Recently, lofty valuations, bumper M&A activity and unwinding of easy monetary policy have helped to fuel classic late-cycle fears among investors. While some of the more unwelcomed “late cycle” features of credit markets continue to be cause for concern, fears about the next downturn appear largely contained for now and markets are generally not pricing in the next recession.
It may be a matter of time before it happens, but investors looking to time the turning point of the current cycle may find themselves missing out on opportunities. Investors that instead allocate capital to distressed debt through cycles may be best positioned to capitalize on opportunities as and when they arise.
Global corporate bond issuance has held up relatively well. Demand from investors for both bonds and loans remains high while credit conditions remain benign and default levels low, particularly in Europe.
Additionally, European private debt markets continue to expand, with higher fundraising levels outstripping the available investment opportunities. This has pushed dry powder to record levels, providing an additional source of financial support to companies.
Secondary markets have, so far, supported this benign view of the cycle, with credit prices trading within their normal ranges.
Rating agencies have also remained positive. Average high-yield bond and loan defaults remain close to historical lows and corporate borrowers appear to be shoring up their balance sheets by improving free cashflow, extending their debt maturities, and paying down existing debt or making pledges to delever. On account of this, more companies are seeing upgrades to their public credit ratings than downgrades.
The ongoing dilution of investor documentary protection, due to borrower-friendly surplus market liquidity, has led to a near 80% conversion from maintenance to incurrence covenants in the global leveraged loan market – essentially taking the form of a high-yield bond covenant. Together with greater instances of financial metric “manipulation”, some are fearing that the proliferation of covenant-light (cov-lite) structures in the market could cost lenders and expose underlying investors to losses – through lower recoveries – when the credit cycle eventually turns.
Covenants do not offer one-size-fits-all protection against capital loss. However, covenants can influence the timing of when a lender can act by providing triggers linked to early warning signals of deterioration in creditworthiness, thus helping protect value and cash in a struggling business.
A lack of triggers is therefore likely to impact the timing of restructurings once the current cycle ends, as companies are more likely to run out of cash before approaching lenders for help. At that stage, a borrower will be under enormous time pressure to refinance its debt and raise additional liquidity to prevent a short-term cash squeeze from becoming a full-blown liquidity crisis.
This creates an opportunity for an agile and well-founded distressed debt investor, who has kept some “dry-powder” on the side to take advantage of these unexpected and fast-moving opportunities.
It is worth remembering that a reversal of the credit cycle is but one of the many situations and circumstances that could generate distressed credit opportunities – whether issuer-specific, driven by market-wide concerns or a combination of both. The probability and pace of a company moving from encountering difficulties in the short term to facing financial distress and a subsequent loss of control, can be influenced by any of the following factors - too much leverage amid tightening credit conditions, declining profitability and higher idiosyncratic risk, as well as the changing nature of market liquidity.
Corrections and disruptions can occur at any point of the credit cycle to expose weak borrowers and offer distressed debt investment opportunities, so it is important to be prepared and consider allocations to distressed debt through cycles.
An ability to act quickly and decisively is often crucial in distressed investing. Opportunities to invest in stressed and distressed credits could come thick and fast, and may be highly competed, so distressed investors with flexible investment mandates may find themselves at an advantage when the cycle turns.
Late in the cycle, we think it is especially important to stick to your investment strategy and not be distracted by the “fashionable” deals that offer rare opportunities to quickly deploy capital and may tempt other distressed investors. There may be too much credit and execution risk in these deals, for example where the true value of the underlying company cannot be reliably assessed, and an investor is ultimately relying on an increase in market prices to exit the investment and achieve the expected returns.
Finding successful investments often requires a deep understanding of the specific sector to perform a close analysis of the business and establish whether it has a reason to exist or is merely a “value trap”.
Closely monitoring the companies we believe may become distressed down the line can front-load the work needed to understand and analyze the credit before a restructuring becomes apparent. This way we can position ourselves for the best opportunities.
Paul Taylor is the head of restructuring at M&G Investments.