The troubles in the eurozone, unpredictable changes to financial regulation in the West and a withering of investors' risk appetite may be creating a "robust distressed opportunity", says Mark Okada, chief investment officer and co-founder of Dallas-based Highland Capital Management.
The firm manages $24 billion of fixed-income securities and is one of the biggest managers of below-investment-grade credit in the US, notably collateralised loan obligations.
Currently senior secured loans make up about 70% of Highland's portfolio, but over the next few years this portion will decline in favour of distressed assets as more loans come due and borrowers can't pay, says Okada.
He has been managing alternative fixed-income portfolios for 20 years and has seen four full cycles. After the troubles of Greece, he's looking two or three years down the road. He sees the refinancing of high-yield debt looking vulnerable and an upcoming 'wall of maturities' on refinancing corporate bank loans and other securities starting in 2012 that will contain plenty of distressed opportunities.
Between 2012 and 2015, some $1 trillion of high-yield bonds and leveraged loans will mature.
Okada notes that bankers have described the scale of debt that needs refinancing in America and Europe as enough to supply three transactions a week all year, assuming the bond markets were to remain open. He assumes that not all of these deals will get done, however.
Citing the current market expectations for high-yield corporate default rates this year to be 3-5%, he says: "Those figures depend on the bond markets staying open, and we are preparing for that not to be the case." The firm is keeping cash at hand to take advantage of distressed deals.
Okada says, for example, that the markets are active with private-equity owners trying to do debt exchanges or achieve equity infusions for many assets acquired in the heady days of 2005 and 2006. "Some of these will fail, and companies will end up owned by their creditors," he says.
For investors such as Highland, this creates an opportunity to do fundamental research to determine which companies are going to find themselves in such an uncomfortable situation. Unlike 2008, when the distressed window shut nearly as quickly as it opened, there will be more time for investors to pick and choose distressed deals, because there is far less leverage now in the system, and therefore less volatility.
For the time being, however, senior secured loans continue to be compelling. Highland projects that high-yield bonds should return 8-10% and leveraged loans 8-12% in 2010, which it deems attractive relative to other asset classes, especially given lower historical volatility.
On current transactions, pricing is often enticing, with companies rolling over debt at 150-200 basis points more than the original pricing. There are also new loans being syndicated with big sizes and at attractive pricing.
Although Okada believes default rates will begin to rise as maturities start to come due in 2012, he is not as bearish on conditions in the West as many of his clients in Asia.
He does not equate problems in the eurozone to a crippling sovereign debt crisis. "Market pricing of European government CDS [credit-default swaps] are way out of kilter," he says, noting the $1 trillion European rescue package for Greece caught a lot of short sellers off guard.
Although he recognises the general reason for pessimism about the rescue package, which simply delays Greek debt payments, Okada argues that it would be foolish today to simply assume the euro project will collapse in three years once the new bill comes due. Governments can tax companies and individuals, or print money, and Greece (or at least the European Union) has time to find ways to meet its obligations.
"Asian investors are very negative about the world," Okada observes. "They're staying invested in safe government bonds. I've seen this reaction many times over the past 20 years. I can't tell you that I know better, but I tell you that when the consensus is so bearish, it's usually a good time to buy."
This is true of developed countries in general. As the US, Britain, Europe and Japan vie for international capital, they will enact reforms, such as a consumption tax in America or Japan. Yes, growth will slow down, but governments can address their debts, with the US the best placed to do so.