Distressed Debt: What Happens When The Tree Stops Growing?

Distressed debt markets have four themes emerging, according to a recent paper issued by the Wells Fargo Investment Institute. They are: the consequences of central bank tightenings around the globe; the elevation of debt levels, also something happening globally; the regulatory pressure over non-conforming loans (especially in Europe); and the rise in geopolitical tensions.

Together, these themes add up to an opportunity for investors to pick up on the distressed debt that is being and will be created. These opportunities exist both for liquid hedge funds and for illiquid private debt funds.

“Trees don’t grow to the sky,” as the late Louis Rukeyser used to say, and an upward movement that is now close to 10 years old surely won’t go on forever. When this one turns because of the particular combination of those four themes, there will be “meaningful price dislocations,” which will be ripe for exploitation by those with extensive experience underwriting and the necessary scale to successfully capitalize.

The Institute comments on these four trends in the above order. As to the central banks, it observes that though the two big ones, the Federal Reserve and the European Central Bank, get—and warrant—a lot of attention—the central banks of three important emerging economies have recently tightened policy to defend their currencies. In each case (India, Indonesia, and Turkey) the currency had fallen to historic lows, so it is understandable that the central banks have acted as they have, but in so doing they “may have put the brakes on near-term economic growth prospects.”

Debt: GDPs and NPLs

As to elevated debt: Wells Fargo tells us that there has not been much by way of “fiscal restraint” since the global financial crisis. In its absence, debt levels have gotten to or at record highs in many economies.

In the United States, atypically, total debt as a percentage of GDP has been flat lately. Stated as a percentage of GDP it was below 300% at the start of this millennium. It got up to roughly 370% in the build-up to the GFC and then fell back to 350% by 2011. Since then it has been quite flat with a slight downward slope and is now at 344%.

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