Distressed Debt Themes for 2012

I think the one word to describe this year's distressed debt market was "unexpected."  Whether it be the tragedies in Japan, Congress pushing us to a near technical default, the subsequent U.S. government downgrade, heightened and unforeseen issues with Europe, and a number of surprising bankruptcy filings (MF, AMR, etc), this has been a tough year to price risk for a distressed debt investor.  According to HSBC's most recent "Hedge Fund Weekly", hedge funds classified as "Distressed Security, Global", excluding Paulson & Co affiliated funds, have seen year-to-date returns ranging from -9.5% to 7.4% with a number of funds hugging right around zero.

While I will save my post discussing the expectations for high yield returns for 2012 (I know, a fool's errand) for next week, I would like to talk about some issues and themes that distressed debt investors may possibly encounter through 2012.  But first, let us look at my favorite chart:  The number of distressed debt issuers traded over the course of the year:



(Note: I've cut the graph off as of two days ago to account for the dearth of trading around the holidays)


As this chart shows, the distressed opportunity set has increased precipitously over the past 12 months.  Many of the new opportunities comes from junior capital (TRUPS, preferred, unsecured bonds, etc) of European banks.  In addition, as the definition of distressed according to Bloomberg is a spread of over 1000 basis points along with a much tighter treasury curve, the bar is set a tad lower this year.  With that said, I think any investor you speak to participating in the distressed debt market would tell you there is a lot more to do at this time time year than last year.

In terms of themes, I might as well get the elephant in the room out as quickly as possible:  Europe.  I have read every major investment bank's credit outlook for 2012 and everyone's projections for next year's returns are based on possibly scenarios in Europe.  If you were to compare the two issues that rocked the equity markets over the past 12 years (the "Tech Bubble" and the "Mortgage Crisis"), issues in Europe are so heavily portended that I'm starting to wonder how much is already discounted in.  I mean, were people talking about the Tech Bubble in 1999, like they are talking about Europe today?  Were (informed) people talking about the mortgage crisis in 2007, like they are talking about Europe today?

I have no idea what is going to happen in Europe. I am not a macro analyst and find myself much more comfortable (and at an information advantage) discussing various bottoms-up situations than trying to guess which European Summit, if any will fix the problem.  With that said, you can't ignore the situation because that is what is driving monthly returns (in fact, an interesting data point: many funds have put on hold hiring fundamental analysts for the mere fact that the added value is muted by macroeconomic / Europe factors).

One way that I like to think about situations is determining, where on a bell curve, the situation is priced.  Here is the standard bell curve we all learn taking the CFA exam or intro stat:



Where the entire European debacle began to unfold, the +1/-1 standard deviation events were not priced in.  I'd say, with everyone focused on Europe, the +2/-2 standard deviation events are probably pretty closed to being priced in and the thing you have to worry about as a portfolio manager are the very far tails, for instance, and Italian default.  12 months ago if you told people you were pretty confident that Greece was going to default, they'd say, "You know, its a possibility...but probably not."  CDS on Greece has gone from 1000 basis points to 10,000 basis points (I don't have the points up front data in front of me) just this year.  Everyone expects some sort of Greek default.

The question I then fall back on is this:  Will Europe suffer a mild recession or a very bad recession?  The problem with a very bad recession is the domino effects it has on the rest of the world.  Here is the scenario:

1. Europe falls into a bad recession
2. Europeans purchase less due to austerity measures (wage cuts, higher taxes, etc)
3. China's economy, which benefits from Europeans purchasing their goods, slows down on lower exports
4. Australia, Singapore, Korea - all major exporters to China, slow down because China has slowed down because Europe has slowed down
5. Global commodity prices (and definitely Australian real estate) drop because China has slowed down
6. Major commodity producers, other than China, including Brazil, Canada, and Russia slow down because exports are lower due to lower prices and lower demand from everyone above
7. Pain

Do I think this will all happen?  I am probably more likely to tell you these events will unfold than the average person on Wall Street.  But that's why there is something called "tail hedging" (Up until June, Australia CDS was one of the cheapest tail hedges out there).   

