anticipates continuing supply chain issues emanating from, among other things, China’s zero-COVID policy and truck and rail transportation challenges.
“On top of supply chain issues, layer into that inflation, rising interest rates, and high food and energy prices that directly impact consumer wallets, and you have large chunks of the economy facing meaningful headwinds,” Hardie says.
Adding to the data points coalescing around a potential new restructuring wave, Hardie points out that, in the bull markets since the Global Financial Crisis, leveraged debt investors have been able to be patient. They have, for instance, been generally agreeable to transactions that provide runway for companies to fix their operations, such as amend-and-extends. “Those runways are ending,” Hardie says. (For more on that see "Amend-and-extend activity soars in June, with borrowers extending $27B.")
Dan Zwirn, CEO and chief investment officer of Arena Investors LP, concurs with Hardie’s view of the U.S. economy. He notes as proof of a slowdown that auto repossessions and delinquencies are rising, while he sees corporations experiencing margin compression as raw material costs and interest rates increase.
Beyond corporate earnings challenges, Zwirn is seeing “cracks” in fixed-income markets, citing a weakening securitization market, investor difficulty trading subordinated debt and an unsteady leveraged loan market “infrastructure.” Regarding the latter, Zwirn foresees that as leveraged loan market liquidity declines, companies may not be able to refinance as easily as they have in the past, nor will they be able to lever further, possibly right at the point that they will most need capital.
Houlihan’s Hardie also sees liquidity issues. “Liquidity is not available the way it has been,” he says. Though he believes there is “a tremendous amount” of capital on the sidelines for rescue financing, “creditors and lenders are taking a more measured view regarding to whom they will provide capital.” He adds that, “managers of that capital are being picky, because they can be.”
For his part, Hardie believes that it is still early in the distressed cycle, where the companies needing capital most urgently “are at the bottom quartile of businesses, namely poorly performing companies with weak balance sheets.” Those, he says, are generally not the businesses that investors will want to save with capital infusions. Instead, Hardie sees rescue capital being deployed later in this cycle, when good companies with bad balance sheets will encounter liquidity issues. These classically distressed businesses are more likely to find rescue capital willing to be deployed to restructure their balance sheets.
Steven Oh, global head of credit and fixed income and co-head of leveraged finance at asset manager PineBridge Investments, is more constructive longer term on the economy and markets. Like most investors, he currently sees “deteriorating fundamentals as central bank actions have their intended effect of tightening conditions.”
But Oh is not expecting a flood of corporate defaults. He notes that until recently, “conditions have been supportive of issuer balance sheets,” enabling companies to refinance at lower rates, pushing out maturities and putting cash on balance sheets. As a result, he predicts there will be fewer defaults than have been seen in past down cycles.
The state of the leveraged loan maturity wall reflects Oh’s view. As of June 30, only some $132 billion of loans will come due between this year and 2024, while less than $250 billion come due in each of 2025, 2026 and 2027. The remainder of the market, nearly $600 billion of debt, comes due six or more years from now.
In fact, Oh believes that “we have fleshed out the majority of default candidates for this cycle.” He doesn’t expect the economy will get much worse, and in particular he doesn’t see a harmful recession on the horizon, noting that strong employment levels will cushion the economy’s landing.
“Employment will move from too tight, to healthy levels,” he said. Along with his constructive view of the economy, Oh sees the high-yield option adjusted spread (OAS), which currently sits in the mid-400s basis points off the curve (using the ICE BofA High Yield Index), hovering in the 500s range and not going materially wider than that.
Allowing himself room for error, Oh adds that “macro trends are still down and we might overshoot on the wides,” but he feels it is time to consider adding risk exposure. He notes that absolute yields have been in the 8% area and “over the next year or two, the average prices of loans and bonds is setting up a scenario where total returns could easily be double-digit[s].”
Richard Fels, managing director at sell-side shop Odeon Capital Group, says that the distressed investors he speaks with are uniformly “very pessimistic,” manifesting their feelings by putting on noticeably fewer trades than he has seen at this point in prior recent down markets.
But like PineBridge’s Oh, Fels also thinks we might be near the bottom. Using the Dow Jones Industrial Average as a proxy for equities generally, he thinks that “31,500 is the appropriate low-end of the range right now,” for the Dow, citing high levels of corporate capital expenditures as an indication that the future may not be as bleak as some expect.
