Outlook 2010: Distressed debt supply misses its mark in 2009; new issues help to fill the void

By Stephanie N. Rotondo

Portland, Ore., Dec. 31 - The distressed debt market had its fair share of blowups in 2009, as the default rate soared and bankruptcy filings hit record levels.

Though that was largely expected toward the end of 2008, what was not expected was the resulting lack of supply in the distressed realm, as companies were actually able to enter the credit markets.

"We were supposed to be in a horrific environment and we have bankruptcies ending in under a year," noted Kerry Stein, head of distressed debt trading at Jones Trading.

But the loosening of credit allowed many distressed companies to refinance or restructure, something that no one had expected. The end result was a "vibrant" new issue market, which is expected to continue through 2010 as companies come back to refinance debt at cheaper rates.

"There is just a ton of money available, so people will be chasing ideas," said one anonymous source.

Still, supply is not expected to increase too much, though there is expected to be a number of so-called "blowups." However, it is unclear where the shoe will drop next.

2009: Hit or miss

Though market sources differ on whether or not 2009 hit its mark, they can agree that there were a few surprises.

Diane Vazza, managing director of Standard & Poor's global fixed income research, said that her expectations for the past year were met, in so far as credit spreads came down and defaults ticked higher - though maybe not as high as was expected.

"At the end of 2008, credit spreads were at an all-time high," she said, adding that they "came down gradually in 2009. At that time, the forecast was that default rates would be higher."

And in fact, every month, the default rate did go up, reaching 11.11% by mid-December. Still, she said, "it did not reach as high as we had thought."

And that is where the surprises came in.

"A number of weaker issuers were able to restructure and had access to the market that surprised everybody," she explained.

"We saw it pick up, but we didn't see it explode," said Eric Tutterow, managing director of Fitch Ratings' leveraged finance division. In his view, that was because many companies were able to "extend maturities on loans," as to avoid covenant issues in the near term.

Being able to renegotiate with lenders enabled the companies to "push the problem out," though that was not necessarily a solid solution, he said.

Assuming the economy picks up, Tutterow said, they could refinance at a later point - that is, if they can access the credit markets.

But Stein was not nearly as optimistic about the market as Vazza and Tutterow.

"Given where we started this year and what the expectation was, I don't think anyone would have envisioned the orderly nature [in which] we got things done this year," he said.

For example, he explained, the number of pre-packaged bankruptcies was rather high, allowing companies to enter and exit Chapter 11 protections swiftly and efficiently, pointing to names such as CIT Group Inc.

"So there really was no fallout," he said.

Stein believes, like Vazza, that the missed expectations of the year were due to the credit markets opening back up.

"Capital came back into the market way faster than I would have envisioned and probably faster than 99.9% of market participants would have envisioned in the end of 2008," Stein said.

"That's not to say there wasn't a lot of business this year, but it turned into a new issue market," Stein added. "I certainly didn't expect that and didn't expect [new issues] to be as vibrant as it was."

"I thought it was going to be a much longer distressed cycle," added another market source, echoing Stein's comments regarding those companies that were able to file for bankruptcy and restructure in a quick and orderly fashion.

"We had a fair number of restructurings, and there are still a lot that will occur," the source said. "But the market turned," as economic manipulations by the government seemed to help open up the credit markets.

Still, "there was a fair amount of stuff to trade, a fair amount of volatility," the source conceded. "That made it interesting, but it would have been great if it lasted longer."

But even though many companies were able to restructure in some form or another, "now the big question is have they weathered the storm?"

New issues surge

Getting back to what Stein said about the new issue market, things in that space did pick up considerably in 2009 as companies began to issue new debt, mostly in an effort to pay off old debt. This renewed access to the credit markets was remarkable, as a fair few of the companies participating in the new issue market would likely have not been able to do so in 2008 or even 2007.

Tutterow opined that the surge in new issues was simply the market reacting to demand for high-yield paper, noting that the financing "instrument of choice" in the previous cycle - that is from about 2002 to 2007 - was leveraged loans. That resulted in "pent up demand for paper in the high-yield market."

"Demand is great," he said. "Most deals are being oversubscribed."

But that wasn't the only reason, he continued. Asset and money market funds, as well as bank deposits, were increasing, leading investors to seek higher yields - and in some cases, higher risks.

Even CCC-rated companies are able to get financings, with yields higher than they once were, he said. One major difference, he pointed out, was that many new issues were coming secured rather than unsecured. Also, original issue discounts are "now smaller than they once were."

"At least the way the market feels right now, you will continue to see a pretty active new issue market," a source said. Companies that recently accessed the credit markets at higher prices, for example, will come back to refinance with better terms.

New players take the field

The last year also saw the emergence of some new distressed debt investors, investors that are "a little more savvy," according to one source.

