With corporate bond risk premiums hovering near all-time lows and scarcely a bankruptcy or missed payment in sight, the question has become: how do you measure distress? The distinction between speculative-rated, or junk, bonds and distressed debt is blurring as investors pay less attention to an historical divide between the two asset classes in their pursuit of fatter returns.
Traditional high-yield investors are meeting their distressed debt counterparts — mostly hedge funds — in the lowest reaches of the junk bond market where yields are juicier. This confluence of demand at the most speculative credit tiers is helping to keep troubled companies afloat, while stoking concerns that some high-yield investors could be over their heads should a turn in the credit cycle put the squeeze on their holdings.
In general, distressed debt refers to bonds of companies that have either defaulted or appear to be at a heightened risk of doing so. Such risk drives the bond prices lower and the yields higher. The most common measurement of distress is a bond that currently yields at least 1,000 basis points over Treasurys, according to Christopher Garman, a high-yield analyst at Merrill Lynch.
That sort of pricing can make distressed bonds attractive investments for investors with a high tolerance for risk. This has tended to make such instruments the province of hedge funds, vulture investors, private equity and other specialized players, who often take large stakes in such credits in order to wield greater influence in bankruptcy proceedings.
Lately, however, as spreads have compressed and defaults have nearly evaporated, investors are finding these instruments in short supply and being forced to look elsewhere. “Distressed investors are crossing into other asset classes because there’s nothing out there that’s distressed,” said David Keisman, an analyst at Moody’s Investors Service.
The speculative-grade default rate registered a mere 1.5% in April, according to Moody’s Investors Service, well below the historical average of around 5%. Meanwhile, the U.S. distress ratio, often viewed as a leading indicator of defaults, has fallen even lower, measuring 0.8% in April, according to Standard & Poor’s.
“Distressed credits are being propped up by the same tide of liquidity that’s propping up the default rate,” said Diane Vazza, head of global fixed-income research at S&P. While the lack of bankrupt paper has caused more distressed investors to move up into speculative-grade investments, high-yield investors with broader mandates and fewer risk constraints have simultaneously been moving down in credit quality in search of better returns.
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