The emergence of a post-COVID-19 recovery has not diminished the stresses on some sectors and companies.
Investors would be wrong to assume the opportunities for distressed investing have passed. The advent of vaccines and the potential for a sustained global economic recovery have brought considerable optimism. It is true the U.S. stock market continues to set records and credit spreads have narrowed, suggesting investors aren’t overly concerned about risks to the markets.
Generally, the opportunities in distressed investments are greatest when a major disruption, like a pandemic, causes pessimism to a degree that securities’ prices sink below their intrinsic value. Now that optimism has returned, as the global economy emerges from the COVID-19-induced slowdown, is it even possible to continue finding these pricing dislocations?
In our view, the answer is yes for several reasons.
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While broad data suggest the economy and markets are doing well, the recovery has been very uneven. Many traditional sectors – like retail, hospitality, leisure, and energy – continue to lag in the recovery. Even accommodative monetary policy and the extensive fiscal stimulus the U.S. government has provided have not been enough to help these sectors fully overcome the impact of the COVID-19-required restrictions on social gathering and travel.
Around the globe, one key to economic recovery has been the rate of inoculations. Many countries in Western Europe are still behind a pace that would provide more sure footing for their economies to rebound.
In early April, the World Health Organization even called out the European Union’s vaccine distribution as “unacceptably slow.”1
By April 1, Britain had delivered 52.4 doses of COVID-19 vaccines per 100 people, ahead of even the U.S. rate of 44.9 doses. But for the European Union, only 16.4 doses had been administered per 100 people.2
When finance ministers and central bank governors from the world’s 20 leading global economies met in early April for a virtual G20 conference, the unevenness of the economic recovery across the European Union and parts of Asia was a primary concern. The attendees confirmed the need to ensure that stimulus measures were not eased too soon and that some relief was provided to poorer, debt-laden countries.3
We believe there will be opportunities to invest in distressed securities in those regions that are slow to recover, as well as in the still-struggling sectors in countries that have rebounded more quickly.
Amid a massive slowdown, companies have many levers they can pull to try to limit the impact of greatly reduced business activity. They can cut costs and reduce or even eliminate any previously planned investments in expansion and growth. While these measures offer a temporary stopgap, they can hamper the long-term viability of a company. Now that we have surpassed the one-year mark of the pandemic, many companies have been stretched to their financial limits. We expect the default rates on corporate debt to remain elevated this year.
Finding opportunities among distressed securities, in any environment, does take skill. First off, it requires an ability to differentiate between the widely perceived risks and the actual risks with a sector or company.
Currently, for example, the consensus is that the hotel industry will continue to suffer from a long-term decline in travel. The consulting firm McKinsey & Company last year projected that hotel occupancy rates might not recover to their pre-COVID-19 levels until 2023.4
Even with that ominous forecast, the impact of COVID-19 was not uniform across the sector. Economy hotels, for example, cater to customers, like truck drivers and extended-stay guests, that still needed rooms throughout the pandemic. In both the economy and luxury sector, many of the best-known names simply franchise their brands and the decline in occupancy rates hurt their franchisees more than it did the companies with the best-known brands.
In any sector, assessing the opportunities with distressed securities must be done on a case-by-case basis. It’s not enough to simply look for a company on the verge of defaulting on its debt and even declaring bankruptcy, with the assumption that there is a chance to buy a viable asset on the cheap.
Corporate debt that might be selling at 50 cents on the dollar may seem attractive if one believes the company could be poised to recover. Still, it takes expertise to gauge the viability of the company and its industry. Is it a company that can successfully emerge from the disruption, or is it a business that many never thrive in the newly changed landscape, like a retailer with a primarily brick-and-mortar business that isn’t equipped to handle the shift to e-commerce that the pandemic accelerated?
Just as importantly, investors who take on the risk of distressed securities may benefit from having experience in guiding companies on the steps they must take to revitalize their business.
With companies that have gone into bankruptcy, ownership transfers to the creditors. The largest and most influential creditors may lead the steering committee that will aim to lead the company out of its financial straits. This may include spearheading the discussions on determining how to restructure the company, identifying where value can be extracted from it, and determining what lines of businesses it should focus on and what it should discard. In essence, they’ll be deciding what the company should look like as it emerges from bankruptcy.
Unquestionably, getting the most from the investments made in these distressed securities requires considerable business acumen, beyond the skills of only identifying investment opportunities.
It is a relief for everyone that the world seems ready to get past the many challenges the pandemic brought, but we believe there are still opportunities to realize substantial returns from distressed securities at companies whose fortunes are not poised for an immediate rebound.
In fact, we believe these opportunities can be found in any economic environment. For that reason, a distressed investing strategy might be worth considering in a portfolio through all market climates.
Additionally, the factors that drive the performance of these securities are more closely tied to the idiosyncratic risks associated with each company. This is what sets distressed securities apart from traditional stocks and bonds, whose performance can be largely driven by general perceptions about broad markets and macroeconomic conditions like interest rates. The typically low correlations that the returns of distressed securities have with the returns of traditional asset classes have the potential to make them excellent diversifiers at any time.
1. Source: “Covid: Europe’s vaccine rollout ‘unacceptably slow’ – WHO,” BBC News, 4/1/21
2. Source: “Covid: Europe’s vaccine rollout ‘unacceptably slow’ – WHO,” BBC News, 4/1/21. BBC drawing on Our World in Data as source for inoculation rates.
3. Source: “G20 to discuss uneven recovery from COVID crisis, officials say,” Yahoo Finance, 4/6/21
4. Source: “Hospitality and COVID-19: How long until ‘no vacancy’ for US hotels?” McKinsey & Company, 6/10/20
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