William John Market Report 28-08-21
William John looks at the success of distressed debt hedge funds and high yield credit during the pandemic era.
William John, High Yield, Capital Markets, Bonds, Credit, Distressed Debt
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William John Market Report 28-08-21

William John Market Report 28-08-21

Category: Reports

Debt – the financing of companies with borrowed money – has been an unlikely hero during the pandemic era. Particularly, distressed debt, which involves lending to companies that have bad balance sheets, are defaulting on debt covenants or are nearing bankruptcy, has performed extremely well. 

According to Eurekahedge.com, their Distressed Debt Hedge Fund index, which measures the equally weighted performance of 21 constituent funds using distressed debt strategies, has seen a return of 11.43% in 2021 – including 6 months of perpetual positive gains. Assessing the returns of distressed debt hedge funds against the benchmark Eurekahedge Hedge Fund index which includes 2,366 constituent funds with a broad base of strategies:

Source: William John Analytics, Eurekahedge.com

Whilst a general observation can be made that Distressed Debt Hedge Funds have outperformed the Hedge Fund industry historically since index measurements began in 1999, since December 2019 the accumulation in index points for Distressed Debt strategies have outpaced the Broad Index’s gains. 

Looking at distressed debt performance relative to other major hedge fund strategies in 2021:

Source: William John Analytics, Financial Times, returns are rounded to nearest per cent.

Aside from distressed debt success from a strategical point of view, ‘risky debt’ as an asset class is booming. The average yield, which moves inversely to bond prices, for High Yield U.S. Corporate Debt stood at 4.05% on 27/08, a record low for U.S. junk rated bonds indicating the significance of investor demand for riskier credit. 

The reasons for the success of both distressed debt and high yield credit are two-fold. Firstly, interest rates across multiple western markets are ultra-low due to accommodating monetary policy to combat the economic fallout of the COVID-19 pandemic. This, in turn, has buoyed the returns of sovereign and investment grade debt which (as low risk asset classes) do not need to offer a substantial premium return to investors as they are phenomenally credit worthy. In a low interest rate environment, investors will allocate more capital to riskier assets to make up lost ground, but this must be justified on rational reasoning. 

This leads to the second reason. The common view held by investors is that companies on the brink of financial distress or that have been struggling through the pandemic can take advantage of low interest rates to refinance their balance sheets and that many companies facing financial difficulty are only in that position because of enforced economic lockdowns, as opposed to having fundamentally poorly ran businesses. Companies in temporary pandemic-induced financial distress within an accommodating monetary policy environment, has likely fuelled investor confidence in risky credit. 

Despite a positive outlook for businesses in a difficult financial position, caution is advised. High-yield bonds and distressed debt practices offer higher returns, but they are considered junk (or of low credit ‘worthyness’) for a reason. On the contrary, however, Fitch Ratings remarks that during this month so far, the default rate for U.S. High Yield bonds has come to just 0.4% for the year to date, according to the Investor’s Chronicle. 

Overall, financing businesses in financial distress and in need of risky capital respectively represents both a material and symbolic success. Materially, high yield credit is reaching historic heights as seen with low junk bond yields and high hedge fund returns. Symbolically, during one of the most economically challenging periods this century, businesses that have struggled are being backed by investors – a show of support that is likely to propel western economies back into a booming business cycle. 

Any opinions expressed in these documents are those of William John and are provided for information only. E&OE.