For investors who thrive on chaos, the pandemic had all the hallmarks of a generational opportunity.
The shock waves that convulsed through financial markets back in February and March sent the level of distressed debt soaring, as a slew of U.S. and Canadian companies faced the sudden prospect of bankruptcy or default.
Reminiscent of the credit crisis more than a decade ago, these kinds of episodes usually see hedge funds generate astronomical returns by sinking vast sums of money into companies that cannot access financing through normal channels.
But then the central bankers changed the game, practically overnight. The U.S. Federal Reserve, Bank of Canada and others reacted to the COVID-19 crisis with incredible force, promising essentially unlimited liquidity to stave off a credit crunch.
“The central bank response has really spoiled the party for bottom fishers,” said Hanif Mamdani, lead manager of the PH&N High Yield Bond Fund. “The flood of cash into the credit markets completely changed the psychology.”
While a wave of business failures is on the horizon, large, publicly traded companies are not the ones at risk, for the most part. This particular crisis has put small business in its crosshairs.
Back in 2009, the collapse of Lehman Brothers put the global market crash into hyperspeed, and the spreading panic pushed high-quality bonds – senior secured debt issued by big, strong U.S. companies – to fire-sale prices.
For distressed-debt investors, it was a feeding frenzy, scooping up bonds priced as low as 20 cents on the dollar. Apollo Global Management Inc., a major player in the space, invested close to US$50-billion in one four-month period.
As the global financial crisis eventually faded and an economic recovery gained traction, a period of unusual stability in financial markets took hold.
“For the past decade prior to COVID, it’s been a relatively fallow period for distress,” Mr. Mamdani said.
With little choice but to wait for the next big opportunity, distressed-debt funds built up a huge cash pile, which hit a record US$77-billion last year, according to Preqin data.
Cue the pandemic. With entire industries on lockdown and global financial markets in a tailspin, the level of U.S. distressed debt on the market quadrupled in under a week to nearly US$1-trillion – the highest level since 2008. These are securities trading with a yield at least 10 percentage points higher than comparable government bonds.
Even the safest blue-chip borrowers were shut out of credit markets. This was apparently the chance for distressed-debt investors to put all that hoarded cash to work.
Brookfield Asset Management Inc., which last year bought a controlling stake in the world’s largest distressed-debt investing company, Oaktree Capital Group LLC, accelerated its fundraising effort to capitalize on the market turmoil.
“This is one of the great environments possibly, to buy distressed debt, that may have ever been in existence,” Brookfield chief executive Bruce Flatt said in the company’s first-quarter earnings call.
For these kinds of investors, it’s crucial to draw the distinction between good companies facing credit pressures and companies that are simply doomed.
“A pandemic creates opportunities when otherwise healthy companies face strains because capital has dried up. It’s artificial pressure,” said Jonathan Halwagi, a partner at Fasken Martineau DuMoulin who works with distressed-debt funds.
“But when governments are very aggressively stimulating the economy, you don’t get a lot of companies facing artificial pressure,” Mr. Halwagi said.
In late March, the Fed announced a facility to buy investment-grade debt, as well as “fallen angels,” which are generally high-quality borrowers that have been downgraded to junk status. The Fed even started buying up junk-bond ETFs. This was monetary shock and awe.
For its part, the Bank of Canada’s stimulus measures included its first foray into the corporate credit market. While only about $150-million of corporate bonds have been purchased so far, the program was key to restoring confidence, Mr. Mamdani said.
On both sides of the border, credit markets rapidly normalized, yields plunged and the taps reopened. More than US$350-billion in high-yield debt has been issued year to date – already breaking the previous full-year record.
The total stock of distressed U.S. debt has declined by 75 per cent, and now sits at roughly US$240-billion, according to JP Morgan data.
In many ways, the economic burden of the pandemic has shifted away from the corporate sector and onto small business.
“There is a ton of distress out there, and there are going to be a ton of bankruptcies. But it’s going to be mom-and-pop shops, restaurants and small retailers,” Mr. Mamdani said.
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