Outlook 2013: Distressed debt market could stutter along in 2013, barring any major catalyst

By Stephanie N. Rotondo

Phoenix, Dec. 31 - Distressed debt opportunities were few and far between in 2012, as access to capital markets and historically low interest rates gave companies a chance to fix their balance sheet woes now rather than later.

There was also a lot of money flowing into the market, keeping prices higher than usual in distressed names. Put together, that also meant fewer defaults and bankruptcies.

Even with political uncertainties going into 2013, the general consensus is that the New Year will be a continuation of the last few years: a lack of distressed supply and a lot of money in that space waiting to be put to work.

Still, there remain certain catalysts - both known and unknown - that could bring with them a renewed distressed marketplace. A return of fear could result in more volatility.

Should the bubble burst, "it could be interesting," a trader said.

New issues take focus

The high-yield bond market was churning out new issues faster than investors could get their hands on them in 2012. While the ability to access the capital markets was obviously good for companies - especially those looking to extend maturities or refinance higher coupons - the effect on the distressed arena was not so good.

"Having access to capital helped a lot of companies avoid any day of reckoning," one trader said. Had that access been shut, distressed companies or those on the verge of entering that realm would not have been able to repair balance sheets, he said, which would have thus created more opportunities.

"So many companies were able to get refinancings down and push out maturities and extend the so-called runway to grow into their overleveraged conditions," said Kim Noland, director of high-yield research for Gimme Credit LLC. "Only those with a true liquidity crisis [such as AMR Corp.] or serious permanent/secular decline in operations where they could never handle the debt [like NewPage Corp.] ended up in bankruptcy. This is in part why default rates remained low."

But that meant that there were fewer distressed ideas to go around.

"Given that there is so much money in the market and a lot of cash in distressed investors' hands, there were not enough new ideas to get that cash to work," a trader noted. "Everybody's all over it so hard so quick that the opportunities don't sit out there very long."

On the upside, however, was the fact that distressed credits did see decent-sized price gains.

"Since the high-yield market powered forward - returns were double-digit this year in most names - distressed bonds also benefited and traded higher as investors [were] willing to take less return despite risks associated with some of those names," Noland said.

"Maybe I was just more hopeful that there would be more distressed situations, given the relatively quiet market the year before," a trader remarked.

But another trader saw some positives in the market.

"[The market] did better than I expected," he said. "Liquidations yielded more and reorganized companies were priced better so revenues were higher."

The politics of Election 2012

2012 was, among other things, an election year. Election years always cause a little turmoil in the markets, given the uncertainty as to who will take the White House and other congressional seats.

It was because of that uncertainty that one trader said issuers looked to be more aggressive when pricing new deals. With interest rates at historic lows and no one sure how long they would stay that way, it was basically a land-grab to see just how much an issuer could get at the lowest rate possible.

But another trader said the election and the politics surrounding it didn't affect the market much. Instead, he said, distressed investors were more keen to keep an eye on Europe and its economic issues - which could result in distressed opportunities abroad.

Surprise, surprise

For the most part, distressed players were not too surprised by those companies that did fall off the ledge, though with some exceptions.

One trader said that AMR's bankruptcy filing - which came November 2011 but persisted through 2012 - was a bit of a shock given the amount of cash the company had at the time of the filing.

"AMR filed with $5 billion of cash," the trader said. "They did not require a [debtor-in-possession facility]. We thought they would limp along rather than file."

Another trader pointed to the rapid declines some issuers experienced, AMR being one and ATP Oil & Gas Corp. being another.

"It was amazing how fast it went from the 70s to 10," the trader said of ATP's debt price.

Still, AMR's decline was followed by a steady ascent. For ATP, that was not the case and bonds languished at or near the lows.

The case for 2013

While distressed market watchers are expecting 2013 to generally be more of the same - that is, too few ideas and too much money - there are some uncertainties going into the New Year.

One such uncertainty is the so-called "fiscal cliff," which will occur after the first of the year and will result in across-the-board tax increases and massive mandatory government spending cuts. Lawmakers are in process of cutting a deal that would avoid falling off the cliff, but the deep divide between Democrats and Republicans could derail the effort.

But if the cliff is avoided, one trader has every reason to believe that the market will go sideways and maintain the recent status quo. However, if a deal cannot be inked, "it could present opportunities in the distressed market."

Another uncertainty plaguing investors is how much the Federal Reserve will continue to manipulate the market.

In early December, the Fed said that it intended to keep interest rates at the current low rates until unemployment levels were closer to 6% to 6.5%.

"That will keep money moving into asset classes where there is yield," a trader said, specifically pointing to the high-yield arena. "It creates a big bear market which keeps everything rich."

While the trader said he did not wish "to see the world blow-up necessarily," he speculated the market manipulation had caused the market to act almost unnaturally.

"You almost want to get [the Fed] out of the way so the market can operate as it should," he said.

What to watch for

Though it is expected that 2013 will be the "same old, same old" for the distressed environment, there are opportunities that could present themselves.

"I think companies with deteriorating credit measures and leverage over 6-7x due to either secular or cyclical trends will continue to struggle," said Noland.

A trader said that there are certain companies and sectors that have been under pressure of late and speculated that some could end up in the distressed space.

"Anything commodity related could be under pressure if there is no recovery in commodity prices," he said. A continued slowdown in Europe could factor in heavily in that scenario.

Another at-risk sector is technology, the trader opined.

Many tech companies, especially those in the PC market, did not have a great 2012, the trader said. For instance, he pointed to Hewlett-Packard and its "disastrous numbers."

He speculated that the technology industry as a whole was undergoing a transformation and that companies like HP, Nokia Corp. and Advanced Micro Devices Inc. were having difficulties staying ahead of the pack. If such companies failed to stem market share declines, these previous market-leaders could "labor under debt without having enough revenues to stay afloat."

Such was the case for Eastman Kodak Co., which filed for bankruptcy in January 2012.

"They had their hands in so many businesses that their core business suffered," he said. Ultimately, the filing was necessary as the company's management failed to cut costs and deal with leverage issues.

What remains to be seen, he said, was whether those companies would be able to transform with the market or if they were the next restructuring waiting to happen.

The return of fear

In order for the distressed debt market to take a turn, some big catalyst will have to occur, a trader said, whether that be another recession or a major blow-up in Europe or something else that turns the economy around.

"If something happens where there's a blow-up in Europe [or some other situation], it could be interesting," the trader said. Currently, "there is this complacency that nothing is going to blow-up."

That complacency has led to a lack of fear, which can be a pivotal driver of volatility.

That being said, he commented that he believed there would be "a big distressed market" down the road. Whether that market emerges in 2013 or not, he could not be certain.

"Distressed debt investors may have another relatively lean year or at least [the] first half," Noland said. "It is hard to predict whether some 'black swan' will occur that upsets the apple cart."

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