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By Michael J. Holmberg
Debt trading at yields to maturity above 12% has increased by tenfold since January, and is creating compelling opportunities for special situations investors.
The percentage of distressed bonds1 in the high yield index2 has risen from approximately 2% in January up to 20% today. Moreover, the amount of debt trading at yields to maturity greater than 12% has increased by 10 times since the beginning of the year. In our view, markets like these present great opportunities for investors with the capacity to weather short-term volatility for longer-term return potential.
Secondary trading levels for loans and bonds often reflect underperformance well before rating agency downgrades or defaults occur. Therefore, current default rates and expectations,3 which are well below the 20-year average rate of 3%, may understate the risk embedded in high yield and loan portfolios.
We expect this cycle of stress and distressed opportunities to be “U-shaped” and with us for longer than previous “V-shaped” shorter-termed cycles due to the prevalence of covenant-lite loans and the absence of a Federal Reserve put or bailout. Ninety-two percent of the institutional loan market is now classified as covenant-lite. For reference, during the Global Financial Crisis, as lending standards tightened, covenant-lite issuance declined to 6% of the total market. Covenant-lite loan documents have fewer restrictions on the borrower and limited protections for the lender. These loans limit the ability of lenders to declare an event of default based on predefined leverage or cash-flow metrics; instead, defaults will likely be deferred until all financial engineering and liquidity options have been exhausted, prolonging the market volatility.
There are many compelling investment opportunities today, and more are developing; however, investors must proceed with caution as the delays in defaults may reduce recovery rates for senior debt holders to below historical averages. Individual credit selection, positioning in the capital structure, acute understanding of the loan documents, thorough fundamental analysis and expertise as to the restructuring process will be differentiating factors in navigating and profiting from this market.
1 Defined as trading below 80 cents on the dollar and/or yielding greater than 1,000 bps over treasures.
2 Bank of America US High Yield 2% Constrained Index.
3 US High Yield default rate estimated at 0.75% and 1.25% for 2022 and 2023, respectively and US Leveraged Loan default rate is estimated at 0.75% and 1.75% for 2022 and 2023, respectively according to the per JPM Default Monitor dated 5/2/22.
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