The distressed debt market is considered a subgroup of the high yield bond market. Distressed debt is defined as securities that yield at least 10% above the benchmark Treasury. Defaulted debt, our specialty, is defined as securities that trade after the issuing firm has missed an interest payment or has filed for chapter 11 bankruptcy. The returns from investing in a diversified portfolio of distressed debt securities have a low correlation with returns of most other major asset classes.
Our best strategy for investors in 2010 is portfolio diversification. Distressed debt investing can be somewhat cyclical, opportunities increase during economic slowdowns. On Feb 28, we added Smurfit Stone unsecured debt to our model portfolio at a price of 81. We expect these bonds to appreciate as this company exits bankruptcy. The holding period for distressed debt investing depends on how long a firm takes to restructure. The time varies from case to case. The chapter 11 bankruptcy process can be lengthy. Negotiations between a firm's management team and its creditors can crumble or be delayed. Alternatively, reorganization can be expedited in a matter of months. Our diversified portfolio invests both short and long term. We consider short term trading as six months to nine months and long term as twelve to fifteen months. Investing in distressed debt involves purchasing an undervalued debt security and holding it for a period of time until the value moves to a desired level.
For the remainder of 2010 we expect the current weak economic environment to provide new opportunities for distressed debt investors. The large number of leveraged buyouts created by cheap credit with inflated valuations and too much debt will send companies into chapter 11 bankruptcy. In this distressed debt cycle a new credit environment has evolved. The abundant credit that allowed companies to borrow large amounts of debt to fund expansion and acquisitions is over. The Tribune Corp. is an prime example. The debt of some companies was issued based on aggressive corporate earnings growth assumptions and low borrowing costs. This is our targeted audience. In this new credit environment companies will begin to find it difficult to service debt levels, profits will fall. Companies will need to refinance in an extremely crowded market. Rates will certainly go up, further decreasing earnings and cash flow. The most attractive time to invest in distressed debt securities has been towards the end of a recession.
Leveraged Loans
A leveraged loan is made to a borrower who has outstanding debt rated below investment grade or below Baa3/BBB- from Moody's and S&P. Also, the company's debt to EBITDA ratio is three times or greater, and or the loan has a coupon of +125 bps or more above the Libor rate. Leveraged loans are typically secured by a lien against the assets of the borrower. This position in the capital structure provides the best opportunity for the investor to maximize their recovery in a restructuring. Leveraged loans have higher recovery rates than unsecured debt, with an average recovery rate of 80% vs 40%. A tremendous amount of these leveraged loans will mature over the next four years. These loans at final maturity will not be possible to extend. Banks will not be able to keep many of these companies alive by continuing a policy of "extend and pretend". Many non investment grade companies have both leveraged loans and high yield bonds outstanding. The fulcrum security will continue to be the leveraged loan. Distressed debt investors should always invest as high as possible in the capital structure of a targeted company. Distressed debt investors, not banks comprise more than two thirds of the leveraged loan market.
Distressed Debt Market Outlook-2010
The Federal Reserve will wait to raise interest rates. The United States, deep in debt, will want inflation and a weak dollar. This policy will clash with the massive amount of money the United States needs to raise in the coming years. The increase in the supply of Treasuries will drive prices down and rates up. For the remainder of 2010 we expect at least one new investment opportunity per quarter. A diversified distressed debt portfolio should provide investors that due their homework returns of 12-15 %.
Stephen P. Vlahos
Education is a progressive discovery of our own ignorance.
Posted by: English taobao | 01/24/2011 at 06:46 PM