"How many more hedge funds have popped up?" he said. "In theory, there are a lot more people participating" in the distressed market, though now it is a "broader group."

The source said that his firm was one that "tried to convince more equity-type funds to participate in the capital structure because you can get equity-type returns, but you will be in a favored part of the cap structure."

A lot of guys, for instance, got involved in the distressed loan market, as it "got hammered."

"A lot of people were playing in that just because a lot of that paper had distressed-like returns but you were moving up and playing a top part of the cap structure," he said.

Still, he said, while many funds and investors saw good returns - or at least, better than in 2008 - "I don't see people having the same returns as [2009]."

"You really need volatility to get those kind of returns that occurred this year," he said. "They will start to realize they can't sustain that kind of performance."

2010: Another shoe to drop?

As the distressed debt market prepares for another year, questions about what the year ahead will look like remain. In some cases, people believe that the market could face another downturn, while others just cannot imagine that happening.

"I expect to see more distressed situations [in 2010]," said Stein. I can't imagine that we get through [the economic crisis] with as little pain as we have had."

Though Stein does admit that the 2009 market "saw resilience," he equated it with an old saying: "I don't believe this is real, but I wouldn't stand before a running freight train."

"I expect another shoe to drop," he said. "We haven't paid a steep enough rice for what was done with this economy."

For one, he said, the levels of government debt are "not sustainable," unless the economy sees "huge sustainable growth." That could then weigh on the credit markets once again, poising the debt market for another bubble.

Another thing Stein points to is how many low-rated companies have bonds trading well above commonly accepted distressed levels.

"Something is priced wrong, one way or another," he said. "Either it's better or it's worse, but it can't be both."

But another distressed trader thinks it is "hard to imagine" another shoe dropping, even with the "incredible" pricing in the market.

"It's hard to imagine the market will go down again," the source said. "There is still a lot of cash on the sidelines and being put to work."

And, as companies have been able to refinance or restructure their balance sheets, there is less leverage in the market as there was leading up to the recent downward cycle. "So it's hard to think that will unwind as vicious as it did before."

But in regards to current pricing levels, it's all about valuations and how the market is deciding those values, the source said.

"It's all about valuations and whether or not the company can restructure and be a viable business," the source said.

As values gyrated with the market, players were looking for a bottom, which had resulted in a weakening of the market. As value came back, the market rallied.

"Things got pretty ugly and people were forced to sell positions," he said. That resulted in more supply than demand and, as any economics professor would tell you, resulted further in pressure on pricing.

"It probably got pushed down too far," he conceded. However, "now what you are seeing is people are valuing companies no longer at trough valuations.

"Enterprise value has gotten back to a level where there is a chance that senior notes may be made whole," he added.

Some pain still imminent

But regardless on where they stand in the shoe-drop debate, everyone agrees that there will be some blowups come 2010.

Vazza notes that even some of the companies that were able to access the credit markets might still hit a wall, particularly in the consumer discretionary, media and entertainment and retail/restaurant sectors.

"Most of the ratings in those groups are speculative grade," she said. "So if you get softening economic conditions, it's no surprise that those would fall by the wayside."

S&P, for its part, is predicting a 6.9% default rate through the third quarter of 2010, still well above the long-term average of 4.5%.

"Companies that are really the most speculative grade - to the extent that they don't have top line growth - will still have trouble financing," Vazza said. "I don't expect the markets opening up to those."

"What I have found, for the most part, is that an overwhelming majority of our outlooks for 2010 are stable," Tutterow added. That signifies continued - if not marginal - recovery, he said.

But there are still some negative areas, he said, pointing to many of the same sectors that Vazza mentioned.

"The next three months will really give a pretty good idea if this incredible amount of liquidity pumped into the system worked," Stein said. "We won't have to wait long to see if there is ugliness and what that ugliness is going to be."

However, Stein thinks the "ugliness" is not necessarily predictable as far as where it will come from.

"Within any space, there will be winners and losers," he said.

Another source expects that the financial sector "will still be pretty volatile," as the market learns just "how aggressive have guys been on taking writedowns."

The retail space will also be "interesting," he said. In that arena, most of the improvement has come not from top line growth, but from the management of costs and inventories.

"If there is not top line improvement, retail is still going to be a tough spot to be in," he said.

Also, the media sector will be one to watch, the source said.

"Maybe they are bottoming, but I think they are going to go sideways," he said. "I don't think they will ever really rebound."

Look before you leap

In the end, distressed debt players will need to do their homework before making investment decisions, weighing the pros and cons at length.

"There are a lot of companies that have run a long way that are still potentially marginal businesses," Stein said. It will be up to investors and their advisors to pay attention to what specific credits have in the way of assets, as well as what they are doing to position themselves going forward.

"I would not be buying stuff above par," Stein added. "I'd be more apt to leave it alone or short it."

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