With that said, lets turn our focus to more structural / technical / non-European issues distressed debt investors will deal with in the coming year:

Lack of Liquidity and the Implications for Portfolio Management

I have discussed previously about the current abysmally low dealer inventories of corporate bonds. This has been driven by adoption of (absurd) regulation and de-risking of dealer desks across the Street.  What concerns me is that as absolute yields in the high yield / leveraged loan marketplace has decreased while at the same time the relative yield offered by high yield / lev loans relative to other fixed income has increased, the amount of retail money that has flown into the space has increased precipitously.  More retail money means more needs for cash and daily liquidity.  This has a dramatic effect on how a PM will manage a book.

First, it means that the relative spread between illiquid and liquid issuers should increase.  As more daily liquidity is needed, the demand for larger / on-the run bonds increases relative to smaller issues.  This should cause stressed high yield, which is generally illiquid, to gap out even further when bad news hits the tape.  The additional volatility will cause distressed debt investors to demand a higher discount rate when purchasing small issues meaning lower prices.  If you extend this to the point of financial distress, companies should be pushed into bankruptcy more frequently as the need for higher IRRs for distressed suppliers of capital becomes impossible to bear for the marginal issuer.

Secondly, inflows and outflows are inherently volatile and streaky (returns -> more inflows -> higher returns -> further inflows).  And because cash management will be focused on the most liquid issuers, these issuers will experience a whole different sort of volatility.  Now, you may not think this is important until you look at the top holdings of many of the well-known high yield mutual funds: TXU, Sprint, Clear Channel, First Data, HCA, Harrah's / Caesars, etc.  Most of the issuers have rich capital structures with every sort of layer imaginable.  And as spreads widen due to the aforementioned volatility in the senior parts of these capital structures, the junior parts of the capital structure will widen out precipitously.  This is a sort of minefield for investors that will have to be reckoned with next year.  

Third, and sort of a byproduct of our second effect, is that cash balances, should in theory be hire.  This concerns me because when cash balances are high, the propensity for rallies to extend past economical sense increases.  If I am a mutual fund manager sitting of 5% cash position and the asset class grinds in every single week, at some point, I am going to lower my cash balance and spread more gasoline on the fire.

Fourth, and possibly a stretch, private equity will target larger companies next year and the years beyond.  To me, it's a lot easier to finance a $5 billion entity that is levered 4.0x versus a $500M entity levered 3.0x, all else being equal.  And with the amount of capital sitting on the sidelines of private equity, just waiting to be deployed, I think you'll see some big game being taken down next year.

Lower Recovery Rates

Many high yield strategists use a fairly simple formula to calculate projected high yield spreads and as a result, total return over a projected period:  

[100% less Estimated Recovery Rates] * Default Rate Forecast + Excess Spread = Spread Estimates

The problem with this equation is pretty simple:  Excess Spread changes with market volatility.  In a very volatile markets, excess spread, or the spread an investor requires to be paid above what he expects to lose in a default scenario, increases dramatically.  Hence, you have a circular equation.

More important to our discussion is my estimation that we will see lower recovery rates in the future, more specifically in the lower parts of the capital structure.  Whether it be bank debt or secured bonds, more senior leverage is being put on capital structures, leaving junior note holders in a more levered position.  Furthermore, the extremely weak covenant packages put into credit agreements and indentures between 4Q 2009 and 2Q 2011 means while the chance of an actual default is less (less likely to trip covenants if they don't exist), the companies that do default will already have been burned to the ground.  

 Higher Default Rates but still Relatively Benign

Despite my concerns in Europe, I cannot dismiss the data that suggests high yield issuers in the United States have the strongest balance sheets, collectively than in anytime in the modern history of high yield.  And the maturity wall is really just a hill now:

We always see a few surprises each year.  This year, other than MF, we saw AMR file.  Of every analyst covering AMR on the equity and debt side, very few, if any, thought AMR would file in 2011.  Dynegy is a similar story given the pricing of the various HY indices.  Jump risk is something we all have to contend with in the distressed market and 2012 will be no different.  I would expect default rates to increase into the latter half of the year as CFOs and investors alike begin to look out 12-18 months when lots of bonds and bank debt are maturing while at the same time the amount of firepower of CLO purchasing power dwindles due to the closing of their reinvestment windows.

