U.S. distressed bonds account for about 15% of high yield aggregate indices. Energy remains the largest sector, representing about a third of all U.S. distressed bonds, followed by industrial at 28%. The distressed universe declined to about $200bn over the recent months, half below the early 2016 levels. Monetary and fiscal stimulus are acting to limit or delay corporate defaults. Overall, the Fed’s emergency programs would provide $850bn for credit markets.
However, most indicators point to a stronger distressed pipeline. The number of corporate defaults spiked in April and May, as well as the number of U.S. businesses of all sizes filing for the U.S. chapter 11 program. Meanwhile, extensions of debt maturity, some of which aim to avoid a pending default, multiplied. The deterioration of corporate usual credit metrics (leverage, liquidity, adequacy of working capital, margin erosion) in broad equity indices are additional lead credit stress indicators. Moody’s base scenario sees the U.S. default rate nearing the 2008 and 2000 levels. The U.S. expected default rate is twice Europe’s, which is partly explained by the higher relative weight of BB- and B rated issues in the U.S. With 15% of distressed issues maturing within the next 24 months (12% in 2019), tension may rise in the coming months.
While the previous distressed cycle concentrated on energy companies, hit by the collapse in oil prices, the sector breakdown is likely to be more diversified going forward. Defaulting companies since March are predominantly consumer cyclical businesses and, to a lesser extent, industrial companies, which were deepest hit by the consequences of the pandemic. In Europe, defaults have also spiked since March, especially in consumer cyclical and telecommunications.
Distressed hedge funds typically purchase distressed debt at deep discount and seek to profit as the company turns around. The company’s restructuring usually requires a change in its business activity (eg. product mix, cost structure, productivity), and/or in its organization (eg. corporate management, ownership), and/or in its funding (eg. capital structure, liabilities, asset sales). Some strategies also focus on sovereign distressed debt or distressed structured products, they may also use equity stakes. The more diversified the distressed debt universe, the better. The current average U.S. distressed yield is above 25%, with wide differences according to each situation, to the seniority of the debt instruments, the recovery prospects etc.
Historically, distressed strategies are hurting in the early phase of a distressed cycle. They usually deliver double-digit returns when restructurings are progressing, supported by an improving economic environment. This new distressed cycle, triggered by a pandemic, is likely to be highly atypical. The pace and magnitude of corporate profit recovery is still unclear and the consequences of Covid-19 on demand patterns, supply chains, business sustainability remain to be seen. These uncertainties, along with a more laborious economic recovery than the ones following classical recessions, will likely complicate corporate restructuring. Taking opportunity from this new distressed cycle will likely require careful timing.