Distressed Debt Is Dormant. Does It Matter?
There’s little end in sight to the rally in U.S. leveraged credit markets that is approaching its one-year anniversary. The pace of spec-grade debt issuance to date is on track to top last year’s huge totals, with U.S. high-yield bond issuance already topping $100 billion by early March while leveraged loan issuance in January and February posted its largest monthly totals since early 2020 before COVID-19 was declared a pandemic.
Spec-grade bond yields are near their lowest levels on record even with the recent uptick in longer dated U.S. Treasury notes. It is an unprecedented tidal wave of capital in search of a return.
Debates about excessive market valuations are common these days and are mostly centered around market values of equities relative to operating earnings expectations over the next several years and the appropriate discount rate (or multiple) to apply to these cash flows. What makes this a lively debate currently is the wide range of post-COVID recovery scenarios and earnings forecasts across companies and industries as the economy prepares to move into a post-pandemic environment.
Some commentators and investors are wildly bullish on the growth prospects for our reopened economy. Others don’t share that unbridled enthusiasm and question whether operating results can recover quickly enough and grow at rates that justify very high valuation multiples by any historical measure.
However, in the world of credit, debates over valuation are framed differently: Does the return on a bond or loan over a holding period adequately compensate the holder for the issue’s default risk and likely recovery value in the event of default? An overvalued bond would undercompensate the holder in terms of the yield (YTM) it provides relative to the issuer’s risk profile and likelihood of default.