Editor's note: The bond market is facing tough times ahead – that is, tough for certain companies. Rob Spivey of our corporate affiliate Altimetry says this shift will catch many investors off-guard... But it has a flip side, too. In this piece, recently published in the free Altimetry Daily Authority e-letter, Rob covers why a potential crisis signal could give us a surprising opportunity to buy beaten-down gems in the credit markets...

The credit market is having a rough year...

In the first two months of 2023, U.S. corporate bankruptcies reached a 12-year high. And while they've calmed down somewhat since then, S&P Global Market Intelligence reports that 459 companies filed for bankruptcy through August 31.

That's more than we saw in each of the past two years. Rising interest rates, a closed borrowing market, and weakening economic data are driving the surge.

Investors aren't just worried about soaring bankruptcies, though. They're also on edge due to the circumstances of those bankruptcies...

You see, unlike stockholders, bond investors can typically recoup some of their investment if the company goes bankrupt. This is called the "recovery rate"... And today, that rate is dropping.

Said another way, creditors are recovering less money on average when companies go bankrupt. We expect it will only get worse over the next several months... So it's no wonder the credit market is getting jumpy.

Today, we'll cover exactly what's going on in the credit market... and why the wave of panic could be a blessing in disguise.

For bond investors, two questions matter more than anything else...

These folks don't book gains from price movement the way stock investors do. Once they decide to buy, their return is locked in. They know exactly how much money they'll get at maturity – when the issuing company pays off the bond.

So before purchasing any bond, smart bondholders will ask themselves...

1. Can this company stay afloat long enough to pay me when my bond matures?
2. If this company does go bankrupt, how much of my investment will I get back?

Stock investors aren't focused on these issues. If a company goes bankrupt, shares will simply fall to zero. These folks won't recover anything on their investment.

By contrast, creditors care a lot about how much money they'll recover in a worst-case scenario. If a company's assets are worth more than the value of its bonds, it can sell those assets to pay back bondholders – in full – in the event of a bankruptcy.

Over the long run, the recovery rate across all types of loans has been around 40%. In good times, it can be much higher.

Creditors who offer riskier loans tend to require higher recovery rates. For instance, levered loans are loans made to borrowers who already have a lot of debt or poor credit ratings.

These types of loans had recovery rates above 50% for most of the 2010s. Often, they surpassed 60%.

But those higher recovery rates seem to be changing quickly...

Take cancer-treatment company GenesisCare. It was backed by private-equity giant KKR.

GenesisCare had a CCC- credit rating from S&P... meaning it was considered extremely speculative and on the verge of default.

The company filed for bankruptcy in June. And unfortunately, despite being financed with levered loans, it looks like investors will only get roughly 15% of their money back.

That's a pretty bad recovery for a debt investor. It's way lower than the 50% average of the past decade-plus. And it might be a sign of what's to come for more businesses...

According to Bank of America, the expected recovery rate from levered loans is only 20% today. Take a look...

This year's recovery rate is by far the lowest we've seen in the past decade. It dramatically changes the calculus for potential bond investors. Their investments aren't nearly as safe as they once were.

As panicked credit investors head for the exits, they'll punish all bonds...

And that includes the bonds that don't deserve it.

Keep in mind that not every bond carries the same amount of risk. Some bond recovery rates are falling... but not all. There are still safe places to put your money in the bond market.

Investors don't tend to differentiate during times of uncertainty. This time will be no different.

We expect that as more companies go bankrupt, many perfectly safe bonds will start trading at discounts.

Patient investors will be rewarded with better opportunities.

Regards,

Rob Spivey

Editor's note: Altimetry founder Joel Litman says a crisis is coming to one part of the market that could affect up to $50 trillion on Wall Street... with disastrous consequences for hundreds of stocks. (You might even own some of those companies right now.) This shift is only one of the warning signs flashing red today – which is why it's time to take an important step with your money...

It's the exact same strategy Joel used to make incredible returns for his institutional clients when the market crashed in 2008. And it has nothing to do with stocks, real estate, or any of the usual suspects. Make sure you get the details right here.