Disdressed investing evoluted - Howard Marks

 

Key factors affecting the credit cycle have changed since our founding. For one, debt has become much less expensive, as interest rates have trended downward for four decades. The yield on the 10-year Treasury note topped 15.0% in the early 1980s, fell to 7.88% by the beginning of 1995, and is 1.58% today.

Additionally, the default environment has become more benign. Default rates for high yield bonds and leveraged loans fell rapidly after spiking during the Global Financial Crisis of 2008-09 and have spent the majority of the last decade well below their long-term historical averages (see Figure 1)

“GOOD COMPANY, BAD BALANCE SHEET”

Distressed debt investors have traditionally bought the liabilities of companies that are in bankruptcy or otherwise appear unlikely to meet their financial obligations. The preferred target is a business with too much debt but also a strong underlying business, valuable assets, and/or the ability to generate cash. Such companies may struggle to service their debt during economic downturns. These overleveraged companies often reduce their debt by going through a restructuring either within or outside of bankruptcy court, whereby most creditors agree to exchange old debt for new securities worth less than 100 cents on the dollar.

The size of the distressed opportunity set has historically been correlated with the credit cycle. Companies are likely to struggle to service or roll over their debt – and therefore see their debt trade at distressed levels – when markets are falling, the economy is slowing or contracting, and the majority of investors are increasingly risk averse. However, this relationship has become less pronounced in recent years as investors in distressed opportunities have broadened their scope beyond public debt and companies facing Chapter 11 bankruptcy.

During the Covid-19 crisis, default rates for high yield bonds and leveraged loans rose above pre-pandemic levels, but never approached the double-digits heights seen during prior crises. Yet distressed investors with global networks and access to large amounts of capital were still able to find attractive opportunities – especially in sectors most exposed to the pandemic, such as retail, travel & leisure, real estate and energy. We believe the investors best positioned to seize these opportunities were those who had spent decades broadening their investment repertoire.

Investors in distressed opportunities benefit by being able to dispassionately analyze securities and companies; stomach potential illiquidity; control their emotions; and add value, including by leading restructurings, crafting creative financing solutions, and engineering financial turnarounds. Investors may have honed these tools in traditional distress scenarios, but in recent years, some investors have used this skillset to tackle situations in which companies aren’t involved in a bankruptcy process or where solvency isn’t the primary concern.

The evolution of this investment style has been a gradual process. In the late 1980s, investors like Oaktree’s principals, who focused on distressed assets, were primarily targeting U.S. high yield bonds. The opportunity set eventually expanded to include bank debt, mortgages and opportunities in growing non-U.S. markets. In the 1990s, distressed opportunities investors increasingly began exploring situations that were complex but not classically distressed, especially those in illiquid markets or niche industries in which companies’ access to capital was limited.