2025 US Distressed Outlook: Market Strength to Boost Defaults, Opportunity Set?

This story was originally published on PitchBook.

Distressed investors are excited about 2025, despite the current strength of US markets. In the past, when US equity indices were at all-time highs and high-yield option-adjusted spreads were close to all-time tights, distressed players had little to do. But it may be different this time.

“This is one of the richest distressed opportunity sets in a long time,” says Randy Raisman, portfolio manager at Marathon Asset Management. He believes the robust distressed environment has been catalyzed by short-term interest rates that are higher than the rock-bottom levels seen in 2020 and 2021, when the Federal Reserve’s target rate was skimming along between nothing and 0.25%.

“This may be the first time that strength in the US economy is causing higher defaults,” says Canyon Partners investment partner Chaney Sheffield. He adds that US economic health and “animal spirits” generated at least partly by the positive investment mood surrounding the inbound Trump administration are keeping interest rates elevated. He anticipates that a cautious Fed will slow its reduction of the fed funds rate, pushing more highly leveraged companies into balance sheet restructurings, and thus there will be no shortage of opportunities for distressed investors in the year ahead.

Raisman points out that interest rates are now around 400 basis points higher, and valuations lower, than when pandemic-era loans and bonds were issued. With some $500 billion in high-yield bond maturities through 2028, the current environment is one “we’re pretty excited about.”

Context

US debt and equities have been hitting new highs all year. The S&P is up roughly 28% year-to-date, the Morningstar LSTA US Leveraged Loan Index has gained 8.6%, and the Morningstar US High-Yield Bond Index has risen 9.2% so far in 2024 (all through Dec. 9).

What’s more, Hedge Fund Research’s HFRI Distressed/Restructuring Index has been more than keeping up, gaining 11.52% through Nov. 30. That return comes as the distressed subset of the US High-Yield Bond Index has contracted to levels not seen in at least two years.

But while equities are hitting all-time highs, price/earnings multiples have been rising to near-record levels, meaning earnings are not keeping up with securities prices. Whether that is because investors are driving prices higher in fear of missing out or because crystal balls say earnings will catch up is less important than the short-term effect of rising stocks’ value creation.

Value creation has been a self-sustaining cycle because of the “wealth effect,” according to Peter Cecchini, research director of asset manager Axonic Capital. The positive wealth effect of higher equity prices is leading to more consumer spending, which is increasing company earnings and convincing investors and analysts that the US economy is robust.

But Cecchini notes that the US employment picture has been weakening, while the low-to-middle-end consumer has been struggling for months. He warns that the same wealth effect that has spurred the economy can work in reverse. “As soon as stocks stop performing, that can become a self-perpetuating process impairing both equities and the economy,” he says.

Houlihan Lokey managing director Jay Weinberger takes things further. He says that macro events could create a “meaningful step down” in equity markets and the economy, citing the potential imposition of tariffs by the new Trump administration and ensuing trade wars, the ongoing Middle East conflict, and oil and gas prices as potential catalysts.

Table Setting

But an economic slowdown is not currently on analyst radar screens. A US recession, which had been a mainstay of economic expectations for at least the past six years, seems to be completely off the table for now.

Morgan Stanley predicts the US high-yield market will end 2025 at an option-adjusted spread of 300 bps. Barclays is a bit more bullish, envisioning healthy spreads of 275-300 bps at year-end 2025.

On the opposite side of the spread coin, default rates also reflect economic health. Barclays sees high-yield defaults running at 2%-3% (by issuer count, including distressed exchanges) in 2025, well under the 3.6% average of the past 30 years. Morgan Stanley’s expected bond default rate for 2025 matches Barclays’ at 2.5%.

Leveraged loans tell nearly the same story. Barclays projects a 3%-4% default rate in 2025 (also including distressed exchanges), while Morgan Stanley splits the difference, foreseeing a 3.5% rate in 2025.

LCD reported the dual-track leveraged loan default rate was 4.56% as of Nov. 30, while the Morningstar US High-Yield Bond Index’s distress ratio dropped to 3.87% on Dec. 4, its lowest reading in over two years.

But Jeremy Burton, managing director and portfolio manager at PineBridge Investments, believes there has been a “big grab for risk in high yield in the last few months,” pushing spreads tighter. He says that “being in a sustained environment where demand for credit risk is materially stronger than supply is not good. You need balance [which is created by new LBOs and debt deals].” Otherwise investors “will end up making bad credit decisions that will come home to roost.”

Wallpaper

The leveraged debt markets’ maturity walls have traditionally been their canary in the coal mine, indicating to investors the degree of distress that may lie ahead. According to Beach Point portfolio manager Allan Schweitzer, that likely won’t change. “The most compelling and unique opportunities will continue to come from addressing the maturity wall of overleveraged capital structures,” he says.

Before year-end 2027, 20% of the high-yield market and 15% of the leveraged loan market will mature, meaning companies are already starting to plan for either refinancing or restructuring over $475 billion of debt that becomes current or matures over the next two years.

In 2028, the wall steepens considerably, as around $674 billion in bonds and leveraged loans will mature—41% more than the prior three years of maturities combined. That makes for a serious hurdle for leveraged debt markets.

