Braced for the descent

A benign environment of high liquidity and low interest rates may be coming to an end. Distress specialists can’t wait for the fun to start.

White-knuckle rides are one of those things you love or hate, inciting either a welcome rush of adrenaline or blind terror. Distressed debt investors fall into the former category – hence, the wild stock market swings seen so far this year have been very much to their taste.

There have been numerous false dawns lately for those awaiting signs of stress. Early last year, there was a view that distress could be triggered by the outcome of elections in key European states. The reality was far from it: an orderly transition and stronger economy in France and – despite the difficulty in forming a government – little negative fallout in Germany either.

Even many of those companies showing signs of fraying at the edges have been able to fend off decline by taking advantage of continuing liquidity in the high yield bond market. As Duncan Riefler, a senior advisor at placement agent Arbour Partners, told us recently: “Everyone has been chasing the same deals in Europe for some time now. There have been a few blow-ups, but the combination of low interest rates and quantitative easing have allowed companies that are not doing well to keep trundling along.”

“Trundling along” is not an appetising phrase for distressed debt funds, which raised a record-breaking $61 billion last year, according to PDI data – around double that in 2016 and well above the previous high of almost $42 billion in 2012.

But did those successful fundraisers and the investors that wrote big cheques supporting them sense something was afoot? Making predictions about stock market movements is potentially a fool’s errand but – whether envisaged or not – the steep falls and surges seen in the early part of 2018 offer a sense that the foundations of financial markets are starting to wobble as nervousness and unpredictability creep in.

The recent Global Leverage Trends report from S&P revealed that, by its own definition, the proportion of highly leveraged corporates globally stood at 37 percent in 2017 – five percentage points higher than in 2007. With inflation rising in key markets and the prospect of faster and more pronounced interest rate rises – and with monetary policy perceived to be on the path to normalisation – there is a sharpened scrutiny around the sustainability of credit profiles.

Because of the much-hyped erosion of covenants in deal structures, problems will be masked and may only become apparent at the point of collapse, prompting a sudden spike in default rates. Some predict this could happen in the later months of 2018 or perhaps the early months of next year.

Given the way in which the winds have started to whip previously calm waters, expect this year to be another strong one for distressed debt fundraising. By the time things take a clear turn for the worse, there will be plenty of capital waiting to take advantage.

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