Fiscal and monetary largesse have helped to lift nearly all corporate boats since the Covid crisis hit.
But not quite all. Many companies have already snapped back as Covid restrictions have been lifted and as patterns of economic demand return to normal.
Yet there are also industries for which even the easiest of financing terms and government rescue packages will not be enough to plug the huge holes caused by a total collapse of revenue.
For instance, there are large segments of the consumer sector that are still struggling. Lockdowns and travel bans have inflicted grievous damage on the hospitality sector, and cyclical industries like airlines have yet to see substantial recoveries in demand.
With investors starved for yield, companies issuing bonds have found ready demand for securities offering even the most modest income uplift
In some cases, market optimism has run ahead of fundamentals. Some of that is down to base effects — company results have often been stellar in comparison with their struggles a year ago.
As a result, investors often fail to price in the poor underlying state of companies’ finances. That opens up opportunities for distressed debt investors.
In some respects, this is the inverse of what happened in the wake of the market meltdown in the spring of 2020, when corporate prospects were marked down so severely that unusually cheap investment opportunities opened up, particularly in companies’ senior and secured debt.
Distressed and special situations portfolios can invest in any part of a company’s capital structure — they can take long and short positions in both credit and equity, and can also use instruments such as options to take advantage of pricing anomalies in stressed companies, even when overall default rates are very low.
Because of this they deliver the kind of pay-off that investors increasingly value: returns that do not correlate with those of the broader fixed income market and a way to diversify the risks contained in a traditional bond portfolio.
Rating pains
The risk of bond defaults might be concentrated in certain industries for now, but as central banks start to normalise monetary policy, probably later this year, highly indebted companies could start to struggle.
We figure the majority of gains delivered by corporate bonds since the onset of the pandemic have stemmed from central bank stimulus. But liquidity injections do not solve solvency issues.
Dispersion of performance within the corporate credit market is at an all-time low, thanks to official largesse.
But as central banks start to withdraw the vast amounts of market liquidity they provided to support their economies, many of these companies will find it increasingly hard to service those debts. The number of fallen angels will only increase and CCC-rated companies will struggle.
With investors starved for yield, companies issuing bonds have found ready demand for securities offering even the most modest income uplift. The proportion of outstanding bonds rated CCC — just three notches above defaulted bonds — has grown as well.
That is a worry for investors, because historically 25-30 per cent of these bonds default over a two to three-year period from when they were downgraded, according to Moody’s.
Another concern is that a growing number of companies are factoring in future expected cost savings or revenues into current earnings. That is at a time when margins look set to come under pressure from commodity prices, supply shortages and tight labour markets.
But the risks are manifold. The credit market faces further volatility from rising inflation, supply chain disruptions — not least in the UK as it struggles with the after-effects of Brexit — new Covid variants, as well as the possibility yet more regulatory upheaval in China.
Special attractions
Successful investing in special situations demands a very active approach, based on thorough analytical work.
In all, it is a market where substantial experience is important, not just to develop the contacts and understand the sort of analysis needed, but also to know which opportunities present themselves at different points of the business cycle.
As economies emerge from this trauma, they face significant further upheavals, not least those associated with rising interest rates.
Importantly for UK pension funds, these returns are typically uncorrelated with the major asset classes, and this makes distressed and special situations investing particularly attractive additions to investors’ portfolios.
In addition, we believe having an approach that does not require the traditional multiyear lock-ups traditionally associated with the distressed asset class is a positive for UK pension funds.
Galia Velimukhametova is senior investment manager distressed debt and special situations at Pictet Asset Management
