Outlook 2022: Distressed debt shrinks in 2021; cautious sentiment abounds heading into 2022

By Cristal Cody

Tupelo, Miss., Dec. 31 – The distressed debt market shrank in 2021 but is expected to remain a strong force in 2022.

“There is no shortage of concerns that could derail this market: inflation, supply chains, energy shortages, or real estate debacle in China,” according to a BofA Securities, Inc. research note.

Default totals hit record lows in 2021, posting at 0.5% by the year’s end, and likely will remain low in 2022.

Some traders tweaked their definition of distressed debt in 2021 as the market shrank with traders checking out junk bonds yielding under 10%.

“Nowadays, we’re looking at anything over 8% at least,” one source said.

The year saw formerly distressed issuers including Hertz Corp. and Frontier Communications Corp. exit Chapter 11 bankruptcies after filing in 2020.

There were just 10 U.S. high-yield issuer defaults in 2021, according to Fitch Ratings.

“Credit conditions remain extremely supportive, implying low defaults are here to stay, although we expect them to normalize from current extreme levels,” BofA analysts said. “Our key models point to 1.5% to 2% defaults in 2022, with CCC defaults around 6-7%. If materialized, both ranges imply the current benign credit environment extends for yet another year.”

Future defaults in 2022 are likely to be concentrated in sectors with the highest likelihood of restructurings, including in media, utilities and telecommunications, according to BofA.

“It could be a messy year for distressed, but there are guys looking for opportunities and there’s a lot of cash on the sidelines,” a distressed bond trader said. “If there is tremendous negative market-wide news, there’s going to be more defaults. It’s a low bar right now, but we could see an uptick.”

Distressed paper “at the beginning of the year should still be pretty attractive because people are going to be buying on the rebound,” the trader said.

While the distressed debt market shrank in 2021, it’s not expected to subtract further in 2022.

“I don’t think it will be smaller next year, only because it’s so small right now,” a source said. “There’s a lot of various things that could happen in the next year, primarily beginning with the Fed that could give a ripple effect to the troubled issuers. There’s a lot of overleveraged credits out there, and they can’t afford to have any missteps with the overall market.”

S&P Global Ratings reported that as of Nov. 29, the number of CCC category ratings on U.S. and Canadian companies declined to a 21-month low of 144.

The ratings distribution among U.S. nonfinancial corporate borrowers “is still heavily speculative grade” at 63%, with 44% of borrowers in the B category and 26% at B- or below, S&P said.

Distressed returns

The U.S. distress ratio of issuers rated BB+ or lower with spreads over Treasuries of 1,000 basis points increased to 2.6% as of Dec. 6 from 2.3% in the previous month but still well below the 9.7% five-year average, according to a S&P report.

“The distress ratio remains near historical lows despite a record number of U.S. speculative-grade issuers – a sign that market stress in the credit markets is remarkably low,” said Nicole Serino of S&P Global Ratings' Credit Markets Research.

Distressed returns were higher in 2021 after the pandemic shook the market in the prior year.

In December 2020, the S&P U.S. High Yield Corporate Distressed Bond index had a year-to-date return of minus 3.09%.

By December 2021, the index had year-to-date distressed returns of 23%, though it posted negative daily returns during the month.

Since November, secondary spreads increased across all speculative-grade rating categories due to the emergence of the Covid-19 Omicron variant and continued inflation that spurred the Federal Reserve in December to signal it would raise rates in 2022, sources said.

“Guys are pretty cautious right now – pretty negative sentiments going on right now,” a source said. “You have the Fed backed into a corner and looking like they’re going to have to raise rates to battle inflation. In that kind of tapering, equities are underperforming and distressed would underperform. A rising rate environment doesn’t really help with troubled issuers with a maturity wall.”

Reopening trade

Issuers in the reopening space were among the big winners in 2021, sources reported.

“Mostly the reopening trades were the ones that had those kinds of movement,” a source said. “Hertz went from bankruptcy to valued at a $20 billion public market equity cap. It’s a tale of two cities with guys like that.”

AMC Entertainment Holdings, Inc.’s bonds soared in 2021 as one of the “meme stock” names that included GameStop Corp.

The bonds weakened in late December but were ending 2021 at a much stronger place than at the start of the year.

AMC’s 10% senior secured second-lien notes due 2026 (Ca/CCC-) traded at 93 7/8 bid, while its 12% second-lien senior secured notes due 2026 (Ca/CCC-) were quoted at 101 3/8 bid in mid-December.