With lower recovery rates in the junior tranches, I'd expect distressed investors to make an even more pronounced move into 1st lien paper (akin to Oaktree's strategy).  Something like a Travelport 1st lien comes to mind.  

More Cash to Invest due to Distributions from Liquidations

Lehman.  Nortel.  Washington Mutual.  To the innocent by-standers eye, simply three companies that filed for bankruptcy.  To me, and many other distressed investors:  An oasis or bastion of safety.  Nortel has been one of the best performing distressed bonds all year.  WAMU, whichever flavor you choose, has been a solid performer the past few weeks.  And Lehman:  Lehman has let you allocate billions of dollars of capital in just a few trades allowing you to show your investors your are more allocated than you really are while at the same time grinding out returns.  I have a recovery price in the low 30s for LBHI.  Every day I suspect my bonds will grind their way there with little no volatility.

Unfortunately, this party is about to end.  Lehman should start paying out distributions soon, and its just a matter of time for WAMU and Nortel once all the arbitration gets settled and the plan is confirmed, respectively.  Distressed debt investors will find a bunch of cash from these distributions in their fund, looking for similar places to put the capital.  But really, there aren't a lot of situations like that right now.  MF could turn into such a situation, but we are far from that will over a billion dollars still missing.  Maybe this capital will move into something like merger arbitrage (remember our point above about private equity taking down larger targets).  I'd expect to see DIPs massively oversubscribed next year on the bankruptcies we see.  Maybe the capital will move into Europe as European banks trickle out assets despite new collateral rules letting them pledge anything under the sun.  Or maybe investors start taking bold position in deeply distressed situations looking for control while at the same time exposing their investors to more volatility.  My dark horse candidate:  A healthy push into sub-prime and other non-agency RMBS and CMBS. 

Activism (in and out of the bankruptcy court) to Increase

In my opinion, and as mentioned above, the financing market for good and sizable companies is healthy right now.  A healthy financing market fuels activists as they can push for a hostile offer more reasonably with committed financing.  And even if they really do not want to take the company private, the white knight will also find himself with many options to finance a purchase.  For investors in credit, I think the combination of a healthy financing market AND lower recoveries for junior tranches will push distressed investors to write large equity / rights offering checks to give them a chance to recover their investment less they hand the keys over to senior creditors.  We saw this with Great Atlantic.  

As capital structures get more fragmented / layered, and intercreditor agreements become more friendly to revolving lenders, junior creditors are in a unique spot to "create their own recovery" as it were.  One of the most successful endeavors of this sort was Six Flags, where originally bank debt was going to retain the equity.  Then it was the opco noteholders.  Then finally, after a large equity check, the holdco noteholders took over the company and we know what happened there:

And to answer your next question:  Doesn't this contradict with what you said about lower recovery rates?  No.  In fact, it worries me because smaller investors that cannot participate in rights offerings will see a much lower ULTIMATE recovery than their peers that have the chance to participate in an equity check.

This strategy is bound to be profitable, assuming a low enough purchase price, as EVENTUALLY, Europe will correct itself, and valuations across industries will increase  If you can purchase a company in distressed with cheap financing, delever the structure, and fix operations, I think you'll have yourself a home run. 

Conclusion

Everyone is calling for 2012 to be a volatile year.  I hope just the opposite: I hope everything goes lower and assets across the board get cheaper.  But with everyone painting a doomsday scenario, I'm not quite sure that will happen.  The market is NOT ready for a sustained bullish rally - too many investors are flat or are running with a low gross exposure.  The only thing that I've known to be true in macro prognosticating: The market will move in a way that hurts the most people at anyone time.  If everyone is long, it will go lower.  The pain trade today, surprisingly, is up.  It's going to be a hell of an interesting year.  Good luck.