Outlook 2017: Higher commodity prices, interest rates in year ahead in distressed debt market

By Colin Hanner

Chicago, Dec. 30 – The distressed debt market started 2016 on a rough patch, characterized by tumbling commodity prices and heavy default volume. Conditions improved about mid-year and are expected to carry over into 2017 on the back of rising commodity prices and a renewed confidence in the broader markets.

“I think a lot of people thought the market would continue to deteriorate with what was going on with energy and commodity-related names,” a sellside trader told Prospect News. “The rout in our market clearly got worse into the beginning of 2016 from where it was in 2015.”

Yet, the sudden rebound in distressed markets took many by surprise, the trader said.

“I don’t think I would’ve foreseen the market rebounding as much as it did,” the trader said. “I didn’t necessarily see the weakness in commodities lasting forever, but the question was: how long was it going to take to rebound and at what level would it normalize back to?”

A rebound in commodity prices jumpstarted a faltering energy sector as 2016 came to a close, effectively ending a rout in defaults felt so ardently at the beginning of the year. And, with the passage of an interest rate hike by the Federal Reserve before the end of the year, as well as uncertainty at a policy level with an incoming Donald Trump administration, there is much yet to be explored heading into 2017.

Commodities in the crosshairs

“Commodity-related names were the focus of the distressed arena,” a trader said, and referred to the weakness in pricing of coal, oil, natural gas and precious and industrial metals in the early part of the year to see what the market was focused on.

Defaults in the exploration and production sector characterized the earlier part of the year, when oil prices hovered around $30 per barrel, and coal and steel prices led some to believe that those related industries would be negatively impacted.

“We were looking at an increase in defaults primarily from commodity-related sectors, including energy – oil and gas, specifically – and metals and mining,” said Michael Paladino, head of leveraged finance at Fitch Ratings, referring to Fitch’s outlook at the beginning of 2016.

Yet, the turnaround in commodity prices led some companies that were teetering on either filing for Chapter 11 bankruptcy, or coming out of a recently entered bankruptcy, to emerge.

“In oil, some of these companies that you thought were potentially going to have to file are potentially in the clear,” a market source said.

Coal, from red to black

In coal, names like Arch Coal, Inc., which filed for bankruptcy in the early part of 2016, and SandRidge Energy Inc., which filed in May, both emerged within a week of each other in September, thanks in large part to the rising prices of related-commodities, a trader said.

“There were a fair amount of restructurings and bankruptcies, and you knew there were a handful of companies who were going to file and come out [of bankruptcy],” a trader said.

St. Louis-based Peabody Energy Corp., the largest coal miner in the United States, has capitalized on the rising price of metallurgical coal and seeks to emerge from bankruptcy as one of the most notable gainers in the distressed arena after the company files its restructuring plan before the end of the year.

“[Peabody’s] plan is going to look very different than what it would’ve if they were doing it a couple of months ago just because the valuation game has completely gained, given what coal prices have done since the beginning of the summer,” the trader said.

As of mid-December, Peabody’s equities had risen by nearly 450% from when it filed bankruptcy in April.

“I think coal prices are going to stay up for a while,” the trader said. “They may come down in the middle, back-end of the year, but I think prices will stay up for a while.

“Some of these companies have done exchanges [and] some balance sheet management to stay alive without filing bankruptcy, but, for the most part, I think that coal has gotten ticked over and [Peabody] is the last pure distressed name in that space.”

If coal companies have considered higher coal prices – the most recent benchmarks of $285 per ton was reached by Teck Resources Ltd. with several contractors, a “bullish” estimate by some accounts – and still haven’t filed for Chapter 11, “you’re probably in the clear,” a trader said.

And though energy names made up most of the defaults in 2016, there are those who predict the market has worked itself out.

“We worked through a lot of the defaults in the commodity-related sectors,” Paladino said, adding that because of this, defaults in 2017 will decrease.

S&P Global Ratings, which predicts the 12-month speculative-grade default rate to increase, albeit by 1 basis point, by September 2017, noted the defaults in the E&P sector have fallen to 10%, a 3% decrease from October 2015.

‘Idiosyncratic’ sectors eyed

Aside from energy-related issues, Fitch’s Paladino and Rosenthal point to “idiosyncratic” issues and retail as being on the default watch list.

“There are companies specific in nature, but we have seen certain areas of the retail sector come under pressure,” Rosenthal said. “So we’ve seen a few defaults within retail [and] there are certain winners and losers in retail as it relates to online growth strategy.”

As brick-and-mortar retailers shift more of a focus to an online presence – in the face of titans like Amazon Inc. – and online growth continues to persist, companies like J. Crew Group, which reportedly will seek restructuring soon, Claire’s Stores Inc. and rue21 Inc. have caught some traders eyes as weak quarterly earnings test the feasibility of traditional retail.

“I think you could see some opportunities in retail as the sector continues to undergo softness and changes in the way business gets done as business rolls out of malls to online,” a trader said.