The Leawood, Kan.-based movie theater owner’s bonds traded at the start of 2021 in the 27 bid to 33½ bid area.

AMC’s stock moved at $3 in January 2021 and rallied to as high as $62 in June before settling in December at the $47 range.

“AMC had that big equity rally earlier in the year,” a market source said. “The 10% second liens of ‘26 were up around 104 in June. They calmed down as the equity calmed down and now they’re around 102¼ because they have just so much cash on the balance sheet.”

Peabody up on coal

Peabody Energy Corp. was another distressed issuer that saw its bonds gain over the year as coal prices and production jumped in 2021.

Moody's Investors Service upgraded Peabody’s ratings on Dec. 10 to B3 from Caa1 after the company reduced its debt by more than 15% in 2021.

Peabody’s 6 3/8% notes due 2025 were quoted up ¼ point at 93 bid following the Moody’s upgrade and better than the 90½ bid seen on Dec. 2.

The notes rallied from around 60 bid at the start of 2021 and from the year’s low of around 40 bid in April.

“Just from the beginning of June, they were trading around 60; midway in June they were around 74, and then they continued to climb from there,” a source said.

The St. Louis-based coal producer reported $1.3 billion of debt as of Sept. 30, down from $1.5 billion on Dec. 30, 2020.

Issuers including PBF Holding Co. LLC, Envision Healthcare Corp., Diamond Sports Group LLC, Ligado Networks LLC, Nine Energy Service Inc. and Talen Energy LLC highlighted distressed or default watchlists during the year, sources said.

Opioid names

Opioid-related pharmaceutical paper saw a volatile trade in 2021 that’s expected to continue into 2022 after a surprise announcement in December that a federal judge overturned a $4.5 billion settlement with the Sackler family on future opioid claims tied to Purdue Pharma LP.

Endo International plc’s paper was volatile in December on several announcements, including that a California trial court issued a final ruling that the company’s subsidiaries are not liable for opioid claims and a notice from Eagle Pharmaceuticals, Inc. that it received approval of a generic drug cleared by a court of infringement on Endo’s patents.

Endo’s 6% senior notes due 2028 (Caa3/CCC-) were trading at the 73½ bid range in mid-December.

The Dublin-based pharmaceutical maker announced in September that the company and its subsidiaries reached agreements to settle opioid-related lawsuits in Louisiana and New York, following a $35 million settlement in Tennessee announced in July.

Mallinckrodt plc, too, is one to watch in 2022 as the company works to emerge from Chapter 11 bankruptcy, a source said.

The Dublin- and St. Louis-based pharmaceutical company also faces opioid-related lawsuits moving through the bankruptcy court.

Mallinckrodt’s 5½% senior notes due 2025 traded in December at the 55 bid area.

China woes in focus

A host of junk-rated China-based companies, mostly in the property developer space, face defaulting on bonds following missed debt payments in late 2021.

The space saw defaults from issuers including China Evergrande Group, Kaisa Group Holdings Ltd., Fantasia Holdings Group Co. Ltd., Sinic Holdings (Group) Co. Ltd., China Properties Group Ltd., Modern Land (China) Co. Ltd. and Sunshine 100 China Holdings Ltd.

Dollar bonds from China-based issuers had contracted by 13% by December since reaching their peak in February – the first such contraction in the history of BofA Securities indexes, according to a research note.

China Evergrande’s paper plunged about 70 points to trade with a low 20s handle by the time the company officially defaulted in December.

The Shenzhen, China-based real estate developer’s 8¾% senior notes due 2025 (C/C/C) were last seen at the 22 1/8 bid range, a source said.

Debt default fears spread to higher-rated issuers with Shimao Group Holdings Ltd., a Hong Kong-based holding company focused on property management, development and sales, downgraded to pure junk in December.

Shimao’s notes sank about 20 points in mid-December with the 4¾% notes due 2022 (Ba1/B/BB) last seen at 64¾ bid, a source said.

In 2022, China’s property developer defaults are “likely to get worse before they get better,” the BofA analysts said.

“With offshore bond yields currently staying at elevated levels, we expect the offshore bond market to remain largely shut until the Chinese government significantly changes its tough stance on the real estate sector,” the analysts said. “Before the offshore bond market reopens to HY developers, they may need to redeem bonds and make coupon payments by cash on hand.”

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