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Benefits and Pensions MonitorAnnual Report & Directory Of Fixed Income Managers Canadian High Yield Hedge Investing Distressed Debt And Contingent Claims Analysis Distressed debt is also a separate asset class. A brief introduction is helpful for illuminating the relative position of debt and equity investorsʼ contingent claims on a companyʼs assets in bankruptcy. As mentioned, the current trailing 12-month default rate is 1.6 per cent. Dependent on a managerʼs credit selection skill, a widely diversified high yield portfolio will experience defaults. A manager may hold defaulted debt in the portfolio through the restructuring process, or sell to distressed debt investors. Distressed debt investors specifically invest in defaulted debt. They also invest in debt trading at very wide spreads and low dollar prices that indicate a high market expectation of default. Distressed debt investors sometimes buy the equity of defaulting companies. Distressed debt investors generate returns in the recapitalization process, when the defaulted debt is exchanged for new debt or new equity in the recapitalized company. It is a highly legalistic process and distressed investors often take control of the company.
When a debt issue defaults, it does not trade down to zero. In an efficient market, defaulted debt will trade down to the expected recovery value. The historical average recovery rate of defaulted debt for the period 1982 to 2006 is 36 per cent, according to Moodyʼs. The ratings agency defines the recovery rate as the trading price of the bond 30 days after the default event. An average 3.5 per cent default rate and a 38 per cent recovery rate computes to an average 2.6 per cent loss from defaults over the past 25 years. The equity securities of defaulting issuers usually do trade down to zero – though frequently not until the day the equity is delisted by its stock exchange. The trading price prior to delisting is nothing but option value. In a corporate restructuring, lendersʼ claims must be satisfied before the owners of the company receive any proceeds. The rule of absolute priority in bankruptcy states that the most senior claim must be settled in full before any assets are applied against the next most senior claim – all the way down the ladder to the common equity at the bottom. Regardless of rating or subordination, any debt securities in the capital structure rank ahead of all equity securities in terms of contingent claims on the issuerʼs assets. Occasionally lenders consent to a restructuring that leaves some residual value for equity holders.
High Yield Hedge: The Canada Advantage Structural inefficiencies in the Canadian high yield market include:
For funds able to take advantage of alternative strategies, the inefficient Canadian high yield market offers an opportunity to reduce volatility and enhance returns. Marret Asset Management Inc., for example, employs three main strategies in its alternative high yield funds: capital structure arbitrage, directional trading of credit spreads through the three phases of the credit cycle, and opportunistic trades. The broader mandate is to go long or short any part of the capital structure of a Canadian high yield issuer, a leveraged buyout target, a ratings downgrade candidate, or an Income Trust. Capital structure trade ideas are discovered through fundamental bottom-up research. The strategy also employs sector and macro overlays. For example, during the latter stages of an upswing in capital expenditures in a sector, when borrowing increases, the short positions in this sector are increased.
A high yield capital structure arbitrage trade typically combines a long position in an issuerʼs debt securities (the senior part of the capital structure) with a short position in its equity securities (the junior, more risky part of the capital structure) using a hedge ratio. Optimal hedge ratios are calculated by regressing the historical trading prices of the debt and equity over multiple time periods. The price volatility of a typical issuerʼs equity is four times the price volatility of its debt securities. Therefore, the typical hedge ratio is 25 per cent – for every $1,000 of debt held, the short position is $250 of the common equity. In the case of over-valued equity, a capital structure trade is characterized as long the inexpensive part of the companyʼs capital structure and short the expensive part. There is only one set of cash flows and one group of assets supporting the capital structure or total enterprise value of any company. Using an enterprise value (EV) to earnings before interest, taxes and depreciation and amortization (EBITDA) valuation, where enterprise value is the total book or par value of a company ʼs debt added to the market capitalization indicated by the current trading price of the issuerʼs common stock, there may be too many ʻturnsʼ through the equity. For example, a four times leveraged company, as measured by debt-to-EBITDA, may have an EV-to-EBITDA multiple of 16 times, ascribing a value of 12 times EBITDA to the equity. As well as cheap/rich trades, capital structure trades are also yield harvesting trades. The coupon on the debt security creates a positive carry and the short stock position hedges potential deterioration in the issuerʼs credit quality. The coupon and the hedge ratio also provide protection if the equity valuation gets richer. For example, assuming a typical hedge ratio of 25 per cent and an eight per cent yield on the debt leg, the equity price can increase 32 per cent and the trade is still a break-even proposition. Other high yield hedge trades include:
A basket of these trades and capital structure trades that are dynamically hedged (actively adjusting the hedge ratio for price movements in the debt and equity securities in each trade) has a very attractive risk-reward profile which should appeal to Canadian pension funds seeking fixed income substitutes with higher returns and lower volatility than traditional fixed income products. ■
Laurence Cashin is a vice-president and a credit analyst and Barry Allan is president and chief investment officer at Marret Asset Management which sub-advises on Core Plus mandates for Greystone Managed Investments.
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