Fels nonetheless sees the high-yield OAS going “at least a couple of hundred basis points wider” than its current level. He believes that if it does, the move would be less of a reflection of the state of the economy and more an indication of market illiquidity. As he describes it, although he sees markets as unusually quiet now, when sellers eventually begin to hit down bids, a cascading effect of prices being walked downward could drag the high-yield market significantly lower and its OAS higher.
A veteran distressed hedge fund manager who has seen multiple bear markets agrees with Fels’ view of the high-yield spread. He pencils in 800 off the curve, 350 basis points wider than today’s mark, as where he is most likely to begin buying in earnest, but concedes that markets are likely to overshoot to the downside “because they always do.”
Reflecting on the current state of the economy, the veteran distressed player said that we are probably in the “1973-74 part of the inflation cycle,” where the Fed might pivot and take its foot off the brakes too soon.
Elaborating, he said he fears this would lead to a resurgence of inflation, then renewed Fed tightening, another too-soon Fed pivot, a new inflation surge, and so on, creating disconcerting market oscillations and preventing the establishment of conditions conducive to renewed economic growth. He guessed that this oscillating phase could last as long as eight years, at the outside.
Arena’s Zwirn also sees the end of inflation as not nearby, worrying about a too-soon Fed pivot, and saying that “inflation never doesn’t accelerate, and never ends until either massive Fed rate moves or a recession” eventually kill it. So far, he notes, we have had neither. Zwirn added that, In the past, bear markets have not ended until investors respond with what he characterized as a “Jesse Livermore-era style panic,” referring to the investor believed to be the lead character in the classic book, Reminiscences of a Stock Operator.
Where to look?
The veteran distressed hedge fund manager has been looking for, and finding, cheap first- and second-lien bonds of companies, both those he feels may be more likely to experience near-term coupon misses that catalyze restructurings, and those that will avoid it.
He has also been looking at troubled and bankrupt crypto currency platforms. He notes that their business models are relatively simple, with crypto assets on the left side of the balance sheet and customer claims on the right. Correctly modelling expected crypto asset values will drive the success of these investments, he says.
Houlihan’s Hardie believes the sectors that will see continued distress include homebuilders and building products companies, which will be impacted by the housing slowdown, and oilfield services companies, which could be hurt in a slowing economy as both oil prices and usage decline. Hardie also believes that mortgage companies and health services providers are likely to see ongoing or outsized pressures.
Odeon’s Fels believes that the securities of venture-backed and PE-backed tech companies are in a “no-man’s land, with whole swaths of debt not having traded in months.” He feels that when that dam finally breaks, the new, lower prices will provide “studious and bold investors” with favorable returns.
In line with his constructive view of the market, Oh from PineBridge believes “there is no need to be hyper-defensive in this environment.” He said he has been adding to leveraged loan exposure, buying U.S. company debt, rather than going offshore. As an example, he said he believes the debt of travel and leisure companies has not fully recovered and still has room to run.
Oh said he would avoid producers of “big-ticket, high-financing-cost” assets like recreational vehicles, homes and autos, and related companies, such as building materials providers and automotive parts suppliers.
Arena’s Zwirn has been buying distressed convertible bonds and protecting his downside with equity put options. He is also seeking out private lending opportunities among non-public companies with good business models but negative cash flow, particularly in the tech space.
The private debt markets are a huge unknown in this economic decline. Distressed investors have salivated over that market’s massive growth, seeing a huge future opportunity set, but the 2020 recession disappointed them. This time around, Fels described that market as “cloudy,” but wondered aloud whether, as before, opportunities would actually come from that corner of the market.
Perhaps seeing things the same way, Hardie says he considers private debt lenders as “patient capital,” with the time, dry powder and sophistication to work out their own issues without them bleeding into the broader distressed market.
The unavoidable question is whether these distressed market players are expressing what they hope will happen more than what their research suggests will happen. While it is likely that some bias has leaked into their views, there can be no doubt that this summer, with the fed funds rate, and the equity, high-yield and leveraged loan markets all rising, distressed investors need to decide quickly if a bottom is in, or if the recent rally is a head fake in perhaps a long-running bear market.