Why credit crunch represents an opportunity to achieve attractive, non-correlated returns
Businesses large and small must now try to cope with higher interest rates. We’ve seen the effects in the US with the failures of Silicon Valley Bank and Signature Bank, and in Europe with Credit Suisse. For distressed credit investors, this is a classic case of “unfortunately/fortunately” ‒ unfortunately, a business is facing a credit crunch, but, fortunately, this may present an opportunity to achieve attractive, non-correlated, risk-adjusted returns.
After a decade of benign credit conditions with historically low interest rates and exuberantly high investor risk appetite, the worm has finally turned. The transition in monetary policy from easing to tightening has created hurdles for businesses trying to raise capital through the credit markets. Companies can delay or roll over their debt for only so long before coming back to credit markets, hat in hand. This leads to rising distressed exchanges and default rates as companies face an inhospitable environment. Corporate borrowing costs have spiked to levels not seen since the great financial crisis (GFC). I expect the trend of rising levels of stressed and distressed businesses that require financing and, potentially, restructuring of their debt to continue well into 2023.
Bad balance sheets
Distressed credit investing is investing in good companies with bad balance sheets. Distressed credit investors seek sound businesses ‒ with valuable assets and the ability to generate cash ‒ that have hit a rough patch, making it difficult to service their debts. When this happens, companies may choose to restructure their debt through bankruptcy proceedings or outside of the courts.
Distressed credit investors can help facilitate a turnaround. For example, a creditor could exchange old debt for new debt at a lower value (less than 100 cents on the dollar), take an ownership position in the company by exchanging debt for equity, and rehabilitate the balance sheet to achieve greater liquidity. Unlike index investing, stress investing is hands-on, boots-on-the-ground. Each business situation is unique.
Distressed credit investors have a certain temperament. They are patient and able to see beyond today’s headlines and rumours; they are comfortable with potential episodes of illiquidity. At the same time, to be successful, you need to be value-oriented and tightly focused on company fundamentals. Of course, you also need the technical skills to analyze a business and dissect a balance sheet. You must be willing to engage directly with the stressed company, with legal counsel and the court system, with accountants, and with the whisper network of employees, suppliers, and other members of the resource ecosystem, as part of a scuttlebutt approach to determining the margin of safety. There is no standardized valuation across each credit situation. When people ask me if this is difficult to do, I say, “Short answer: it’s difficult. Long answer: it’s very difficult.”
However, even in better times, there will always be company-specific credit issues that present opportunities. Experienced distressed credit investors seek situations where there is a significant price dislocation between the fundamentals of the business and its price.
The current climate of rapidly rising interest rates, tightening financial conditions, increasingly volatile markets, and geopolitical uncertainty, among other factors, create negative expectations in the credit markets. The general pessimism provides a robust set-up for distressed credit investors looking to diversify their fixed-income exposure.
Today, there is a growing list of opportunities for patient investors with a long-term orientation. For example, in the two years following the troughs in CCC high-yield credits, this segment of the credit market delivered an outsized return of over 70 percent to investors up until mid-May. This created an attractive opportunity developing in the areas of stressed and distressed credit, with high return potential.
It’s a good thing distressed credit investors are a patient sort. For 128 months after the GFC, the economy expanded, steadily bobbing along on a sea of liquidity. Distressed credit investors had to wait for their chance to, as the song says, “Do that voodoo that you do so well.”
To paraphrase Warren Buffett: Unfortunately, opportunities come infrequently. Fortunately, when it rains gold, put out the bucket, not the thimble.
Parul Garg is an associate portfolio manager at PenderFund.