Additional content provided by Michael McClain, AVP, Research.

Current Backdrop and Historical Performance 

As we enter the final month of the third quarter, the distressed market landscape remains one of the more complex opportunity sets for allocators. It’s been an oft-cited area to watch for several years now, as investors consider the balancing act of ongoing economic resilience, while being mindful of any small, yet potentially emerging areas of weakness.  

Historically, and as measured by the HFRI Event Driven: Distressed and Restructuring Index, the industry has delivered attractive risk/return profiles for qualified investors. However, this performance has not been without risk, as the cyclical and choppier performance has typically exceeded that of other hedge fund investment strategies. Performance dispersion across managers is also typically wider than that of other sub-strategies, as the timing of bankruptcy proceedings and deal-specific restructurings is distinct from manager to manager. 

HFRI Event Driven: Distressed & Restructuring Index – Annual Returns

Source: LPL Research, FactSet 09/03/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested directly. 
The HFRI Event-Driven Index is an index that tracks the performance of event-driven strategies in the hedge fund industry. Event-driven strategies often focus on deep value equity exposures and speculation on mergers and acquisitions.

What To Be Aware of Going Forward 

While skilled managers remain the most consistent source of returns over the long term, we are watching the following areas of the market to gauge the opportunity set: 

• CCC-rated high yield bond spreads remain subdued and in-line with 10-year averages. For distressed debt investors, this represents a rather weak backdrop, where building up cash or deploying it in higher-rated, more liquid securities may be prudent. Over the short-term this may be a drag on performance as compared to having a more extensive distressed debt opportunity set, however, being able to capitalize on today’s higher rates should mitigate the lack of distressed debt volume. 

CCC-Rated High Yield Bond Spreads

ICE BofA CCC & Lower US High Yield Index Option-Adjusted Spread

Source: LPL Research, Federal Reserve Economic Data 09/03/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested directly. 

• A broadening of opportunities across sectors is also an area to watch. From a sector perspective, over the past several years, the market has seen brief, sector-specific areas of weakness, however, in aggregate, a meaningful and widespread opportunity set has failed to materialize. While these one-off events provide opportunities for managers to deploy cash, they can also lead to a crowding of investors in the same trade. For managers who prefer to lead the restructuring process, this becomes more difficult, as even more investors seek control over the bankruptcy process.  
• CCC-rated high yield bond interest rate coverage ratios remain strong, with data from Bloomberg Intelligence indicating a 2.0 coverage ratio at the end of the first quarter of 2024 versus a 10-year average of 2.7. A higher interest rate coverage ratio is indicative of stronger corporate fundamentals and an ability to cover debt interest expenses. While the quarterly trend has been on a downward trajectory, it remains above any level of immediate concern but is an important metric to gauge more widespread weakness.  

Summary 

Current opportunities across the distressed debt market remain limited, yet we believe it to be a strategy to watch going forward. Our preference for multi-strategy funds is warranted in this area and given the limited opportunity set, we prefer managers with more flexible investment mandates and experience investing across the capital structure. Rather than having to maintain a high cash balance, multi-strategy credit managers can deploy cash in more liquid credit opportunities until we observe a more robust distressed environment. Prior manager experience across bankruptcy proceedings and market environments is also a key feature to consider, as is their ability to structure more asymmetric risk/reward payouts. As in the case with any restructuring, there remains the risk of a complete loss of investment, so being able to properly model a worst-case scenario and/or be best positioned to first receive payments from assets in the event of a liquidation are also part of what we consider in a manager.