Most investors think that we are in the late stages of the current market cycle and the bull market in stocks and credit does not have too much room to go. So, one would expect that investors start reducing their risky assets and increase the liquidity in their portfolios. After all, that would not only protect them from the possible drawdowns in a bear market but give them ammunition to pick up distressed securities at a bargain price once the market is in full panic mode.
Yet, not even the investors with supposedly long investment horizons like pension funds and insurance companies seem willing to put their money where their mouth is. Institutional Investor reported that distressed debt funds are on track for their worst fundraising year since 2009. Until mid-May, only four distressed debt funds closed, having raised a mere $2.5bn.
In an analysis I published in 2018, I showed, how short-sighted this is. Not only, will investors miss the opportunity to buy distressed securities at bargain prices, they will likely put their capital at work, only when returns on distressed debt strategies decline again. In the report I showed that the opportunity set for distressed debt strategies is basically given by the ratio of assets under management in distressed debt strategies relative to the amount of bonds in default. This ratio can explain 36% of the variation in return of distressed debt strategies one year in the future. If one adds the option-adjusted spread of high yield bonds, the explanatory power increases to 48%. In short, the lower the assets under management of distressed debt strategies to the amount of bonds in default, the higher the returns of distressed debt strategies will be over the coming twelve months. And thanks to institutional investors’ declining propensity invest in distressed debt strategies we are now in a situation, where the expected return for the coming twelve months is at or above 10%. Compare this to the 7.7% average annual return of distressed debt strategies since 2000. Truly contrarian investors have an opportunity that is not to sneeze at, but as always with contrarian positions, they require a certain amount of “guts” to enter and hold until they pay off.
The opportunity set in distressed debt
Source: Bloomberg, Standard & Poor’s