Portfolio manager says heaviest-hit sectors remain in the mire and there is value to be unlocked
Distressed credit markets remain an excellent opportunity, with many areas still struggling with dampened growth prospects, high fixed costs and considerable debt loads.
That’s the view of Amar Pandya, senior investment analyst and associate portfolio manager at PenderFund Capital Management, who believes there is significant hangover from late March, when the amount of US distressed debt had quadrupled to nearly $1 trillion, its highest level since the 2008 financial crisis.
Government stimulus has mitigated the potential depth of the crisis but while some of the heaviest hit sectors, including energy, retail and transportation, have seen much-needed improvement, they continue to labour.
“We believe that many of the indicators we follow continue to signal that distressed credit markets are trading at an attractive entry point,” Pandya said. “With equity markets having rebounded sharply during the crisis and investment grade credit providing meagre returns in a near zero-rate environment, investing in distressed credit could be an excellent opportunity.”
However, Pandya warned that, unlike equity or even corporate bond markets, identifying, analyzing and executing on distressed credit opportunities requires a unique set of resources. When a company is undergoing a bankruptcy process, the flow of information tends to dry up and trying to talk with management becomes challenging. He said it’s vital, therefore, to have a subscription to a news flow service that is specific to court and legal actions on North American bankruptcies. Having access to a pool of credit analysts covering various sectors of the credit market, including specialists in distressed credits, can also help.
Acquiring the security can be challenging. So, leveraging a large network of broker dealers who can provide information flow, ideas, inventory and trade execution at competitive spreads becomes essential. A well-resourced back-office and good legal representation are also crucial.
For the investor, it’s crucial to take advantage of market dislocations and the energy sector, which has been among the hardest hit, with oil prices cratering to negative levels as global oil demand collapsed, presents opportunities. The sector remains oversupplied with troublesome second- and third-order effects, while oil prices are still below all-in sustaining costs for the majority of North American producers.
Pandya said: “With energy among the most levered sectors and representing a significant portion of total high yield debt and new debt issuance over the past few years, the sector is highly distressed but also provides a plethora of potential opportunities.”
For example, Penderfund owned a small equity position of Athabasca Oil Corporation, a Canadian small-cap oil producer in the Pender Small Cap Opportunities and Pender Value Funds.
Pandya explained: “While the company had high costs and concentrated assets, our investment thesis was predicated on the catalyst-rich nature of the business with several catalysts available in the capital structure, asset base and ownership, any of which could unlock value. As oil prices collapsed our thesis was negated and we decided to exit our equity position.
“But as we looked through the capital structure, we identified an opportunity in the company’s 2022 notes which we switched into. The notes are the most senior and are the only issue outstanding for the company, and we noticed they had become materially dislocated during the oil price rout in late March and early April. At our largest accumulation, the notes were trading at a severely distressed level in the teens as expressed in dollar terms, with the market value of the debt well below the cash value of the company.
“We viewed this as unsustainable as the company had sufficient liquidity to survive the price environment for an intermediate period, with significantly higher asset value than what was being reflected in the market. While still distressed, the notes have appreciated multiple times from that level, far outpacing the modest recovery in the equity. In periods of severe distress rare opportunities with higher upside and lower downside can be found, but a good fundamental understanding of the business and quick execution are critical to capitalize on these opportunities.”