LMEs became popular because issuers could exploit out-of-court processes to their advantage, often by playing creditors against each other. As creditors have become more collaborative, this advantage has diminished, making LMEs less beneficial for issuers and likely capping their future frequency. Vanguard treats all LMEs as defaults.
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The primary threat to the high-yield market isn't a wave of corporate defaults, but rather a reversion of the compressed risk premium that investors demand. This premium has been historically low, and a return to normal levels presents a significant valuation risk, even if fundamentals remain stable.
Default rates are not uniform. High-yield bonds are low due to a 2020 "cleansing." Leveraged loans show elevated defaults due to higher rates. Private credit defaults are masked but may be as high as 6%, indicated by "bad PIK" amendments, suggesting hidden stress.
The classic distressed debt strategy is broken. Market dislocation windows are now incredibly narrow, often lasting just days. Furthermore, low interest rates for the past decade eliminated the ability to earn meaningful carry on discounted debt. This has forced distressed funds to rebrand as 'capital solutions' and focus on private, structured deals.
In a distressed scenario, simply asserting seniority as a junior capital provider is ineffective. You cannot force the majority owner and management team, whom you've just told are worthless, to run the business for your benefit. The only viable path is to renegotiate and realign incentives for all parties to work towards a recovery together.
Aggressive Liability Management Exercises (LMEs), common in the US, are rarer in Europe. This isn't due to a gentler culture but stricter laws where board directors can face criminal charges for insolvency. This incentivizes collaborative restructuring over contentious, US-style creditor battles.
While default risk exists, the more pressing problem for credit investors is a severe supply-demand imbalance. A shortage of new M&A and corporate issuance, combined with massive sideline capital (e.g., $8T in money markets), keeps spreads historically tight and makes finding attractive opportunities the main challenge.
The two credit markets are converging, creating a symbiotic relationship beneficial to both borrowers and investors. Instead of competing, they serve different needs, and savvy investors should combine them opportunistically rather than pitting them against each other.
In a market where spreads are tight and technicals prevent sustained sell-offs, making large directional bets is a poor strategy. The best approach is to stay close to benchmarks in terms of overall risk and allocate the risk budget to identifying specific winners and losers through deep, fundamental credit analysis.
When a company enters Chapter 11 bankruptcy, common stockholders are the last to be compensated, meaning their shares will likely become worthless. Investors should view this filing not as a potential turnaround but as a clear and final indicator to sell their position immediately to avoid a total loss.
A credit investor's true edge lies not in understanding a company's operations, but in mastering the right-hand side of the balance sheet. This includes legal structures, credit agreements, and bankruptcy processes. Private equity investors, who are owners, will always have superior knowledge of the business itself (the left-hand side).