Some of these returns were given up in the third quarter as high yield credit spreads widened resulting in an 8% average loss for distressed funds. Leveraged loans have also been hit despite an almost total absence of defaults.
The big drop
As a result credit markets are now pricing in a big drop in earnings consistent with a severe recession and a material pick up in default rates. The same cannot be said for equities, which look pricey on any cyclically-normalised measure of earnings.
Credit markets usually provide a better warning sign than equity markets, particularly when it comes to potential downturns. Whether or not they are a better predictor this time, credit prices currently provide investors with a greater margin of safety than equities. Nowhere is the margin of safety more pronounced than in distressed debt.
However, the disastrous performance of distressed debt in 2008 begs the question: “What’s different this time?”.
Well two things. First there is the starting point, and secondly the nature of the default cycle.
Unlike previous cycles, the 2008 default peak was not caused by falling corporate earnings and poor balance sheets, but the disorderly deleveraging by the owners of the credit instruments (structured credit vehicles (CLOs), banks and highly levered hedge funds).
As liquidity receded and lenders asked for their money back, geared loan investors couldn’t get their hands on the cash. The banks enforced their security and dumped illiquid paper on a market where there were no buyers, with a predictable effect on prices. Even though distressed investors virtually never use leverage, all credit instruments – especially complex and illiquid ones – traded down in sympathy to levels that had never been seen before, regardless of the fundamental quality of the credit. Some distressed managers got hurt further by buying in too early on the way down.
The default cycle that ensued was largely confined to the financial services sector with over 70% of the Moody’s bankrupt corporate bond index coming from this part of the economy. A bank going bust is fine as a distressed opportunity, unless it‘s your prime broker, hedging counterparty or worse, the source of billions of dollars of other credit instruments coming onto the market.
A cycle to join
Looking forwards, the situation appears very different. Moody’s sector forecasts for bankruptcies over the next 12 months indicate that over 90% of bankruptcies will be in the “real economy” – with virtually no contribution from the financial sectors. Secondly, those geared funds and CLOs which owned large amounts of illiquid credit instruments, with on-demand debt structures don’t exist anymore. Their nearest equivalent is the European banking sector which following the Lehman debacle is unlikely to be allowed to fail, or at least not in a disorderly fashion. Regulators may not have learned much, but they do know that they don’t want another self-inflicted wound like that of 2008.
Nevertheless, it is undoubtedly true that European banks and regulators squandered the opportunity to put their house in order after 2009. This is now being forced upon them with the result that large portfolios of loans are currently changing hands. The resulting restructuring of these debts is likely to mark the start of our ascent to the second of the twin default peaks. Seasoned distressed investors are starting to buy.
For those thinking about allocating to distressed debt, timing the market has never been easy, but with a significant repricing having already happened, the risk/reward balance is now firmly stacked in your favour.
This second peak is likely to last several years with the current eurozone banking crisis being merely the start that will involve the restructuring of trillions of dollars of debt. Given the huge opportunities for the providers of capital in this environment, it would be a shame to sit this cycle out.