Outside of retail, sectors like broadcasting have been largely driven by iHeartCommunications, Inc., a name Paladino said is on Fitch’s watch list in 2017.

If a default were to happen with iHeart in the coming year, it could drive the rate for the sector up nearly 1%, Rosenthal said.

Trump administration eyed

From the United Kingdom’s decision to leave the European Union to Donald Trump’s surprise victory over Hillary Clinton in the U.S. presidential election and, most recently, a Federal Reserve decision to raise interest rates, geopolitical repercussions had affected financial markets.

The results of both have yet to be explored fully, but with president-elect Trump to enter the White House in just a few weeks, there are still lots of questions to be answered.

“When a new administration comes in, you don’t necessarily know what’ll happen there,” a trader said. “Could they enact certain polices in the first 100 days that could shake up some sectors?”

Days after Trump won, sectors felt the sentiment shift toward policies that could be enacted under a Republican-controlled White House and Congress.

Names in the distressed health care spaces teetered on the reputation and platform Trump had built throughout the campaign, but shifted on soundbites that reversed earlier discourse.

A contagion spread through pharmaceutical companies, like distressed Valeant Pharmaceutical International Inc., when Trump announced he would get tough on high drug prices.

Hospital and health care providers, like Community Health Systems Inc., were down on speculation that a new administration would seek to cut the Affordable Cut Act and climbed, albeit marginally, when Trump said he would not cut all parts of the act.

The GEO Group, Inc., a Florida-based private prison company, saw one of the biggest gains in the high-yield market a day after Trump’s victory because he had lauded the privatization of prisons.

Yet, with no enacted policy to act on, the long-term impact has yet to enter the market.

“It's still early in terms of actual policies that will get implemented and the potential impact there,” Fitch’s Paladino said.

The volatility expected, or rather, unexpected, came-and-went after Dow futures dropped several hundred points on election night. Since then, markets have appeared to be strengthening in line with pre-Election Day strength.

If people choose to ignore corporate earnings and continue to buy into the market without looking back, markets may continue to run higher and higher, a trader said.

“The market has had a huge run, so you’re hoping that there might be a lot more volatility through the market with Trump being elected,” a market source said. “The market has been running in one direction. It leaves you to wonder, next year – what are we looking at?”

On the Fed hike

On Dec. 14, the Federal Reserve announced that the benchmark interest rates would increase by 25 basis points to a 0.5% to 0.75% range, the second time in two years – and the second time since the recession – in which a rate hike has occurred.

And, with the Fed announcing they see three more hikes coming in 2017, it leaves the question: will or won’t distressed companies refinance sooner rather than later with the indecision on the horizon?

In terms of a short-term impact, there may not be one, a market source said.

“You’re still in a position where you have the ability to refinance at really favorable rates, low interest rates, low cost on the balance sheets,” the source said, adding distressed companies have continued to rebound well despite a rate hike last year.

Despite the uncertainties surrounding a new administration, increased refinancings have continued to occur, a trend that could continue as interest rate hikes loom.

“I think what we have seen is more conviction of the upward trajectory of interest rate movements, and so what you’re seeing and what you’ll continue to see is increased refinancing activity in the loan market to address maturities,” said Paladino.

There are essentially no impending maturity walls, Paladino said, and refinancings in the last three months of the year have increased to push out floating-rate loans.

“I think that’s something that we’ve already started to see,” Paladino said.

Capital ‘on the sidelines’

Putting capital to use in the distressed markets continued into 2016, but where and how much had been put to use left some wondering whether the market reached its potential.

“There’s certainly been a lot of distressed capital that was raised,” said Eric Rosenthal, senior director at Fitch. “I think what we saw, and that we were somewhat surprised about, was that it didn’t get put to work in a significant degree with respect to the commodity-related sectors.”

Defaults picked up in 2016, Rosenthal said, but capital that “sat on the sidelines” remained selective of where it was put to work.

The credit discipline of private equity firms that could’ve broken down due to, for example, weakening transaction terms and conditions, adjusted EBITDA and favorable incremental facilities for issuers remained strong, an “encouraging” aspect moving forward, Rosenthal said.

What may have happened, one trader offered, is that people began to buy into energy-related bonds at the beginning of last year and late 2015 on what they believed were temporary dips in the market.

As the year progressed, energy names began seeking bankruptcy and restructuring, and shareholders were either in a nonrewarding tranche of bonds or were in the “fulcrum” securities that drove the restructuring, leading some to hold onto distressed securities for longer periods of time.

“I think the catalyst to possibly derail these bets” – like a swing in commodity prices or turbulence in a new Administration – “has been pushed out further,” a market source said. “I think guys can ride out bets they’ve put in place for a good bit longer than they’ve anticipated.”

“Commodity-related names were the focus of the distressed arena.” – A trader

© 2015 Prospect News.
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