An improving economy can be tough for some businesses. Case in point: firms that invest in distressed debt.
Edward I. Altman, a noted expert in credit risk, predicts a default rate of just 2.8 percent in 2011 for corporate debt, which he termed very low. Economic conditions are improving rapidly, Altman told a packed luncheon this month at the New York chapter of the Turnaround Management Association.
That 2.8 percent rate was Altman’s forecast as of mid-February. When he ran the numbers a month earlier, he got a 3.2 percent rate prediction, a product of improving economic trends and low interest rates. While that might be beneficial to most buyout shops, “it’s not good news for these [distressed debt] guys,” Altman said in an interview with Buyouts after his presentation.
For firms that invested in distressed securities during the financial crisis, returns could be strong:
Investing in distressed debt and turnaround funds remained a highly popular strategy for sponsors in 2010.
Market sentiment has turned sharply bullish in a remarkably short time. Altman, the Max L. Heine Professor of Finance at the Stern School of Business, part of New York University, bases his forecasts on his Z-Score for Predicting Bankruptcy, a statistical methodology that he first laid out in 1968.
The model uses more than a dozen variables in three main buckets—fundamental analysis, macro economic factors, and market values of stocks and bonds including credit default swaps. Although studies have found the model to be 70 percent to 80 percent accurate in predicting bankruptcies, it couldn’t account for the $2 trillion intervention by the Federal Reserve after Lehman’s collapse, Altman told his audience. “We didn’t have in our model that the U.S. was going to play such an important role.”
This recovery also was unusual in another way. Historically, default rates spike for two or three years at a time. The year 2009 was unique in that defaults spiked for a single year, to 10.8 percent (the second highest default rate ever, trailing only 1991) then fell sharply, he said. “I’ve never seen such a rapid recovery.”
Credit markets hit a milestone last week, with a yield to maturity for high-yield debt at 7.35 percent, the lowest in the history of the market, Altman said. And the premium for high-yield debt versus 10-year Treasuries is 3.7 percent now, compared to a 2.6 percent premium in June 2007 at the height of the boom and a spread of more than 20 percent post-Lehman.
“Do the fundamentals justify a 3.7 percent risk premium or have we moved too fast to a lower level?” he asked. “Investors are reaching for yield in any place they can find it. The best game in town seems to be high-yield bonds.”
With U.S. interest rates likely to continue to remain low, perhaps the greatest risk is an unexpected shock to the system, such as the subprime mortgage crisis that infected credit markets around the world, he said. “Oftentimes the catalyst for fundamental change has nothing to do with fundamentals.”