After years of slim pickings, distressed debt investors are preparing for more abundant times.

Following an extended period of low interest rates, rising valuations and easy access to borrowing, many companies have amassed big piles of debt. The massive fiscal and monetary stimulus launched during the pandemic, which masked underlying financial stresses at debt-laden companies, only exacerbated the situation. Now those companies are grappling with a series of headwinds including a slowing economy, falling corporate earnings and rising costs of raising debt financing.   

These shifting market conditions, which make it harder and more expensive for businesses to raise new capital or refinance debt, are likely to leave many corporate borrowers that have heavy debt loads in financial distress. In short, these are exactly the conditions in which distressed debt investors thrive.

This so-called turning credit cycle is a global phenomenon, and default rates on high-yield corporate debt are likely to stay high for years, some investors said. The problems may be especially acute in Europe due to economic challenges posed by an energy crisis and political uncertainties, they said.  

"While it is still early, we've passed the stage where we have to question whether we're actually going to get a distressed cycle," said Paul Goldschmid, a partner and co-portfolio manager at King Street Capital Management. 

A handful of investors have raised fresh capital recently to invest in distressed debt, boosting their firepower as they prepare to take advantage of economic dislocations around the world. JP Morgan and Zetland Group are among asset managers that closed funds this year targeting troubled industries and struggling companies' debt, according to PitchBook data. Several other asset managers—including Oaktree Capital Management and GoldenTree Asset Management —are reportedly tapping investors for more money to invest in credit-constrained companies.

Yield spreads on bonds issued by lower-rated corporate borrowers in the US surpassed 500 basis points in late June and early July, before dipping back below that mark, according to the option-adjusted yield spread of the ICE BofA US High Yield Index, a benchmark for the high yield bond market. Early this week, the index hovered around 500 bps. 

A similar gauge for European high-yield bonds topped 600 bps earlier this year before dropping below that level. 
 
"Over the past 8 months, we have been grinding down with high-yield spreads widening from 300 to 500 bps," said Victor Khosla, the founder and chief investment officer of distressed-debt investor Strategic Value Partners, in an email. "Generally, a complete distressed cycle will see spreads gap out to above 800 bps. So we are currently in the middle of the sell-off."

"It is likely to continue to be a tough market over the next nine months or so," he added. "There have been five large distressed cycles over the past 22 years with high-yield spreads at 800+ bps. We believe we are setting up for the sixth cycle in Europe and potentially one in the US."

High-yield spreads, a measure of the premium investors demand in order to hold riskier debt instead of US Treasuries, are an important indicator of corporate default risk. A bond trading with a spread exceeding 1,000 bps is generally classified as distressed. 

As further evidence that credit conditions are likely to worsen, Goldschmid pointed to past distressed debt cycles. 
 
"When high-yield credit spreads widen to 500 bps or 550 bps and investment-grade spreads to 150 bps or 160 bps, it’s rare that they would not get much wider six to 12 months later," Goldschmid said. "That's because once they widen to that point, it begins to affect the optimism, cost of capital, corporate decision making, hiring decision-making and investment decision-making. Companies start to worry about their balance sheets."

Default rates, another indicator of distressed debt cycles, remain relatively low in the US and Europe compared to historic levels, but credit analysts expect defaults to tick up in coming years, especially if economies tip into recession, as many economists expect. 

S&P Global has projected that by June 2023, default rates for US speculative-grade companies over the trailing 12 months will increase to 3.5%, more than double the 1.4% in June of this year. The default rates of European speculative-grade issuers will reach 3% next year from 1.1% this June, the company projects.  

Deutsche Bank strategists Jim Reid and Karthik Nagalingam expect the US junk default rate to increase to 5% by the end of 2023 and 10.3% in 2024, Reuters reported. 

Goldschmid said low corporate default rates are yet another indicator that the distressed debt cycle is still at an early stage.
 
"In a normal economic downturn, we'd see default rates at least in the mid-single-digit percentage range," he said. 
Goldschmid also noted that the impact of central banks slimming their balance sheets through quantitative tightening and hiking rates has only begun to be felt in the corporate world and financial markets. The effect of those policy actions continue to impact economic growth and corporate earnings for some time, he said. 

"Following the Jackson Hole Symposium, it is even clearer that US central bankers are focused on bringing down inflation, which requires raising rates and holding them at an elevated level for longer in order to bring down future inflation expectations," he said, referring to the Federal Reserve Bank of Kansas City's annual meeting of global economic and monetary policymakers. "In short, post-Jackson Hole, we are more confident that there will be a distressed cycle in the US that will last longer than originally anticipated."

Last month, in a speech at the event, Federal Reserve Chairman Jerome Powell said the central bank would have to use its policy tools "forcefully" to reduce inflation, which was likely to produce pain in the economy. Market observers expect the Fed to raise interest rates again at its next meeting.  

Featured image by Olivier Le Moal/Shutterstock

This article originally appeared on PitchBook News