Outlook 2016: Distressed opportunities rise in 2015 as commodities wane; supply expected to grow

By Stephanie N. Rotondo

Seattle, Dec. 31 – The distressed debt market started 2015 on somewhat solid footing, but that foundation crumbled throughout the year as commodity prices struggled. And in 2016, commodities will remain a focus of the market.

“Broadly, heading into 2015, credit conditions were still quite favorable,” said Michael Paladino, head of leveraged finance at Fitch Ratings. The main issue at the start of the year was commodity prices – crude oil in particular, which had started to drift lower in late 2014.

The result was “a bifurcated market,” Paladino said, with E&P on one side and the rest on the other. “Spreads widened out as the market anticipated market tightness.”

By the third quarter, it was clear that “the contagion had spread,” a Connecticut-based sellside source said, mainly to other commodity-driven areas, although retail and other consumer-related areas were taking hits as well.

“Underlying credit fundamentals hurt the performance of some sectors,” the trader said.

As concerns about performance increased, so did concerns about redemptions and forced selling.

“Because of the lack of ideas in the market over the last few years, everybody starts going the same way,” the trader said. “All the guys are in the same trade. Nobody is going to sit there and defend these trades so prices get exaggerated.”

Liquidity lacking

Making the lack of depth in the market worse was a lack of liquidity.

“Now that guys are really getting buried in their positions, some of the buyside guys aren’t willing to provide that liquidity and the dealers aren’t doing it [either],” he said. “The strategy of buying on dips isn’t working, so a lot of guys are stepping away from the market.”

Paladino reports that it is true that distressed funds are sitting on a hefty stash of cash, but “how much of that has been put to use is a bit more questionable.”

Asset sales – again, particularly among E&P and mining companies – are one potential way these funds could start putting that cash to use. But, Paladino wondered, “what is the bid/ask spread for these asset sale transactions?”

“It’s still a bit of a waiting game,” he said. Does the investor wait until a company enters bankruptcy and buy the asset at auction, or “do fund managers be more aggressive,” and start buying up the assets as soon as possible?

“The problem is we haven’t seen that come together yet,” Paladino said. “The bid/ask spreads are still a bit too wide.”

E&P boosts default rates

The trouble in the commodity linked-space helped to ramp up the number of defaults and restructurings – whether by bankruptcy or otherwise – during the year.

“There were certainly more of them,” a trader said.

But that followed several years of low default rates and restructurings, which was due in large part to a vastly open credit market that allowed many companies to get the capital they needed.

“From an investor standpoint, there hasn’t been a lot [of distressed opportunities],” the trader said. That was because “a lot of debt issuance was available” and companies were “able to refinance upcoming maturities.”

Still, the trader added that the uptick in 2015 was “not surprising,” given what was going on in the E&P space.

“Some of the commodity pricing has surprised me,” he conceded. With domestic crude oil looking to end 2015 in the mid-$30s, “I would have expected it to level out a little higher. So maybe the rout in commodities was a little more than I expected.”

Across the board, defaults in the commodity arena were seen rising, due mostly to the increasing number of distressed exchanges – or as one trader put it, “sliding the deck chairs around.”

“People went along” with such transactions “because they bought themselves more time and they were hoping that the underlying commodity prices would rally or level out.”

As said prices had not done that by the end of 2015, “they’ve basically used up all the options that they had.”

While commodity prices were “the main thing driving actual weak returns,” Fitch’s Paladino said, if you stripped out anything commodity related, as well as the Caesars Entertainment Corp. bankruptcy, the default rate for 2015 would come in below 1%.

“That still indicates that, outside of specific areas, we still had a relatively benign default outlook,” he said.

Benign outlook or not, the rising level of defaults and restructurings did result in a higher level of risk aversion.

That aversion, according to Sharon Bonelli, a senior director at Fitch Ratings focused on bankruptcies, “is likely driven by federal banking regulations,” as well as the ability of energy companies in particular to access the capital markets – especially amid declining EBITDA.

“There seems to be bifurcation in terms of investors willing to take on risks,” Christopher Collins, director of leveraged finance at Fitch, said. That is evidenced by the fact that CCC-rated debt has widened out more than BB-rated paper.

“So investors are sticking to debt that is higher rated,” he said.

The role of the Fed

Over the course of the year, the broader market gyrated as there continued to be “will they or won’t they?” buzz in regards to the Federal Reserve and interest rates.

But as the central bank opted to raise rates by 25 basis points on Dec. 16, the forward-looking impact started to become something to think about.

Ahead of the actual increase, the threat of a potential hike played a much smaller role than commodity prices, Paladino said. However, he opined that “now that it is actually here, it’s something that has started to filter in.”

“Certainly it is going to drive what is going on with Treasuries and all of this is interconnected,” a trader said. “But I am not sure that many in high-yield think it is a big driver of the tone and direction of our market.”

But what the rate increase will do is potentially make refinancings and restructurings harder, at least for a portion of distressed companies. “No question,” the trader said.

“We expect rising U.S. interest rates to mostly adversely affect the lower-rated entities in the high-yield market, just as low oil and coal prices have exposed weaknesses in the oil and gas and commodity sub-sectors,” Fitch Ratings said in a press release published after the rate increase was announced. “In particular, this could include credits rated 'B' and below that already face a mixture of long-term solvency issues, refinancing risk, unproven business models, lack of free cash flow and high leverage.”

“Investors will become more risk-averse as interest rates rise,” said Bill Wolfe, a senior vice president with Moody’s, in a statement commenting on the interest rate rise. “Credit spreads began widening in anticipation of the interest rate hike, but this will continue to mostly affect the weakest companies in the weakest sectors, which will be the most vulnerable as market sentiment becomes more cautious.”

More pain in 2016

As the market turns its gaze toward 2016, investors will continue to focus on commodity prices and how the Fed’s rate hike will affect those trying to raise capital to stay afloat.

“Certainly valuations have taken a big hit [in 2015],” Bonelli said. But said valuations are not necessarily set in stone.

“We are still pretty early in this commodity distressed cycle,” she said.

And in fact, “we haven’t seen these companies get reorganized,” she said. “Those cases have yet to shake out.”

That means increased expectations for restructurings, including bankruptcies.

“There are a lot of open-ended questions [for 2016],” said Kevin Horan, director of fixed income indices at Standard & Poor’s. For instance, will oil and other commodities rebound? In that space, even though there were some issuers that managed to refinance their debt at lower rates, will they continue to “burn through cash because they aren’t seeing positive revenues?”

Away from commodities, the retail space is another sector that Bonelli, for one, will be “keeping a closer eye on.” While she noted that the industry is not facing “sector-wide problems,” some are continuing to struggle with a transition from bricks-and-mortar strategies to online shopping.

One trader agreed that retail was a sector to watch, noting that he expects “specialty retail to underperform.

“Bonds are [currently] trading where they are because people don’t expect them to get better,” he said.

2016: Supply vs. Demand

One other big question for 2016 is will there be enough demand to soak up the expected supply?

“When is the next wave of distressed buyers going to come back to the market,” a trader said. “There are a lot of knives falling. When are guys going to start trying to catch them?”

“There could be more knives falling than hands available,” he said.

“A lot of money managers have already been through their portfolios cleaning out energy names, commodity names,” said Horan. “But the market is a broad thing.

“For every seller, there is a buyer.”

© 2015 Prospect News.
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