Meanwhile, in a sign of current weakness among leveraged companies, interest coverage of issuers in the LSTA US Leveraged Loan Index at the end of 2024’s third quarter hovered around 4.0x (4.5x average but 3.8x weighted average), well under its recent peak of 6.0x (average) in 2022’s third quarter, based on issuers that file publicly.

What Matters Most

Drilling down to specifics, Sheffield believes finding opportunities in the current market is less about picking out troubled sectors and more about identifying weak balance sheets. “Capital structure matters,” he says, adding that “it isn’t sector-specific, but rather it’s about levered structures that can’t outrun interest rates.” He continues: “Right now, it is a tale of two markets. If you are properly capitalized, you are seeing spreads near all-time tights and your prognosis is good.” But he says overleveraged companies and those with fundamental issues (even if they are in healthy sectors) will ultimately need to restructure.

Still, narrowing his focus, Sheffield says he has his eye on healthcare, where political appointments are “leading to tremendous uncertainty” in the sector. On the other hand, he notes that declining oil prices could help troubled consumer cyclical companies, as customers will have more discretionary money to spend.

Raisman concurs, noting that “we are not seeing a traditional distress cycle where one particular industry falls out of favor.” Rather, he says, distress this time is diversified, as private equity levered companies across a wide swath of industries.

Who Moved the Fulcrum

Beyond deciding what sectors and issuers are ripe for investing, Schweitzer points out a change many distressed investors have noticed lately: a shift in the process of investing in distressed companies. In the past, distressed investors identified the “fulcrum” debt instrument in a capital structure—that is, the loan or bond class most likely to be converted into equity ownership after a debt restructuring. Investors sought to buy enough of the fulcrum to control it, then used that position to dominate the restructuring process as a key step to gaining control of the company.

Schweitzer says that uptiering, drop-downs, and other liability management exercises can now move the fulcrum, potentially morphing what had been a control position into a subordinated one. He explains that LMEs are not only changing the inter-creditor dynamics of troubled issuers, but also often “raise leverage and drain capital that could be used to grow.” He characterizes some LMEs as value-destroying, leaving companies in worse shape as trouble drags on.

Weinberger also identifies LMEs’ outsized presence in the distressed market, saying there is “a lot of capital out there keeping companies afloat and available for LMEs,” which can simplistically be considered a modification of amend-and-extend transactions. He says he sees greater sophistication among the private equity community as well. If these equity owners of troubled credits can use “loose documentation and agreeable markets to extend their runways, they’ll do it all day long.”

Sector Focus

Nonetheless, investors picked out weak sectors that have their attention. Raisman sees software companies as a generator of distressed investments this year and next, as many were acquired in 2020 and 2021 for mid-teens EBITDA multiples with floating-rate debt, and they are now burning cash “and in need of a solution.” He is also looking at healthcare, consumer, travel, and real estate for distressed investing opportunities.

Schweitzer also sees software as a source of distressed investments, adding that building products were a hotspot for capital four years ago, on the expectation of robust housing construction, “but it hasn’t worked out that way.” He identifies staffing companies and doctor roll-ups as potential trouble spots in healthcare. Finally, he notes some small signs of economic slowdown in retail, small-market gaming, packaging, and chemicals.

Burton says troubled large-cap companies provided solid distressed returns in 2024 as “real money investors came back into the big, troubled names they’d been out of for a while.” He notes that the debt of subsectors such as television broadcasters has been lingering and not appreciated. Speaking generally, he hypothesizes that a resolution to the Ukraine conflict and Russia’s “return to the global economy” could benefit both basic industries in Europe and US companies negatively impacted by the war.

Weinberger also thinks broadcasters may present distressed opportunities in 2025, noting that they were buoyed this year by election-related advertising spending. While some are attempting to diversify, their legacy businesses are declining. He adds that more generally, he is seeing restructuring candidates from “across the board,” with particular opportunities in business services, cable, software, and tech generally. He says minimum wage increases in California and elsewhere are also negatively impacting companies in sectors like restaurants and retail.

Zoltan Donovan, managing director and head of restructuring and special situations at First Eagle Alternative Credit, also believes technology and software will offer distressed investing opportunities next year. Business services, gaming, and aerospace/defense/government contracting companies are on his list as well.

Location, Location, Location

Many distressed investors have their eye on commercial real estate. Zach Liebmann, managing director at Waterfall Asset Management, sees the office market as an especially cheap sector, but he says the return potential could be challenging. While class-A buildings are filling up, “it is very hard to have a view on class-B and class-C buildings.” And as always with real estate, location is a key variable. Liebmann identifies New York’s Park Avenue corridor and pockets of South Florida and Los Angeles as having potential.

On the other hand, Liebmann feels industrial buildings are trading too richly for distressed investors, while malls, although more difficult to analyze, may be an opportunity, if only because of the “general bearishness” around them. In multifamily properties, he sees some overbuilding in the southern US, as it has been easier to build there recently. Meanwhile, the Northeast has been “more robust than expected,” with higher demand driving up prices and less new construction contributing to the market dynamics.

By Jack Hersch