A $56 Billion Pile of Cash Seeks Home as Distressed Debt ShrinksBy
Low rates, rising commodity prices translate to less distress
‘Low interest rates are letting companies prolong problems’
They raised the money, and now they have few places to put it.
U.S. distressed debt managers have $56 billion to invest, the most dry powder for the industry ever, according to research firm Preqin. But there just aren’t enough bad loans and bonds for them to buy: the amount of outstanding troubled debt has fallen by more than two-thirds since peaking in March, Bank of America Merrill Lynch index data show.
Supply is low in part because of rebounding prices for commodities including oil, boosting revenue for energy companies that would have otherwise gone broke. And the Federal Reserve is expected to keep rates lower for longer than investors planned, which is making it easier for distressed companies to refinance.
“Low interest rates are letting companies prolong their problems without having to restructure,” said Keith Luh, manager of the $5 billion Franklin Mutual Quest mutual fund, which invests in distressed bonds and loans as well as undervalued equities. “It’s made life very difficult for distressed funds.” Corporate bankruptcy filings have fallen more than 40 percent since mid-May, a Bloomberg index shows.
The trouble underscores how the Fed has distorted a wide range of markets by keeping rates low. It also illustrates how hard it can be to time distressed investments. Few investors anticipated a shortage of troubled debt in 2015 when the Fed started to hike rates and the price of oil was plunging. Funds ranging from Oaktree Capital Management LP to Centerbridge Capital Partners to Blackstone Group LP’s GSO Capital raised a total of about $37 billion last year.
With less distressed debt, investors are likely to take more risk, said Bennett Goodman, co-founder of Blackstone’s credit arm GSO Capital Partners.
“We see how much capital is coming to the market, we see that guys are willing to do more aggressive things because there’s more competition,” Goodman said, speaking at a conference last month.
With investors more willing to lend, companies with maturing debt have been able to refinance instead of going under. Demand for higher-yielding debt has lifted prices for much of the bonds and loans to levels so high, it can’t be called distressed anymore. To qualify as distressed under one common definition, a bond or loan must yield at least 10 percentage points more than Treasuries.
Even debt that still clears that hurdle is offering lower returns for investors: The average yield on distressed debt in the Bank of America Merrill Lynch U.S. Distressed High Yield Index fell below 19 percent in October from 24 percent eight months ago.
Consider coal producer Peabody Energy Corp., whose bond prices in some cases have risen around 700 percent since the company filed for bankruptcy in April. Its $1 billion of second-lien bonds maturing in 2022 traded around 7 cents on the dollar on April 13, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority, and now trade around 56 cents on the dollar.
“It’s harder and harder and harder to find value even if you look in the dustbin,” said Wilbur Ross, the billionaire distressed-debt investor who runs WL Ross & Co., on Bloomberg Television last month.
Funds that have raised money for distressed bonds and loans have few options. Those that can invest in other strategies, such as merger arbitrage, are doing so, money managers said. They asked not to be identified, because their strategies are private. In some cases, the investors can put money into stocks or other assets like troubled real estate, or in European distressed debt. But many money managers cannot go these routes, because their investment policy statements do not allow it.
“People are sitting on a lot of money and waiting,” said Jay Goffman, co-head of restructuring practice at law firm Skadden Arps Slate Meagher & Flom, which advises clients investing in distressed debt.
It’s possible that their waiting will be rewarded. Bruce Richards, chief executive of distressed debt investment firm Marathon Asset Management, predicts a 2018 recession in the U.S., and a “big wave of defaults.” His firm is “waiting for the shoe to fall off,” he said. “After it hits the ground and you head the thud, then we go in and we evaluate it.”
For now, default rates are declining. Fitch expects about 5 percent of outstanding junk debt this year to default, a figure it lowered last months from its prior forecast of 6 percent. Next year, it expects a 3 percent default rate. The recessionary average is 11.1 percent.
“As long as the Fed continues to pump money into the market, troubled companies will continue to survive,” Skadden’s Goffman said.