Outlook 2014: Fed's stimulus tapering, interest rates to play key role in distressed debt market

By Stephanie N. Rotondo

Phoenix, Dec. 31 - The distressed debt market saw few flare-ups in 2013, continuing a trend seen in 2012.

The main reason for this was that credit markets continued to be open, even to companies on shaky ground. Companies were able to access the markets - at low interest rates - to push out maturity walls and do other forms of refinancings.

"There have been a number of credits that have been able to bail themselves out with balance sheet repair," said one distressed bond trader.

In addition to low interest rates, demand for high-yield debt remained high.

"There is a ton of money going into high yield," a trader remarked.

As 2014 commences, distressed market players are expecting things to stay pretty much the same, barring any sort of catalyst that can create volatility. Whether that catalyst is the tapering of the Federal Reserve's bond repurchase program or some other unforeseen one-time event remains to be seen.

"The crack won't surprise people," a trader said. "The question is timing."

Low rates mute action

Volatility was severely lacking in the distressed realm in 2013.

"It's not like there were necessarily any real big blow-ups," a trader said. "I think a lot of the same names just sort of drifted around."

Several companies were on the distressed radar screen throughout the year - J.C. Penney Co., Inc., Energy Future Holdings Corp. and certain of its subsidiaries, and RadioShack Corp., to name a few - but open capital markets allowed struggling enterprises to exchange debt at cheaper rates or undertake some other form of refinancing that helped to delever balance sheets and push out maturity walls.

Additionally, "the low rates have kept other companies from filtering in," a trader noted. For example, he said the coal sector as a whole has been able to access the markets during a period of time when demand for product, as well as prices, was on the decline.

"If the new issue market wasn't open, they wouldn't be able to deal with some nearer term maturities," the trader said, pointing specifically to Arch Coal Inc.'s cash tender offer for its 8¾% notes due 2016, which was announced in early December.

But even as many companies were able to repair balance sheets, that did not mean that operational issues were necessarily improving. However, assuming that interest rates stay low, "that should help to improve the numbers, so maybe they can manage their way for a little while," a trader said.

Investors look for ideas

Given the low-interest-rate environment and high demand for high-yield issuance, there were fewer distressed opportunities available to investors.

One trader said that activity was centered on the same "tired names" that have been hanging by a thread for some time, like Energy Future Holdings or Nortel Networks Inc.

As such, market players have had to look elsewhere for new ideas, such as in Europe or in emerging markets.

"People are looking at a broader number of things because of a lack of ideas," a trader said. In addition to looking at other geographic spaces outside of the United States, investors are also paring down their investment strategies.

"Maybe their return parameters aren't as aggressive," he said. Instead of aiming toward 20% to 30% returns, returns in the low-double digits were becoming acceptable.

Distressed funds in 2013 were meantime giving investors some of their money back because of the lack of distressed opportunities. Fund investors "don't want to take profits at year-end because they are not going to be able to refill [their portfolios with other distressed investments]."

I don't think it's a surprise that you see these funds giving back money," another trader said. "They don't have opportunities to invest in."

The trader also pointed out that said funds had no lack of capital, only a lack of opportunities. Should those opportunities increase come 2014, "they'll have no problem raising money."

Rates to drive 2014

Interest rates and how the Fed's potential stimulus tapering will impact said rates are going to be key in 2014's distressed arena.

"The whole world is looking at it," a trader said. "The biggest concern investors have is just interest rates and the Fed's exit from the [stimulus program]."

"As long as we have this low-interest-rate environment, companies are going to be able to refinance," another trader said. "If we see tapering and interest rates rise, non-traditional money will exit the market. Then all of a sudden, people will be more risk averse."

In that scenario, some distressed or near distressed companies could come under pressure, thereby adding more opportunities to the distressed pool.

Still, barring a rise in rates, many market players believe 2014 will bring more of the same.

"I'd like to be more bullish on distressed, but it all depends on interest rates," a trader said.

Even Moody's Investors Service foresees a stable environment for what it deems to be lower-rated companies.

"Looking to 2014, the ratings list and other Moody's indicators suggest calm credit conditions will continue for lower-rated companies," wrote David Keisman, lead analyst at Moody's.

Still, Keisman says there could be a catalyst to drive companies downward.

"A solid economic rebound next year could improve business prospects for companies at the Caa rating level, but they would also be the most vulnerable if the economic recovery or financial markets were to stumble."

Sector watch: Coal, retail

Come 2014, the coal and retail sectors will stay in focus.

"Eyes will still be peeled on the coal sector," one trader speculated. "You have got a couple stressed credits [such as Arch Coal and Alpha Natural Resources Inc.] that have decent-sized capital structures."

Investors will also be keeping an eye on retailers such as JCPenney, RadioShack and even "somewhat stressed" Claire's Stores Inc.

Once fourth-quarter results come out after the first of the year, investors will "take some clues from that as to how the economy is really doing," a trader said. If JCPenney, for instance, can continue to report gains in sales, that could indicate that the economy is strengthening, which would be good for retailers across the board.

"But they've got to keep doing that," the trader commented. "[JCPenney] is already on a short-leash with investors and vendors."

"You will wonder how it's going to translate," the trader said of fourth-quarter numbers. "They may not all be bankruptcy candidates, but they could certainly be under pressure."

The distressed market is incredibly cyclical, and an environment of low interest rates has allowed the current down-cycle to trend "a little longer," a trader said. To some degree, the market is just waiting for the other shoe to drop.

"We need a market that is going to be more volatile," the trader said. "There will be a day when this market gets hot again."

Therefore, market players will remain in flux until a catalyst - whether that is a rise in rates or some other one-off event - occurs. The big question is whether that will occur in 2014 or not.

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