November 13, 2018
James W. Sweetman, Senior Global Alternative Investment Strategist
Yegin Chen, Global Alternative Investment Strategist
Distressed Debt — Four Global Themes Beginning to Emerge
- Over the next several years, we believe that significant segments of the global economy are susceptible to meaningful price dislocations, creating compelling opportunities for the distressed debt strategy (both in liquid hedge funds and in illiquid private debt funds).
- Globally, geopolitical tensions remain high, with most regions of the world affected to some degree. The potential for trade wars between the U.S. and its major trading partners and new conflicts in the Middle East represent heightened risks to the global economy.
What it May Mean for Investors
- For qualified investors, we favor private debt and distressed credit managers who have distinct competitive advantages, including extensive experience underwriting and scale to successfully capitalize on global distressed opportunities.
Potential market opportunities
With the U.S. economic recovery approaching its 10-year anniversary, many investors are concerned about the inevitable downturn and are interested in whether the downturn may present opportunities. The following are four key global themes that we believe may lead to opportunities for the distressed debt strategy to take advantage of meaningful price dislocations and outsized returns.
Global central bank tightening
Two key central banks, the U.S. Federal Reserve (Fed) and the European Central Bank, have embarked on tighter monetary policies, creating a widening divergence with other central banks. This monetary tightening (and any resulting increases in interest rates) opens the possibility of decelerating economic growth and intensifying pressure on the monetary systems of emerging economies where recovery has not been as robust. Recently, for example, the Indian rupee dropped to an all-time low versus the U.S. dollar. The Indonesian rupiah fell to its weakest level in over 20 years, and the Turkish lira plunged by more than 40% versus the U.S. dollar. The central banks of all three emerging economies have raised interest rates to defend their currencies, but in doing so, may have put the brakes on near-term economic growth prospects.
Elevated debt levels
Globally, economies have not exercised fiscal restraint during the decade since the global financial crisis. As a result of fiscal stimulus and similar measures, debt levels as a percentage of gross domestic product (GDP) are at or near record highs in many major economies and often surpass levels we saw prior to the 2008 financial crisis. Total debt (including household, government, and non-financial corporate) to GDP levels in several major economies—including the U.S., Canada, China, Australia, France, and Italy—generally have been trending higher or are at levels comparable to those prior to 2008.
In particular, despite steady economic progress in recent years, the European Union (EU) has a total debt-to-GDP ratio of over 200%. Several economies—notably the U.K., France, Spain, Italy, and Ireland—have levels exceeding the average, leaving some households and corporations vulnerable to economic slowdown and potential future higher interest rates.
Continued regulatory pressure on banks with non-performing loans1 (NPLs)
Despite a firming economic recovery, the volume of NPLs remains elevated in many European economies, weighing on banking sector profitability and encouraging sales of residential mortgage as well as other loans. In 2017, approximately €24 billion2 in residential mortgage loans were sold, more than double the €11 billion3 in 2016, as government sponsored asset management agencies disposed of the mortgages as house prices improved, particularly in the U.K. and Ireland. Several economies—specifically Greece, Italy, Portugal, Ireland, Spain, and Poland—still have material NPL issues.
Heightened geopolitical tensions
Global geopolitical tensions are high, with most regions of the world affected; this presents risks to the global economy. Trade disputes between the U.S. and its major trading partners—including China, the EU, and Canada—show no signs of cooling off at the moment. The deteriorating relationship between the EU and Russia since the 2014 Ukraine crisis has resulted in sanctions that have hampered trade and reduced economic cooperation. And as of October 2018, there is still little clarity on the means by which the United Kingdom will leave the EU on March 29, 2019, as the possibility remains of a “no-deal Brexit” that may increase volatility and reduce trade.
In this environment, we believe that the distressed debt strategy offers the “best of both worlds”—the cash flow potential of debt investments with the upside potential of equities. Distressed debt generally trades at a significant discount to par value (for example, $300 for a $1,000 bond), because the borrower is under financial stress and faces default risk—or from volatility that has lowered the price of both distressed and healthy debt. Qualified investors can participate via an illiquid private debt, drawdown structure that allows the manager to deploy capital opportunistically over a three-to-five year period as market dislocations occur, or they can participate through a distressed credit liquid hedge fund structure that grants access to a seasoned portfolio of global distressed investments.
There are risks involved in investing in this strategy. Distressed securities are primarily debt securities which originate from companies that are in the process of reorganization or liquidation under local bankruptcy law, or companies engaged in other extraordinary transactions such as balance sheet restructurings. Investing in distressed companies is speculative and involves a high degree of risk. The market values of distressed securities may not reflect their true values due to illiquidity related difficulties in the pricing process, inadequate research coverage, among other things. Distressed companies most likely will declare bankruptcy shortly, could currently be in bankruptcy proceedings or are just emerging from bankruptcy. Because of their distressed situation, private debt funds may be illiquid, have low trading volumes, and be subject to substantial interest rate and credit risks. These funds often demand long holding periods to allow for the end of the debt's term or an exit strategy via the secondary market.