Economists are renowned for their uncanny inclination to see dark clouds on a sunny day. Restructuring professionals tend to fall into the same camp; we’re no Pollyannas when it comes to forming views on business conditions. Perhaps working extensively with challenged companies tends to skew our outlook. But, biases notwithstanding, we’re quite confident that 2016 is shaping up to be a solid year for restructurings and workouts - measurably better than a respectable 2015 - as the challenges of slowing global growth, depressed commodity prices, disrupted business models and less accommodative credit markets show no signs of abating in the year ahead.
Greater corporate credit market discipline
2015 marks a distinct turning point in this business cycle. Corporate earnings growth has begun to sputter, events of debt defaults, restructurings and workouts have moved decidedly higher from very low levels in the prior two years, and credit markets are more judicious in rationing credit among risky corporate borrowers. The distortions caused by QE programs and the easy credit environment they encouraged are starting to fade. Bank lenders are increasingly mindful of Leveraged Lending Guidelines and the potential consequences of aggressive loans or lending practices that would run afoul of regulators. In short, corporate credit markets are finally displaying some discipline that is sorely lacking in US equity markets. Credit markets are now divided and those on the wrong side of that divide are finding it harder to tap new financing. Several leveraged debt offerings in recent months that would have cleared the market in 2014 were either pulled or sweetened due to push-back from solicited investors. Many very low rated companies (“deep junk issuers”) have effectively lost access to primary credit markets. High-risk-tolerant behaviors by fixed-income investors are changing and this is a healthy development but one that will continue to have consequences for affected borrowers.
Indicators of default and bankruptcy rise
US equity and credit markets couldn’t be giving more conflicting views about where this business cycle might be headed. Major equity indexes are within striking distance of all-time highs even as earnings growth has slowed appreciably - stretching valuation multiples to multi-year highs - while credit markets are telling a more cautionary tale. We’ll take our cues from corporate credit markets, which have a better track record of anticipating turns in the business cycle. (You may recall that credit markets were prescient in the months preceding the 2008 financial crisis.) At the moment, high-yield credit markets are sending clear signals that defaults and bankruptcies will be picking up smartly in the year ahead. S&P’s distressed debt ratio, which measures the proportion of speculative-grade bonds with excessively high yields (YTM) based on market prices, is at a six-year high with 20 percent of all high-yield bonds considered distressed. Absolute levels of distressed corporate debt now exceed such amounts outstanding in early-to-mid 2008 when investors began to flee credit risk. High-yield bond spreads for deep junk issues are also at their highest levels since early 2008. Credit quality, which we evaluate from the distribution of corporate credit ratings, is weaker today than it was in 2007 at the height of the LBO boom. We’re not suggesting that anything calamitous is at hand but this is the most vulnerable that leveraged credit markets have looked in years except during the Great Recession itself.
2015 has been unusual in that the uptick in distress and defaults has been so dominated by the energy, metals and mining sectors, which collectively account for 40 percent of defaults and 50 percent of distressed debt this year—more than twice their proportionate share of all high-yield debt. But it would be a mistake to characterize the year in restructurings as a two industry phenomenon. Other major industry sectors, such as retail, media and high-tech, have also seen defaults and distressed debt levels climb, though not nearly to the same degree.
The new year
None of the rating agencies expect a surge in defaults next year. That would likely require a recession, which has a low probability of happening in 2016 (somewhere between 15 and 20 percent). However, we anticipate that the trends seen over the past few months will continue and even accelerate in the new year. Back in the old days we called it a normal year.
Andrew J. Hinkelman