Alternatives: A Return of Distressed Debt Opportunities
Leading indicators of escalating credit stress point towards an environment with more distressed opportunities
Chief Investment Office19 Oct 2023
  • At the cusp of an economic slowdown, distressed debt funds are poised for opportunities
  • Distressed debt investing targets companies with a high likelihood of default
  • Elevated interest rates, tightened lending standards, and rising refinancing risks support defaults
  • Distressed debt funds to extract value from surge of steeply discounted non-performing debt
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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.

Figure 1: Dis-inversion of an inverted yield curve has preceded the last three peak default rates

Source: Bloomberg, S&P Global Ratings, DBS. Shaded areas represent NBER recessions

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