Distressed Credit: Changing Tides

What are your views on today’s opportunity set versus past cycles?

Ray Costa: Since the global financial crisis 15 years ago, a large amount of credit has been created through leveraged finance. In the last 12 months, the federal funds rate has risen dramatically. These two types of events typically precipitate a market event: an economic slowdown or a recession. There’s often a break somewhere. The recent U.S. regional bank crisis is certainly symptomatic of recent macro headwinds. However, we don’t believe there is a large, systemic issue at play here like we last observed during the GFC, or during the commercial real estate crisis of the 1990s.

Today’s opportunity set is more reminiscent of the early 2000s when there was neither a deep recession nor a total breakdown across credit. What did persist however was significant credit dispersion and market volatility, which are optimal forces for creating a prolonged and rolling opportunity set for credit investors. Back then, gains came from both income and appreciation, and credit picking became a skill that could be handsomely rewarded.

We believe that the current environment is highly compelling and will reward strategic credit investors.

Tell us about the European macro situation.

Eric Larsson: Russia’s invasion of Ukraine has created additional, and different, macroeconomic forces in Europe when compared to the U.S. The greatest economic impact of the war has been on the cost of energy. In the immediate aftermath of the invasion, energy costs were completely out of control and there was a real risk that some German manufacturers might default on their loan obligations. Thankfully that’s not the case anymore.

Today, the macroeconomic picture is much more benign, but gas prices remain high by historical standards. Also, inflationary pressures persist. European inflation has been more cost-driven than consumption-driven, and that may mean that traditional monetary policies from the European Central Bank won’t be as effective. Regardless, we should expect an economic slowdown as we move further into this higher rate environment. And that naturally creates opportunities for special situations investors.

What has been the impact of these macroeconomic forces on both the European and US distressed market?

Eric: The size of the European stressed and distressed opportunity set is now above €120 billion. This is double what it was in 2020. We define the opportunity set as capital structures with high yield bonds and leveraged loans in excess of €100 million nominal value, trading at or above a 12% yield.  Given that credit markets are in a very different place to where they were for the best part of a decade, we expect the opportunity set to increase. There is a wall of maturities due in 2025, with many companies also expected to experience slower growth. Today, it’s possible to build a diverse portfolio of 30 senior loan and high yield bond holdings yielding around 20%, which is quite unique in the context of recent financial market history.

Ray: In the U.S., there are US$300 billion worth of bonds and loans at distressed levels. We measure this by bonds trading at spreads greater than 1,000 basis points and loans below 80. Since early 2022, this is up nearly 400%. We echo Eric’s sentiment on the remarkable diversity of the opportunity set. After 15 years of very easy monetary policy, very easy financing conditions, and very muted economic cycles, we have a US$4 trillion leveraged finance market that is being tested.

In the US, where are you seeing opportunities from a sourcing perspective?

Ray: There is a lot of activity bubbling below the surface in the primary debt markets. Even up to 2022, large volumes of credit were still being created. For borrowers, the conditions were favourable in terms of the amount of leverage and its cost. But 2023 is a very different place. Many companies recognise that they have created unitranche-based capital structures that are not easily re-financeable and are potentially not debt serviceable. Even if inflation and rate hikes slow, there won’t be an immediate return to the goldilocks, post-GFC environment. 

We’re receiving many inbound enquiries from companies that need urgent capital solutions, more than we’ve seen in decades. Fixing these structures could take a variety of different forms: a shift to a more traditional, layered capital structure where investors get paid for taking on higher loan-to-value (LTV) risk, or the creation of sidecar investment strategies to fund acquisitions. There are ample opportunities to be creative here, and to design the right capital structures for over-levered firms.

What’s happening on the sourcing front in Europe?

Eric: There’s been a noticeable shift in the enterprise value of the corporates we’re dealing with, from equity to credit, and when we assess their cashflows too. The current market is offering compelling entry points such as lower LTV levels, lower leverage, running yields around 10-12%, and capital appreciation. Our approach is to lend more defensively as we move up the capital stack into sectors such as healthcare and telecommunications.

In Europe, our focus is mainly on northern and western Europe where you have reliable credit-friendly jurisdictions. When we don’t know the outcome of a process, we step away. The great thing about the present moment is that there’s choice and we’re using that opportunity to our advantage.

What’s surprised you the most about this moment in credit markets?

Ray: I’ve been very surprised that in the face of all this uncertainty, it’s not the more traditionally cyclical sectors like retail and consumer sectors that are providing the largest investment opportunities. Instead, it’s healthcare which has historically been quite defensive.

It’s a sector that people were comfortable levering up when rates were low because of that defensive nature. But then two unexpected things happened: the rising cost of capital strained that free cashflow profile, and labour-cost inflation started squeezing profitability. To date, we’ve identified 52 issuers in healthcare that are distressed – 10 mega caps and 42 mid-market caps. We’re also seeing similar dynamics in technology, a sector that has accounted for 20% of all issuances in the last three years. From both a primary and secondary origination perspective, opportunities for credit investors are coming from surprising places.

What are your predictions for markets over the next 12-24 months?

Ray: U.S. core inflation will be much stickier than many people would like it to be. From a monetary policy perspective, I expect the ECB and the Bank of Japan to be more flexible than the Fed.

On default rates, it really depends on one’s definition. If you include distressed debt exchanges, liability management, capital structures, and capital solutions, then I foresee defaults in the region of high single digits. But I expect much lower levels of pure Chapter 11 defaults. Most people are motivated to avoid them because they become very expensive and can be value destructive.

Eric: Inflation is going to stay higher for longer, therefore rates are also going to stay higher for longer. I’m surprised that there are some people who are predicting a fall in rates this year. That seems too optimistic.

Furthermore, I fear an escalation in the Russia-Ukraine conflict, as well as increasing tension elsewhere, for example, between Taiwan and China. Bank defaults get a lot of press, but I don’t think that’s where the risk lies. Investors must pay much closer attention to today’s geopolitical environment.