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Shortage of distressed bonds and loans makes life difficult for funds

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Shortage of distressed bonds and loans makes life difficult for funds

Thanks to a decadelong stretch of low interest rates that has made it easier for troubled companies to kick the debt can farther down the road, the already scant opportunity for funds looking to buy up paper at distressed levels continues to shrink.

A seventh consecutive decline in the U.S. distress ratio has pushed the share of bonds trading in excess of 1,000 basis points above the risk-free Treasury rate — the common measure of distress — to its lowest level in 3.5 years. At just 5.2%, it is significantly below the post-crisis high of 33.9% from February 2016, according to S&P Global Fixed Income Research.

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In dollar terms, that equates to just $48 billion, a hair’s breadth from the nearly four-year low of $46 billion reached last month, and just 15% of the February 2016 high of $328 billion.

By count, the tally of distressed bond issues is down to just 97 across 59 issuers, versus 349 issues from 139 issuers in May 2015.

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The dearth of opportunities is even starker in leveraged loans, where the share of performing loans in the S&P/LSTA Leveraged Loan Index trading below 70 cents on the dollar — a level normally associated with deep distress and significantly high default risk — fell to just 0.56% as of May 30, the lowest it has been since December 2014.

By amount, that equates to just $6 billion.

For context, the U.S. leveraged loan market surpassed the $1 trillion milestone for the first time in April.

Of course, higher recoveries are reflected in the higher pricing of leveraged loans, compared to bonds, backing a company on the verge of default. According to LCD, the average bid price of Index loans at the time of default was 70 in 2018, versus 48 in 2009 — the latter part of the financial crisis.

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To that end, 2.11% and 4.76% of Index loans are trading below 80 and below 90, respectively.

Driving factors

Distress is low, in part thanks to the 2016 energy-specific default cycle flushing out the weaker credits, while the subsequent rebound in energy prices has buoyed debt valuations of those companies that made it out the other side of the low-price environment.

In loans specifically, in addition to a sharp reduction in oil and gas distress, the metals and mining, broadcast (after iHeart’s mega default), telecommunications and utilities sectors have all experienced sharp reduction in distress.

In fact, according to LCD, there are no longer any Index issuers within oil and gas or broadcast trading in distress at all.

Distress is now most prevalent in retail, at 24%, and cosmetics/toiletries, at 32%, the latter driven entirely by Revlon. Both are post-crisis highs.

In the bond market, the decline was led by the telecommunications sector, which had the largest month-over-month decrease in number of distressed credits — down by three credits, or 12.5% — pushing this month’s distressed ratio in the sector to 12.9%. However, it should be noted that the sector still accounted for the most distressed issues in May, with 21.

Oil and gas followed, with 18 distressed issues.

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Within the telecommunications sector the most distressed issues are held by Frontier Communications, which has 12, accounting for $9.8 billion in distressed debt. Frontier recently announced its plan to tender a portion of its bonds maturing in 2020–2023 as part of an amendment that allowed the company to raise second-lien debt and refinance near-term maturities.

The retail and restaurants sector, however, leads in terms of the distress ratio, at 15.6%, with 15 distressed issues, followed by telecommunications at 12.9%.
About 80% of distressed issues are either unsecured or subordinated, S&P Global finds. In a default, these note holders' claims to a firm's assets are secondary to those of senior debt holders.

Stockpiling

Against this ever-shrinking inventory, the amount of dry powder waiting for the supply of distressed and defaulted debt to finally come to fruition in this long-running bull cycle remains high.

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According to Preqin, U.S. distressed fund managers sit atop roughly $74 billion of capital to invest, in anticipation of what many say is an inevitable increase in default activity, considering the unprecedented levels of debt issuance since the financial crisis and seemingly perpetual pushing out of maturities over the past few years.

Intermediate Capital Group holds the largest amount of available dry powder among private debt fund managers, at $9.9 billion, followed by HPS Investment Partners at $9.8 billion, GSO Capital Partners at $9.1 billion, and Oaktree Capital Management at $8.3 billion.

Oaktree held the largest amount of dry powder until 2017, but has since fallen to the fourth spot following a decrease of $4.9 billion.