Canyon Capital is recession-ready as bond markets look vulnerableMichelle Jones
The Canyon Distressed Opportunity Funds II reported gains from a post-reorganization gaming company during the second quarter. In their second-quarter letter to investors dated Sept. 30, which was reviewed by ValueWalk, the Canyon Capital team said the company was their biggest positive contributor after announcing its sale to a strategic acquirer. The deal included a bigger-than-expected cash component and plans to sell some of its properties to a post-reorganization gaming real estate investment trust. The hedge fund reduced its exposure during the increased trading volume and liquidity that followed the announcement about the transaction. The fund also de-risked the rest of its position with about two-thirds of the position turning into cash when the deal is consummated.
The biggest negative thematic contributors during the second quarter were the fund’s offshore drilling credits, which declined as oil prices tumbled 23%.
Adjusting the portfolio
The Canyon Capital team said they have adjusted their portfolio in several ways. For example, they said for the first time, they didn’t draw all of their LP capital commitments. Their draws peaked at 66%, and they returned more than 20% of their capital commitments by the end of the quarter.
They have also been emphasizing stressed and special situations over defaulted securities due to a lack of “good company / bad balance sheet” situations in the last few years. They have been favoring “special situations with relatively idiosyncratic risk drivers and performing stressed debt of companies where we believed the probable ultimate outcome was a par recovery.”
The Canyon Capital team also has favored shorter durations as many of their previous distressed investments had longer projected recovery times. Focusing on shorter durations has gotten more difficult in the past few years because many distressed companies have had unclear paths to recovery. Thus, they preferred investments with shorter recovery windows and have “played a more active role in catalyzing events that truncate duration.”
Current macro outlook: vulnerable
They expect to see distressed and special situation opportunities in the next few years because the global economy, credit markets and some industries are becoming more fragile. Specifically, they note that the International Monetary Fund has downgraded its expectations for global growth to the lowest level since the Global Financial Crisis. In fact, the agency predicts that more than 70% of the global economy will slow this year, which would be the most “synchronized slowdown” since 2011 during the U.S. rating downgrade and European sovereign crisis.
The Canyon Capital team also notes that there have been a growing number of cautionary signals in the U.S., including declines in CEO confidence and corporate earnings growth estimates. The Federal Reserve has switched from hiking rates last year to cutting rates this year, and the yield curve has inverted for the first time in 12 years.
Additionally, they said the Fed has just 200 basis points of capacity for interest rate cuts before hitting zero, unlike in the last three recessions when the central bank had more than 500 basis points of capacity. Further, government debt has already reached record levels on both an absolute basis and relative to GDP.
They also point out that political views which were once considered to be radical are now more widespread in the U.S., which creates a broader spectrum of potential outcomes on issues. They have already observed this risk in valuations in some sectors which sensitive to government policies, and they expect the 2020 election cycle to amplify this risk even more.
Credit markets are vulnerable too
The Canyon Capital team noted that the corporate credit market is also stretched, having reached record levels on both an absolute basis and relative to GDP. Recessions followed this same situation in 1983, 1991, 2001 and 2008.
The ratings quality in the credit market has also deteriorated. Even though the leveraged finance markets have increased by 1.8 times since 2007, the B+ and below tiers have grown by 2.3 times. Additionally, credit metrics and protections in general have been poor. Leverage is higher, there is less of a subordinate debt cushion, and covenants in all categories are weaker.
The supply and demand balance in the high-yield market is also fragile. They said in past distressed cycles, 23% to 45% of the BBB Index was downgraded from investment-grade to high-yield status. Thus, if the same holds true in the near future, $600 billion to $1.2 trillion of “fallen angels” will fall into that category, marking an increase of 50% to 100% in high-yield supply.
If a recession occurs, these industries could be vulnerable
In the event of a recession, the hedge fund’s management expects “disorderly security price action” across cyclical industries, especially media, airlines, chemicals, consumer discretionary, industrials and specialty financials. They also look for “dislocations” in structured products.
Even if there is no recession, they still expect to see “meaningful” opportunities in sectors which are undergoing transformations that don’t have anything to do with cyclical drivers. They believe companies in these industries will probably see “challenges on the left sides of their balance sheets that require rationalization of the right sides of their balance sheet.”
The industries they expect to see opportunities in include technology, healthcare, energy and telecom / spectrum. They explained that technology has been one of the biggest growth areas in leveraged loans due to a huge increased in private equity sponsorships. In fact, sponsor to sponsor exits are now so common that valuations depend more on healthy credit markets and low interest rates than in other sectors where demand for private equity is not as strong.
The healthcare sector is currently amid policy debates in the U.S. and has become much more levered with over $800 billion in debt. Private equity firms have moved toward certain demographics and issues like Medicare for all, opioid litigation, drug price transparency, balance billing and more.
New shale technology and horizontal drilling have affected the energy sector, changing how breakeven costs are determined and even supply and infrastructure. The telecom sector is levered as lenders have eagerly financed their subscription-based business models. Additionally, telecoms have been pressured due to changing patterns of communication and new technologies.
The Canyon Capital team expects winners and losers in all of these sectors.