Recent market and economic volatility may be the trigger that distressed debt investors have been waiting for, but capitalizing on opportunities will require a different playbook than those of past cycles.
For investors trying to time their entry into distressed debt strategies, the last several years have proven tricky. Despite the elongated credit cycle and concerns about loosening terms in credit issuer documentation, defaults have remained low by historical standards across the high yield and leveraged loan markets.
Some of this is surely a result of historically low interest rates, which have, in many cases, enabled otherwise troubled issuers to ride out the cycle without running into liquidity problems. And while the emergence of the coronavirus as a formidable threat to global growth prospects likely means that interest rates will not move higher in the foreseeable future, it may also prove to be the trigger that drives weaker issuers into stressed or distressed situations.
Where Stress in the System is Likely to Appear First
Most immediately, issuers with supply chain reliance on China look most exposed, although this is likely to propagate into other regions in the weeks and months ahead. The knock-on effects from supply chain challenges and increased working capital requirements will inevitably impact a wide array of corporate debt issuers. For those companies that were already teetering on the edge—or geared to perfection—liquidity issues could quickly follow. Beyond that, a general slowdown in economic growth has the potential to impact issuers across almost every industry, particularly if sustained for more than one or two quarters.
Additionally, the substantial growth of the private credit market over the last decade will naturally result in more middle market issuers running into stressed situations this cycle. Weaker documentation, higher leverage levels and a proliferation of new entrants are likely to be key factors contributing to the growing distressed opportunity in this space.
Similarly, the collateralized loan obligation (CLO) market looks set to be a source of stressed or distressed opportunities in the months and years ahead as CLO managers trim their exposure to downgraded (CCC-rated) loans in order to meet required ratings tests. And while the latter is more of a technical problem than a fundamental one, the impact is the same: distressed debt managers have the opportunity to buy assets at discounted prices because of technical selling pressure.