Hedge Fund Investing in Distressed Securities

Credit outlook: it may get worse before it gets better

THOMAS DELLA CASA AND MARK RECHSTEINER, MAN INVESTMENTS

The sharp correction in the US sub-prime market in mid-2007 was the catalyst for what has been a near perfect storm in the global credit markets. Competing fears of recession, default, inflation and the possible collapse of a large financial institution and subsequent fire-sale of their loan book helped chase liquidity from the market and lead to a substantial re-pricing of all forms of credit risk.

Distressed securities are primarily debt securities which originate from companies that are in the process of re-organisation or liquidation under local bankruptcy law, or companies engaged in other extraordinary transactions, such as balance sheet restructurings. Distressed securities typically trade at a yield-to-maturity of more than 1,000 bps over US Treasuries (UST) or below 80 cents on the dollar. Looking at the current US high yield market approximately $200 billion, or 28% would be considered distressed, up from only $8 billion a year ago. Trading in distressed securities is highly inefficient, partly because of forced selling. A hedge fund specialising in credit is often able to purchase securities at a substantial discount to its intrinsic value.

This article looks at the outcome of the current credit crisis and discusses how hedge funds can profit. The analysis is based on the US high yield and leveraged loan market which, despite the growth of other market sectors in recent years, remains the largest and most actively traded distressed securities market. Currently, the leveraged loan market trades below its previous cyclical lows, whereas the high yield market is in better shape. Hence, at current prices, the loan markets offer a more compelling opportunity. We examined the previous bear market in 2002 to estimate the best time to enter the distressed market and found compelling evidence that investing early, before the bottom, offers more upside than investing late. Therefore we recommend increasing allocations in anticipation of a J-curve like recovery. It is not necessary to pick the bottom of the market to generate above-average returns.

At the end of 2007, the high yield market was worth $888 billion and the leveraged loan market $1,061 billion. While the high yield market has not grown since 2002, the loan market has grown rapidly during the last few years and last year overtook the high yield market for the first time. This rapid growth has occurred on the back of a boom in large leveraged buyout deals, often financed by issuing leveraged loans. At the height of the credit boom last summer, over 30% of all M&A deals in the US were announced by private equity firms.


Credit markets are cyclical and generally follow the economic cycle. There were two significant bear markets in credit before and during the last two recessions (198990 and 20012001). The default rate always lags the credit spreads (credit risk spreads over US Treasuries, spreads to worst STW) as the market prices in the estimated default rates for the subsequent 18-24 months. Historically spreads have been a leading indicator of economic weakness and widened before the economic downturn was evident.

When the economy is healthy, as it was from 2003-2006, default rates decline and risk spreads tighten. This environment is supportive for long credit strategies as investors benefit from rising bond prices and falling credit spreads in addition to the current income from coupon payments. When spreads widen, as in the late 1980s 20012002 and H2 2007YTD 2008, credit risk is re-priced and while the current default rate is still low, higher future default rates are priced in. Credit spreads are sensitive to liquidity which is a leading indicator to equities and the economy. Therefore leveraged loans are usually the first to correct, followed by high yield bonds and eventually equity markets.

During 2007, close to 50% of all new high yield issues were rated B- or below. Given the recent market turmoil and the resultant closure of the credit markets, we expect to see a significant increase in the number of companies going into default, as they will no longer be able to refinance. The situation is further exacerbated by the strong possibility of a recession in the US. This will greatly improve the opportunity set for distressed managers.

In a study conducted by Ed Altman, 23.4% of bonds rated B (by S&P) defaulted over the four years ended September 2007. For bonds rated CCC, the default rate for the same time period increased significantly to 49%. This is notable as nearly 25% of issuance was rated lower quality over the period. Due to the massive growth of the credit markets and the fact that lending standards were extremely loose over the last few years, the opportunities are likely to be unprecedented in size. (see Fig.1)

If the US economy is slipping into a recession, we believe default rates of 6-7% are likely in 2009. Presently, at 794 bps STW, the high yield market is pricing in a greater than 50% probability of this outcome. According to JP Morgan, current spreads reflect a 5.4% default rate. For reference, historical average default rate are about 4%. The current average price of a high yield bond is 89.38% of par. In the last two bottoms for the credit markets (1991 and 2002), this figure was just below 70%, as seen in Fig.2. During both periods the US was in a recession, which is where it seems to be heading now.


Therefore, historical guidance indicates that there is still some downside left before markets reverse. However, if markets rebound quickly, we may not have as many compelling distressed opportunities but rather a recovery opportunity.

Prices in the loan market have already reached, or even overshot, their 2002 lows. This is due to lower liquidity and forced selling. Opportunities in the leveraged loan markets are plentiful. Given the sharp drop in loan prices over the past several months, with most issues currently trading in the mid to high 80s, loans are priced at deeply recessionary levels.

Some estimates point to an implied default rate three times higher than during the savings & loan crisis in the early 1990s, which is widely considered to be the worst credit crisis in the last 30 years. Hence, loans currently offer a more compelling investment opportunity compared to bonds (Fig.3).In order to capture potential defaults and possible recoveries, it is absolutely crucial for distressed hedge funds to invest early, as spreads usually tighten faster than they widen, especially for fundamentally sound companies. Fig.4 below shows the difference between early and late investing after the 20012002 recession. It demonstrates that the optimal date to invest would have been November 2002, thereby generating a two-year annualised return of 21.9% as October 2002 was the bottom of the market.

As it is hard to capture the bottom of a credit cycle, it is better to invest early rather than late. The average two-year annualised return for investing 1-12 months earlier than the optimal month was 15.9%, while the average for investing 1-12 months later was 13.9%. On average, investors who purchased high yield early earned nearly 34 of the return of investors who timed the market perfectly and they outperformed investors who invested too late. This asymmetrical response rate is a function of the illiquid nature of the high yield market.

Conclusion

The current credit crisis offers attractive investment opportunities for distressed hedge funds, as distressed markets are inefficient and hedge funds can often buy securities at deep discounts, benefiting from forced selling by other market participants. As a result of the very loose lending standards such as covenant-lite structures that were put in place between 2005 and H1 2007, average prices for high yield bonds have fallen substantially during the last few months while those for leveraged loans have already overshot their 2002 lows and are priced at deeply recessionary levels.

Credit markets are cyclical in nature, but capturing the bottom of the credit cycle is difficult. In anticipation of a J-curve like recovery, investing early offers more upside potential than investing late. This has been evident during the previous bear market in 2002. Furthermore, investors should not forget that distressed investing should be seen as a long-term investment.

While distressed hedge funds tend to perform better during bull markets by harvesting their ‘investment seeds’ sown during bear markets, they can also make money independent of the overall market credit cycle by focussing on company specific turnarounds.

This article appears as part of report published in April 2008 by Man Investments, ‘Hedge fund investing in distressed securities: Capturing the unique value created by corporate and economic turnarounds’.