Outlook 2015: Distressed market sees fewer ideas as Fed keeps rates low; rates in focus in 2015

By Stephanie N. Rotondo

Phoenix, Jan. 2 – In 2014, the Federal Reserve’s decision to keep interest rates low played a large role in how the distressed debt market performed.

“I thought there would be many more defaults,” a market source said, adding that he “thought rates would rise.”

“For the most part, default rates stayed pretty low,” said one Connecticut-based sellside source.

That was because credit markets were open to those companies needing to refinance debt at rates attractive to both investors and issuers. While that was good for high-yield investors, given the level of new issuance in that space, it meant a lack of ideas in the distressed realm.

“With the lack of ideas, a lot of people were on the same trains,” a trader said. “If you are all going the same way, it’s going to be hard to get out.”

But when the Fed ended its quantitative easing program in September, it looked like interest rates might soon be on the rise – though the central bank said at its last meeting in December that it would be “patient” when it came to making such moves.

The latter part of the year also brought a hefty decline in oil prices, putting pressure on the oil and gas arena.

“Focusing more toward the back-end [of the year], it seems like we are laying the groundwork” for an uptick in distressed opportunities, the trader said.

2014: The year deals got done

Fewer bankruptcies were filed in 2014 than in previous years, with only 62 cases hitting the courts.

There were “some big cases hanging, lingering out there,” a trader said, pointing to Nortel Networks Ltd. – which has been in the Chapter 11 process since 2009 – and Energy Future Holdings Corp., which filed in April 2014. There were “some others that were slow train wrecks,” the trader said.

Of the latter, he noted such names as Caesars Entertainment Corp., which has not yet filed for bankruptcy, but it has been reported that one is coming by mid-January of 2015.

There was also the odd case that completely caught the market off-guard.

Take GT Advanced Technologies Inc.’s early October Chapter 11 filing, for example.

A trader deemed that case “interesting” given that one day the company’s debt – two 3% convertible bond issues due in 2017 and 2020 – was ‘trading 130, 150 and you come in one day and they say they are filing.

“That’s one that obviously caught guys off guard,” he said.

The lower bankruptcy rate was due in large part to a low interest rate environment, which allowed many, if not most, stressed companies to refinance looming maturities via the high-yield bond market or, in some cases, the bank debt space.

“Refinancings were off the charts,” said one New York-based sellside source. “Some marginal credits had a much easier time accessing the new issue market.”

One trader expressed surprise at some of the deals that got done.

For instance, Walter Energy Inc. – a metallurgical coal company struggling to make ends met as the price of coal declines amid increased supply and weaker demand – sold $350 million of 11% senior secured second-lien PIK toggle notes due 2020 in April.

The trader noted that the paper was trading in the high-20s as of mid-December.

“It took eight months,” he said. “With the headwinds that coal was facing, why would people do these deals?”

Another deal that raised eyebrows was RadioShack Corp.’s $535 million refinancing of a credit facility, with the help of Standard General LP. That deal – done in early October – allowed the struggling electronics retailer to get through the holidays and stave off bankruptcy – at least for the moment.

The Fed a driving force

As the market enters 2015, the big thing on everyone’s mind will be interest rates and when the Fed might consider increasing them. However, should the Fed raise rates, that could be a boon for distressed investors.

With so many companies able to access the credit markets to refinance their debt in 2014, there were fewer distressed opportunities. But if rates move up in 2015, that could shutter access to the markets – especially for the weakest credits.

“If the new issue window closes, that could certainly hurt,” a trader said.

Another trader said the forces driving the 2015 market will be “exactly the same” as those seen in 2014.

“As long as the Fed is accommodative, investors will continue to hunt for yield and income.”

Bring the pain

There are certain sectors that might feel the pain the most come 2015.

“We could see the deterioration throughout the year” in retail, coal and other commodities, a trader noted. With the plunge in oil prices, that brought a whole new arena into the ballgame – oil and gas.

The decline in oil could play a pivotal role outside of oil and gas. Talking heads claim that a fall in oil prices – and thus gas prices – will result in an increase in consumer discretionary spending, helping retailers, restaurants and consumer products companies.

“At some point, people are going to try to find the other side of the oil trade,” a trader said.

