It's been over a year since the Federal Reserve ended the era of low interest rates with its first in a string of rate hikes. As markets continue to price in this new regime, we see a budding opportunity for distressed and opportunistic credit investment strategies. Investors may now want to prioritize this segment of the market to add diversification and enhance the return and income potential of their portfolios.
As interest rates rise, there is a negative impact on bond prices. Distressed and opportunistic credit managers seek to buy discounted debt with the intent to trade it for a gain, refinance the debt at a more favorable rate and/or maturity, or work with the borrower through a bankruptcy or reorganization.
In 2020, distressed opportunities were largely short-lived due to unprecedented monetary and fiscal stimulus in reaction to the pandemic. Today, such stimulus interventions are much less likely given persistently high inflation, higher interest rates and elevated debt/GDP ratios. Instead, the Fed has embarked on its most aggressive pace of monetary policy tightening since the early 1980s. Fed Chairman Jerome Powell has stressed the need to push monetary tightening to a level that is "sufficiently restrictive." While inflationary pressure has subsided in recent months from a high of 9.1% in June 2022 to
Signs of stress can already be seen, with distressed pricing of U.S. leveraged loans and high yield bonds increasing to approximately 7% and 20%, respectively. Default rates have ticked up as well. The Proskauer Credit Default Index, covering middle market companies, showed a default rate of 2.06% for Q4 2022, up from 1.04% in Q4 2021, with a significant uptick in stress among consumer goods, service sectors, and health care.
In addition, while many loans issued during the previous low interest environment trended towards "covenant-lite" —fewer protections for lenders and fewer restrictions for borrowers — we have seen an uptick in covenant breaches. According to Lincoln International, covenant breaches within its private equity-backed company database have increased to 4.2%, which represents the fourth consecutive quarterly increase. Companies that had previously been able to borrow at low rates must now deal with the prospect of much higher borrowing costs.
Recession odds shortening
An analysis conducted by the New York Federal Reserve Bank in January produced a 57% probability of a recession 12 months out — the highest probability from this analysis since the early 1980s. The combination of economic slowdown and mounting company stress will potentially result in higher default rates, and projections show that default rates could hit approximately 5% to 7% in that environment, with the potential to push higher in a prolonged recession.
Another factor that benefits distressed investing has been the growth of global corporate credit markets following the 2008-2009 financial crisis and lack of bank-sponsored lending to meet the capital needs of the space. Credit markets have seen an explosion in size going back to 2008, with the market now three times larger at $5.1 trillion, according to an October report from Proskauer Rose. The growth in credit has been broad, with high yield ($2.0 trillion), leveraged loans ($1.7 trillion), and direct lending ($1.4 trillion) showing significant increases. Given the previously stated projection of default rates, it is possible that we will see an opportunity during this period in excess of $300 billion, which is larger than the $200 billion opportunity set experienced during the last financial crisis.
While the true outcome of the upcoming distressed environment hasn't fully taken shape yet, distressed managers will have multiple avenues for sourcing and executing on opportunities. During periods of stress, both public and private credit opportunities will see pricing pressure, allowing managers an opportunity to find companies with quality fundamentals that are trading at a discount.
Additionally, as the primary provider of fresh capital, distressed managers can exercise meaningful influence on companies, whether it be through advantageous restructuring or a full takeover. We believe that distressed and opportunistic credit investment strategies are not only poised to play a role in today's environment but can act as a diversifying asset class to an investor's portfolio for the long term.
