I think the one word to describe this year's distressed debt market was "unexpected." Whether it be the tragedies in Japan, Congress pushing us to a near technical default, the subsequent U.S. government downgrade, heightened and unforeseen issues with Europe, and a number of surprising bankruptcy filings (MF, AMR, etc), this has been a tough year to price risk for a distressed debt investor. According to HSBC's most recent "Hedge Fund Weekly", hedge funds classified as "Distressed Security, Global", excluding Paulson & Co affiliated funds, have seen year-to-date returns ranging from -9.5% to 7.4% with a number of funds hugging right around zero.
While I will save my post discussing the expectations for high yield returns for 2012 (I know, a fool's errand) for next week, I would like to talk about some issues and themes that distressed debt investors may possibly encounter through 2012. But first, let us look at my favorite chart: The number of distressed debt issuers traded over the course of the year:
(Note: I've cut the graph off as of two days ago to account for the dearth of trading around the holidays)
As this chart shows, the distressed opportunity set has increased precipitously over the past 12 months. Many of the new opportunities comes from junior capital (TRUPS, preferred, unsecured bonds, etc) of European banks. In addition, as the definition of distressed according to Bloomberg is a spread of over 1000 basis points along with a much tighter treasury curve, the bar is set a tad lower this year. With that said, I think any investor you speak to participating in the distressed debt market would tell you there is a lot more to do at this time time year than last year.
In terms of themes, I might as well get the elephant in the room out as quickly as possible: Europe. I have read every major investment bank's credit outlook for 2012 and everyone's projections for next year's returns are based on possibly scenarios in Europe. If you were to compare the two issues that rocked the equity markets over the past 12 years (the "Tech Bubble" and the "Mortgage Crisis"), issues in Europe are so heavily portended that I'm starting to wonder how much is already discounted in. I mean, were people talking about the Tech Bubble in 1999, like they are talking about Europe today? Were (informed) people talking about the mortgage crisis in 2007, like they are talking about Europe today?
I have no idea what is going to happen in Europe. I am not a macro analyst and find myself much more comfortable (and at an information advantage) discussing various bottoms-up situations than trying to guess which European Summit, if any will fix the problem. With that said, you can't ignore the situation because that is what is driving monthly returns (in fact, an interesting data point: many funds have put on hold hiring fundamental analysts for the mere fact that the added value is muted by macroeconomic / Europe factors).
One way that I like to think about situations is determining, where on a bell curve, the situation is priced. Here is the standard bell curve we all learn taking the CFA exam or intro stat:
Where the entire European debacle began to unfold, the +1/-1 standard deviation events were not priced in. I'd say, with everyone focused on Europe, the +2/-2 standard deviation events are probably pretty closed to being priced in and the thing you have to worry about as a portfolio manager are the very far tails, for instance, and Italian default. 12 months ago if you told people you were pretty confident that Greece was going to default, they'd say, "You know, its a possibility...but probably not." CDS on Greece has gone from 1000 basis points to 10,000 basis points (I don't have the points up front data in front of me) just this year. Everyone expects some sort of Greek default.
The question I then fall back on is this: Will Europe suffer a mild recession or a very bad recession? The problem with a very bad recession is the domino effects it has on the rest of the world. Here is the scenario:
- Europe falls into a bad recession
- Europeans purchase less due to austerity measures (wage cuts, higher taxes, etc)
- China's economy, which benefits from Europeans purchasing their goods, slows down on lower exports
- Australia, Singapore, Korea - all major exporters to China, slow down because China has slowed down because Europe has slowed down
- Global commodity prices (and definitely Australian real estate) drop because China has slowed down
- Major commodity producers, other than China, including Brazil, Canada, and Russia slow down because exports are lower due to lower prices and lower demand from everyone above