But the trader opined that if there is a distressed fallout and it “spills over into equities, that might not bode well.

“The question is, is the economy really as strong as they think it is?”

Also important for any consumer-linked entity will be fourth-quarter results, which the trader said will be “make or break” for some credits.

“If [the numbers] are alright, then retail could be a sector that shows signs of recovery,” he said.

However, even a good fourth quarter might not be enough to help everyone.

“There will definitely be haves and have-nots in that space,” the trader said.

Commodities under pressure

Additionally, coal and commodities are likely to remain under pressure in the new year.

“I don’t see any recovery in sight,” a trader said, as prices continue to hold at lower levels and demand dwindles.

As for oil and gas, that sector “faces a struggle” amid the oil price rout.

“No doubt there will be some carnage in [exploration and production credits],” a trader said. “It sounds as if people [believe] oil prices will be down for awhile.”

If that proves to be true, “there could be a number of restructurings, given that a lot of higher-quality high-yield guys are in this stuff.”

He noted that already, some distressed players are “trying to dip their toe in.

“But it’s not as if a lot of that paper has already transitioned into funds or into distressed investors’ hands yet,” he noted. “The more that blows up, the more opportunities” there are for that group of investors.

“We may even have some perfectly safe performing credits that get dragged down,” he concluded.

Another trader said higher-cost producers, such as those involved in oilsands or deepwater drilling, could see trouble in 2015. Investors are gearing up for that, he said.

“There’s a fair amount of money being raised... specifically at funds looking to pick up distressed energy properties.”

Drama for Fannie, Freddie

The ongoing saga of Fannie Mae and Freddie Mac will likely remain in limbo in 2015 as shareholders continue to fight for their investments.

The drama of the government-sponsored entities hit a pivotal point in October, when lawsuits brought by investors such as Perry Capital LLC, Pershing Square Capital Management and Fairholme Funds Inc. were dismissed by a judge in the U.S. District Court for the District of Columbia. The lawsuits – filed against the federal government – alleged that the government’s takeover of nearly all of the agencies’ profits was illegal.

With the dismissal, it was effectively ruled that the government – acting as conservator of the mortgage giants – had the right to take those funds, thereby leaving investors with nothing in the event of a liquidation.

Investors did appeal the ruling.

“On the legal side, we are going to see price movements in the common and preferreds with every little court ruling there is,” a trader speculated. Investors could take their arguments all the way up to the Supreme Court, he said, though he doubted that would occur until 2016 – or even later.

“So we are just going to [see the preferreds] ebb and flow,” he said. “From here, they stay range-bound until the next major news item.”

“It is still going to come down to the courts,” said another source, expecting that a decision on the appeal will come in the first quarter.

If the appeal goes in favor of investors – allowing them to proceed with their cases against the government – “we could see [the preferreds] jump.”

Winding down GSEs unlikely

In terms of legislation aimed at winding down the GSEs, a trader deemed it “a political whim.”

“It seems like too big a project for something to ever get done in the Senate,” he said.

Another trader echoed that sentiment.

“I don’t see how they could ever get that done,” he said. Because of Frank-Dodd regulations, banks are not likely to step up to fill any vacuum a liquidation of Freddie and Fannie would create. The private sector is similarly unlikely to take on the role of the agencies.

“No one would touch it because of the risk of loss,” he said.

The trader also noted that the government is “probably reluctant” to give up the cash flow Fannie and Freddie have been providing.

“They’ve been bringing in money hand over fist,” he said.

It will probably turn out that there is no way for the government to wind down the two entities, but it could change the structure, making it harder for taxpayers to be on the hook in the event of another crisis.

“Ultimately, I think this will be decided by the Supreme Court,” the trader said. “But I don’t think that will be for a couple of years.”

Optimism for market

Overall, there is “some optimism heading into the distressed debt market,” a trader said, given the belief that there might be a possible rate hike and that oil prices will stay depressed. That could bring about an increase in the amount of distressed opportunities in the market.

“All you have got to do is look at how many bonds are trading in the 70s, 60s and 50s,” a trader said.

Another trader urged investors to “stick with the fundamentals.

“Those haven’t really been in focus in the past couple of years, but it’s got to get back to that.”

© 2015 Prospect News.
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