Special situations: Distressed debt in testing economic terrain

For businesses that maintain high levels of floating rate debt, last year may have been particularly tough as they contended with rising interest rates and other macroeconomic factors such as supply chain disruption.

Persistently high inflation resulted in one of the worst years for the European economy in recent times. Meanwhile, the energy crisis in Europe (fuelled by the Russian invasion of Ukraine, and suspension of flows in the Nord Stream pipeline) has seriously impacted the energy and food markets. All of this, combined with record-low consumer confidence, adds further strain to many already-struggling businesses.

“At a time when many companies may need extra capital to help them trade through a potential recession, capital markets have been disrupted and remain difficult to access.”
 

Investors, on their side, have found themselves contending with higher interest rates and double-digit inflation, and the risk of elevated inflation in Europe this year remains. Indeed, despite troubles in the banking sector, the European Central Bank announced it would hike its main interest rate above the 3% mark for the first time since 2008¹ in March, signalling that inflation remains a high priority on its agenda.

The outlook does not look rosy in the short-term either. Global growth forecasts generally converge around a deceleration of growth in 2023, in fact the World Bank expects the third weakest pace in nearly three decades after the global recessions caused by the Global Financial Crisis (GFC) in 2009 and the pandemic in 2020².

In our view, it is likely that selected corporate stress will persist for a number of years, particularly as refinancings are required.

A tough environment for businesses

Corporate leverage is increasing, and credit spreads are widening, making it harder for companies to refinance. Meanwhile, central banks are reversing quantitative easing programmes after years of unprecedented growth. Although some firms with strong sales growth and strong balance sheet can stay buoyant through periods of high inflation and interest rates, many others will be impacted by these headwinds.

At a time when many companies may need extra capital to help them trade through a potential recession, capital markets have been disrupted and remain difficult to access. Even the high-yield and leveraged loan markets, which typically provide capital to companies with weaker balance sheets, have become significantly more selective. With corporate leverage levels at cyclical highs and the capital markets disrupted, some businesses could struggle to refinance. If this trend persists, many companies are going to need to look for alternative sources of capital.

Additionally, as maturity walls approach, over-indebted companies are likely to struggle with debt burdens, which were taken on in more benign times on the assumption of a smooth recovery from the pandemic. With volatility and uncertainty expected to continue, this has proven not to be the case so far for many businesses.

Faced with significant maturity walls from 2025 onwards, companies fearing they will not be able to refinance in time may seek to pre-emptively negotiate an extension on their loans to gain additional time to address to their financial difficulties. Lenders, such as M&G, can use these amend and extend requests to strengthen creditor protections in the loan documentation.

Distressed debt specialists need to have the legal expertise to understand the covenants in a loan agreement and insert appropriate covenants in place to ensure they are protected if the borrower is unable to satisfy the loan agreement. Furthermore, accounting expertise is crucial in order to better understand the causes of underperformance and financial stress and to help companies regain full health.

Finally, some companies will come to realise that their leverage is simply unsustainable and a reduction is needed. For those that have ‘a reason to exist’, a solution may be found through financial restructurings where the debt pile gets reduced in exchange of equity ownership.

Identifying distressed debt opportunities

As recessionary pressures increase, these create three opportunities for specialists in the distressed debt space: market dislocation trades, restructuring situations, and rescue financing.

With increased volatility and widening spreads, market dislocation trades may provide short-lived opportunities to acquire the debt of high-quality corporates at distressed yields. In restructuring situations, investors could potentially unlock value by restructuring businesses that have a reason to exist but face short-term issues brought on by a challenging macroeconomic environment. Some companies may find themselves unable to access capital because of ‘big but solvable’ problems – this is where rescue financing may come into play.

For each one of these three opportunities, a distressed debt investor needs to have as much information as possible, as early as possible, on the broader fixed income market.

Learning of a company’s challenges earlier means a distressed debt team can understand the situation in greater detail, making the necessary evaluation to identify any potential opportunity to restructure or deploy capital to support the company and help it survive. When combined with a large position in the company’s debt, it also allows the investor to have more of a say at the restructuring table. 

¹ European Central Bank, “Key ECB interest rates”, (ecb.europa.eu) 16 March 2023.
²  World Bank, “Global Economic Prospects”, (worldbank.org), 10 January 2023.

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.