Back in November, still smarting from a year he would rather forget, Russell Clark and his Horseman Capital, i.e. the “world’s most bearish hedge fund” unveiled what he would be short next: according to Clark, the next major source of alpha would be shorting fallen angel bonds.
Citing a recent IMF Global Financial Report, Clark said that “US investment grade debt is very low quality, and could produce some large fallen angels. It then goes on to tell me that mutual funds are much larger in the high yield market than they used to be. It also tells me low rates means the capital losses are much higher than they used to be. And that investors in high yield mutual funds are much flightier than they used to be! Essentially the IMF are telling me that if you get a large enough fallen angel, the high yield market will freak out, and volatility will spike causing volatility targeting investors to dump leveraged positions. Sounds good to me.”
One month later, in the aftermath of of Steinhoff fiasco, in which the ECB found itself long tens of millions of bonds in a company which went from investment grade to deep junk after it was revealed that it may have engaged in occasional fraud, crashing the bonds…
… Mario Draghi only made the bearish “fallen angel” case more explicit, by clarifying that going forward the ECB would likely liquidate bonds which were purchased as IG and subsequently downgraded to Junk (as we explained in detail in “The ECB Has Some Bad News For Junk Bond Buyers“)
Fast forward to today when one of the icons of credit and distressed investing, Oaktree Capital, joined the bandwagon of fallen angel hunters, saying that the fund expects to see a flood of troubled credits topping $1 trillion as rising interest rates overwhelm low-quality loans and bonds.
Speaking at the Bernstein Strategic Decisions Conference on Thursday, Oaktree Capital’s Chief Executive Jay Wintrob said that when the cycle turns it will be faster and larger than ever as “fallen angels” proliferate, and added ominously that “there will be a spark that lights that fire.”
Picking up on last week’s Moody’s warning, in which the rating agency warned of a junk bond default avalanche as rates rise, Wintrob said that the supply of low-quality debt is significantly higher than prior periods, while the lack of covenant protections makes investing in shaky creditors riskier than ever.
According to the Oaktree CEO, those structural flaws of the bond market mean debt will fall into distress quickly once conditions flip, and “Oaktree is prepared with about $20 billion saved for future investing opportunities” he said according to Bloomberg.
Of course, Oaktree could be simply talking its book: the fund fund which ranks among the world’s biggest investors in distressed debt, has been rather bored in recent years in which record low rates have made distressed opportunities an endangered species, and as we noted last wee, credit-rating firms are forecasting even fewer opportunities in the months ahead, although the tide will turn once rates rise higher enough.
But not just yet: for now, the total kept by S&P Global Ratings of potential “fallen angels”, or those investment grade companies in danger of being downgraded to junk, stood at just 45 in April, with $119.3 billion of debt outstanding according to Bloomberg.
This is where Oaktree came in, with the rhetorical question posed by Wintrob to lenders, who “should be asking themselves if the market can continue to lend and extend maturities of debt at very low rates.“
The abnormality in the lending market shows creditors should be “investing with an extra dose of caution,” he said. “We’re living in a low-return, high-risk world.”
The potential opportunity for Oaktree is so pressing that the fund has now allocated about a quarter of its assets to troubled issuers.
Amid slim pickings in the U.S., the firm has looked to spread its distressed strategies into China, India and other emerging markets.
To be sure, Horseman and Oaktree are not alone preparing for a surge in troubled issuers. The amount of “dry powder” held by fund managers to invest in low-quality debt has grown to around $150 billion, Wintrob estimated. Quoted by Bloomberg, he said this number has shown steady growth as the duration of bonds has increased, which could make the coming price drops even more significant than during the turn of the last credit cycle in 2008.
Which of course would be great news for America’s bankruptcy advisors: as a reminder, last weekend we quoted Moelis’ co-head of restructuring Bill Derrough who said that “I do think we’re all feeling like where we were back in 2007,” adding that “there was sort of a smell in the air; there were some crazy deals getting done. You just knew it was a matter of time.”
All that is needed is the spark.
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