Breaking Out of the Pack

Below, you’ll find the latest market update and portfolio review from Porter & Co.’s Director of Distressed Investing, Martin Fridson. We release a full report with a new recommendation on the second Friday of each month, and an update like this one two weeks later. In this update, Marty provides the “Top 3 Best Buys” – a regular feature that highlights what he views as the three most attractive positions to focus on in the portfolio, to help those who are new to distressed investing get started. As always, please call Lance, your Director of Customer Care, with any questions. You can reach him and his team at 888-610-8895, or internationally at +1 443-815-4447.

The Dow Jones Industrial Average dropped 2,000-plus points (roughly 5%) between Wednesday, July 31, and Monday, August 5. Less conspicuously, in the bond world, the ICE BofA U.S. Distressed High Yield Index also sustained three consecutive days of declines. Distressed debt prices dropped by 4.1% over the period, partly offset by interest income, to post a negative 3.9% total return.

That 3.9% drop represents an average return for all 117 bonds in the distressed index, weighted by the issues’ respective shares of the index’s total market value. Of course, averages can be deceiving. As one classic illustration of this principle goes, “I have one foot in a bucket of ice water and the other in a hot oven. On average, I feel fine.”

The table below shows extraordinary dispersion around the distressed market’s negative 3.9% weighted average. Returns ranged all the way from 4.3% at the top to negative 28.2% at the bottom. Remember, this all occurred in a period of just three trading sessions. A 4.3% return is almost three times as great as the distressed index’s historical median quarterly return of 1.6%, which covers about 90 days.

These numbers are even more intriguing in comparison with data for the ICE BofA BB U.S. High Yield Index. That index contains the least risky variety of speculative-grade securities, which are regularly vilified by the media as “junk bonds.” Most distressed bonds are rated CCC to C, which is at the bottom of the speculative-grade category.  

Not surprisingly, distressed bonds as a group performed worse than the BBs, which had a return of negative 0.6% in the early-August selloff. It’s normal for the riskiest securities to get hit hardest. But with the overall market in retreat, the best-performing distressed bond walloped the best-performing BB bond, 4.3% to 1.7%. 

To be sure, the distressed segment’s worst performer did far worse, at negative 28.2%, than the lowest-return BB, at negative 4.7%. But 18.2% of distressed bonds managed to deliver positive returns in the market debacle versus just 13.8% of BBs. Many readers will find that outcome counterintuitive, or even impossible, but numbers – at least these particular numbers – don’t lie.

The lesson to draw from August’s short-lived selloff is that excellent opportunities arise from market volatility for distressed investors to find some future winners – if they can spot them among the losers. Many bonds that undergo financial deterioration severe enough to cause their yields to reach levels 10 percentage points or more above default-risk-free Treasury rates – the definition of distress that I introduced around 1990 – never recover, and go on to default. 

In those cases, investors can come out ahead only if they bought at low enough prices relative to what they’ll ultimately recover when the company’s debt is restructured, either inside or outside of bankruptcy court. But on the junk heap are bonds of some companies that turn themselves around and get out of distress. Those issues re-enter the non-distressed ranks, rewarding holders with big price gains on top of the super-high yields delivered along the way. 

Our job as analysts of distressed debt is to separate the wheat from the chaff. (Not, however, in the manner of journalists, who, according to 1950s U.S. presidential candidate Adlai Stevenson, separate the wheat from the chaff and then publish the chaff.) 

The basis for believing that a troubled bond issuer can reverse its fortunes is often highly idiosyncratic. It is not simply a matter of the distressed bonds with the highest credit ratings having the best chance of returning to sound financial health. In the early-August slump, the number-three distressed performer had a CC credit rating while an issue rated B- came in number 111 out of 117.

Early August’s number-one performing issue by total return illustrates how highly company-specific factors can drive a distressed bond’s superlative performance. The Lions Gate Capital Holdings 5.5% bond due April 15, 2029, rose each day from July 31 to August 5 on the heels of a rally in the company’s stock. Lions Gate Entertainment Class A shares jumped on July 31 following a July 30 report that former Treasury Secretary Steve Mnuchin’s Liberty Capital had increased its holdings between July 26 and July 30. 

Mnuchin hasn’t made his intentions clear regarding Lions Gate, but the market has responded favorably to its corporate restructuring. Lions Gate management recently carved out a pure-play film/TV production entity and plans to collapse the A-and-B-share structure into a single share class. On August 1, Morgan Stanley upgraded the stock to Overweight, meaning it believes Lions Gate will outperform the overall market.  

The Lions Gate 5.5% bond is not one of our recommendations (our recommendations performed comparatively well during the early-August downturn, by the way). But the issue’s recent history provides this key takeaway: Distressed bonds have less tendency to move in lockstep than most other types of securities do. Even when financial markets as a whole are flat, individual distressed issues can break out of the pack and deliver excellent returns. Finding those opportunities requires a deep dive into issuers’ operations and the details of their capital structures to identify superior risk-reward trade-offs.