The default rate is expected to edge higher in 2007 as the economy slows, but market observers expect the trading price of distressed debt to remain high because of the large amount of liquidity flooding the market. This may spur distressed funds to expand their trading strategies to invest in other areas of the capital structure, said market participants.
Chris Roberts, director of research at broker-dealer Tejas Securities Group, said investors have been frustrated with the lack of distressed debt supply in 2006. He expects the trading price of distressed loans and bonds to continue to remain high in 2007. "We expect valuations to continue to be firm. There is still a ton of capital," said Roberts.
High competition in the distressed market is forcing funds to expand their trading strategy. Roberts said distressed funds may choose to pursue other trading strategies such as going long and short equity. An increasing number of funds that have traditionally invested in loans may move into bonds, said Roberts.
Excess liquidity has led companies to leverage up and deal structures to loosen. Tom Sperry, U.S. market leader of corporate advisory and restructuring at PricewaterhouseCoopers, said this could lead to a pick up in distressed activity in 2007. The residential real estate market and the homebuilders sector in particular are vulnerable, he said. Also, the rise in oil prices could make companies producing oil-based products, such as paper and packaging, at risk of default.
Roberts also expects default rates to rise next year with the auto and specialty retail sectors hit the worst. Despite the upheaval in the auto industry in 2006, returns on high-yield auto bonds actually increased this year. Tom Haag, high-yield portfolio manager at Seneca Capital Management, said returns on General Motors Corp.'s bonds were actually up 49% on last year, while returns on Ford Motor bonds increased 21%, according to the Lehman Brothers high-yield index. The restructuring efforts at General Motors and Ford inspired confidence in investors. "Autos had to go one way or the other. They have done what they could do to improve liquidity," said Haag.
Another sector that did well this year was the airline industry. Haag said the airlines' restructuring efforts boosted returns on airline bonds by 14% this year. Overall, Triple-C rated high-yield bonds achieved returns north of 15% in 2006, according to Lehman's high-yield index. Expected returns were 2-10%, said Haag.
The large number of leveraged buyouts in 2006 will continue in 2007, said Haag. He doubted many of these deals will blow up next year, but predicted some could run into trouble over the next two to three years. "There is a lot of capital from private equity firms that will continue as long as interest rates remain low," said Haag. He said it is possible the market could see a leveraged buyout deal that exceeds $50 billion in 2007. "The ton of demand means lending standards have been loose. There is not a sign of tightening," he said.
Meanwhile, the greater role hedge funds are playing in the distressed market could change the nature of restructurings, Sperry said. Hedge funds are increasingly buying debt to take control of a company and are more likely to push for the sale of businesses. "There is more pressure to sell quickly and go through restructurings," he said. The increased dominance of hedge funds could also lead to more inter-creditor disputes. "It could create a potential gridlock, especially as more funds are in multiple levels of the capital structure."