Investors in distressed debt do not follow the conventional market psyche. While most investors relish in an environment of optimism, distressed debt funds operate under a different framework. Episodes of strong growth usually mark exit points, while recessions are fertile ground to scavenge for funding gaps that have the potential for huge upside. With the world seemingly at the precipice of an economic slowdown, distressed debt funds are readying their arsenal for what they consider could be a slew of opportunities ahead

What is distressed investing? Distressed investing strategies involve scouring the market to snap up undervalued debt of bankrupt companies, or those with a high likelihood of default. Distressed debt funds review companies’ capital structure for opportunities and purchase underpriced securities with as deep a discount as possible. They then work with other creditors and enhance the securities’ value (e.g., by negotiating bankruptcies to maximise recovery, taking control of an insolvent yet fundamentally sound business, selling assets of the insolvent business, etc.)

A return of distressed opportunities. The pre-pandemic past decade of cheap funding and relatively low default rates resulted in a dearth of opportunities for distressed debt funds. This is set to change, however, as funding pressures and falling asset prices persist. Although the US economy is displaying remarkable resilience despite undergoing one of the most aggressive monetary tightening cycles in recent history, aggregate data overlooks cracks under the surface. Although households and investment grade corporates could be equipped to weather a challenging macro environment, divergence by credit quality is increasing. Elevated interest rates and slowing growth are already weighing heavily on the weakest borrowers – highly-leveraged companies with floating rate capital structures.

Conditions leading to a rise in distressed opportunities are materialising. For one, recent movements in the treasury yield curve have been sending ominous signals – inversion of the yield curve has historically been a reliable precursor to a US recession, having preceded the past seven recessions by approximately 10 months on average. Furthermore, examining a shorter available history of default data, dis-inversion of an inverted yield curve had foreshadowed the last three peak default cycles in which default rates amongst speculative-grade borrowers reached at least 10% a year. If history is any guide, recent dis-inversion of the deeply inverted yield curve could foreshadow a surge in defaults. The average lead time of inversions across all three prior peaks default cycles was c.34 months, which would place the default rate at c.10% by the second half of 2025, coinciding with a period which sees a spike in speculative grade maturities.

Furthermore, leading indicators of escalating credit stress are apparent, promising an environment with more distressed opportunities, with ratings agency S&P projecting loan defaults to become increasing prevalent in the months to come as companies struggle with elevated rates and refinancing their existing borrowings:

• High interest rates pose a significant challenge, especially for riskier debt – overnight reference rates surged from just 0.05% in February 2022 to more than 5% today. With rates likely to remain higher-for-longer, this adds a significant interest burden for floating-rate borrowers, which already have the weakest credit profiles.
• Banks have begun to curtail lending, especially to riskier borrowers – risk free rates of c.5% offered on default-free government risk present a high hurdle for banks to part with capital. Data from the Fed already shows considerable tightening in bank lending.
• Rising refinancing risks given looming maturity wall by 2024 – nearly USD250b of US speculative-grade borrowers have debt maturing in 2024. These borrowers will face dual headwinds of unwilling lenders and elevated rates. With banks stepping back from lending, this opens a gap for alternative lenders, including distressed debt funds to step in.

Making the most of a stressful situation. Although the current environment threatens to bring difficulties for businesses that are heavily reliant on borrowings, this would mean a surge in supply of heavily discounted, non-performing debt. Anticipating a fertile hunting ground, distressed managers expect compelling deal flow and have begun preparing to capture such opportunities by gathering dry powder. Accordingly, data provider Preqin notes a record number of distressed debt managers now raising funds – more than 80 distressed funds are raising funds (as at June 2023), a figure higher than at any point in the last decade. Similarly, more investors are also becoming convicted of opportunities in distressed debt, with 49% of respondents in Preqin’s Investors Survey expecting this strategy to be the best performing private credit strategy over the next few months.