Distressed-Debt Investors Burnt by Oil Become Coupon Clippersby
Managers renew respect for certainty of interest payments
Strategy dictates shift to higher-graded high-yield securities
It’s come to this: Some sophisticated distressed-debt investors, battered by two years of falling prices for bonds of troubled companies, are giving renewed respect to mundane coupon-clipping.
Asset managers ranging from Franklin Resources Inc. to Trilogy Capital Management LLC are shying from the riskiest issuers in favor of healthier high-yield companies. An epic drop in oil prices, a slowdown in China and the U.K.’s schism with the European Union pushed down the Bank of America Merrill Lynch distressed-debt index more than 40 percent in two years. Liquidity is now a central criteria as buyers become more selective, according to investors and analysts who specialize in troubled companies.
“The more cash a company has including access to credit lines, the better,” said Keith Luh, manager of the $5 billion Franklin Mutual Quest mutual fund. “At least we know it has enough cash to fund operations, pay the coupons and satisfy other obligations.”
Until two years ago, U.S. distressed debt was among the best post-crisis investments, returning 305 percent from late 2008 through mid-2014, according to the BofA distressed index. U.S. high-yield debt gained 173 percent in the same period.
Then oil prices crashed starting in mid-2014, draining liquidity from the energy industry. Britain’s vote to leave the EU added to the uncertainty. The annualized default rate on U.S. speculative debt rose to 4.9 percent on June 30, the highest in six years, according to Fitch Ratings. Distressed defaults were at 3.94 percent as of April 30.
That’s not what distressed investors envisioned in 2013 through 2015, when they raised about $17 billion, according to data from Hedge Fund Research Inc.
“A lot of distressed investors are not heavily involved in distressed energy credit right now” after avoiding the sector or dumping it late last year, said Jason Mudrick, whose $1.3 billion Mudrick Capital Management specializes in troubled assets. “It was too painful.”
The capital losses helped remind funds about the importance of collecting interest, or coupon-clipping as it was known when paper securities came with individual payment vouchers attached. Managers are getting more choosy as yields average close to 7 percent in the BofA Merrill Lynch U.S. High Yield index, versus about 18 percent for the distressed index.
“Going so far down the ratings spectrum isn’t always that attractive right now,” said Jody Lurie, a credit analyst at Janney Montgomery Scott LLC. “More funds are focused on stable income and thinking about how easy they can sell the debt.”
Kodak and Freeport
Franklin recently bought imaging-product company Eastman Kodak Co.’s second-lien term loan due 2020 that’s paying a 10.75 percent effective fixed rate, and metals-and-mining company Freeport-McMoRan Inc.’s 5.45 percent senior unsecured bonds maturing 2043, which yield more than 7 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Mutual Quest held about a third of its assets in corporate debt at the end of 2015, according to its investor letter. The fund, which returned 5.94 percent in the first six months and averaged 6.6 percent annually for five years as of June 30, suffered when Samson Resources Corp.’s bond, then rated CCC, lost most of its value in 12 months. The San Mateo, California-based investment firm was said to have sold most of the holding last year, Bloomberg reported. It’s still fighting for its holdings in bankrupt Peabody Energy Corp., Walter Energy Inc., Energy XXI Ltd. and distressed radio-station owner iHeartMedia Inc.
Trilogy, founded by former Bear Stearns Cos. bond salesman Jonathan Rosenstein, stayed away from risky assets for most of 2015, keeping as much as 45 percent in cash at year end, said Barry Kupferberg, research director at Greenwich, Connecticut-based Trilogy, which manages $125 million. The fund doesn’t own any CCC-rated debt, he said.
“We are running very defensively,” said Kupferberg, 53. “We look around the world and all we see is uncertainty.”
As oil fell below $30 a barrel in mid-February, Trilogy started buying bonds in Hess Corp., Anadarko Petroleum Corp., Nabors Industries Ltd. and Rockies Express Pipeline LLC, Kupferberg said. All were heavy on cash. Hess, with $3.6 billion at the end of first quarter, and Anadarko, with $3 billion, are rated investment grade by S&P.
Trilogy fell 8 percent last year, then gained 5.4 percent for 2016’s first half, said a person familiar with the fund.
Z Capital Group, a New York-based manager of more than $2 billion for private equity and credit funds, stayed away from oil and gas and focused for the last two years on hospitality and consumer goods, where there’s less competition from other investors, said Chief Executive Officer James Zenni, 61.
Jame Donath, founder of distressed-focused hedge fund Magnolia Road Capital, said he favors “stressed but performing credits where we anticipate a near-term takeout at par, as opposed to investing in deeply distressed names where returns are predicated on asset recoveries over a longer time period.” Donath, whose manages about $130 million, pointed to Zekelman Industries Inc. and Ryerson Holding Corp., whose bonds had fallen along with metals prices. Both were able to refinance and repaid the old bonds, he said.
Overall, the U.S. hedge funds investing in distressed debt and restructuring situations returned 3.92 percent in the first half of the year, according to data from Hedge Fund Research, while BofA’s U.S. high-yield corporate bond index gained 9.3 percent. Bonds of distressed or bankrupt companies were top performers in the oil and gas exploration and production sector during the second quarter, according to Bloomberg Intelligence.
Trilogy plans to keep its conservative stance this year, Kupferberg said. "We intend to bring in the sails and prepare for some choppy waters during the second half," he said.