Since the pandemic broke, we have been living through an extraordinary market dislocation with impacts that will be felt in all sectors of the global economy. For advisers looking to reshuffle client portfolios, stressed and distressed credit represent an area of significant opportunity.
There has been an unprecedented buildup of corporate debt over the past decade, particularly in low-grade credit, which includes BBB-rated debt, leveraged loans, high-yield, and middle-market direct lending. Aided by the low interest rates since the global financial crisis, this buildup has seen noninvestment-grade and unrated debt swell to more than $4.5 trillion, while the credit quality of investment-grade debt has also declined, with BBB ratings — the lowest investment-grade debt rating — now representing more than 50 percent of the $10 trillion global investment-grade debt market. As such, the most at-risk areas of low-rated debt have more than doubled since the financial crisis, and the total amount of low-rated debt is almost triple that going into the crisis.
Even before that, the health of the noninvestment-grade market was precarious. The percent of leveraged buyouts with debt-to-EBITDA ratios greater than 6x has been climbing since the financial crisis and is close to 2007 credit-crunch levels. Meanwhile, as it has become easier for companies to access credit, the percentage of covenant-lite loans, particularly in the leveraged loan space, has increased. Against this backdrop, corporate earnings, already facing a slowdown in 2019, have declined significantly. This sharp reduction in earnings from 2019 levels is likely to continue, with weaker companies likely to default.
While the Federal Reserve’s programs announced during the pandemic have had a positive impact on liquid credit markets, they have largely avoided meaningfully aiding a number of at-risk markets, including high-yield and leveraged loans, which represent the bulk of the current distressed opportunity.
Unlike 2007, ratings agencies have acted quickly and downgraded more than $100 billion of debt from investment grade to junk, creating what are commonly referred to as “fallen angels.” These bonds have seen support from the Federal Reserve, as the high-yield market is not large enough to absorb the forced selling from investors with an investment-grade mandate, who are required to dispose of the newly downgraded bonds. In March, pricing for fallen-angel bonds dropped precipitously to distressed levels, and though they have subsequently recovered with the Fed’s support, many offer interesting longer-term restructuring opportunities.
In the past, we did not endorse distressed investing broadly because defaults were concentrated in a small number of challenged sectors (energy and retail), and the level of dry powder chasing the opportunity set was sufficient for the 2 percent to 3 percent default-rate environment. Given the swift and significant government support today, we may not reach the default rate seen in prior crises, and the almost $500 billion of noninvestment-grade defaults that would bring, but the opportunity set is likely to be more than sufficient for the available dry powder. Although many managers in the market today are raising funds, even if the capital raised increases from the approximately $60 billion today to $100 billion, there would be ample opportunity at a 5 percent to 6 percent default rate for distressed and restructuring investors.
Today’s volatile environment offers advisers an opening to reposition portfolios to generate strong multi-year returns. For those considering distressed opportunities, it is critical to choose experienced managers with a proven history of investing successfully across distressed cycles.
Nick Veronis and Aref Jessani are executives with iCapital Network. Veronis is co-founder, managing partner, and head of research and due diligence, and Jessani is senior vice president of research and due diligence.