Deep Dive: Distressed investors weigh risks and opportunities from Iran war

Rising Interest Rates and Higher Commodity Costs

The war with Iran that began on Feb. 28 has driven US bond and stock prices broadly lower, even as investors assess the conflict’s potential winners and losers. At the close on April 3, following a recent rally, major US stock indices are down around 3.5-5.0% since the war began.

Meanwhile, the yield on the 10-year US Treasury note increased by roughly 50 basis points in the month following the start of the war.

But what is bad for the market isn’t necessarily bad for distressed-debt investors. Credit market professionals indicate that the distressed asset class may see its opportunity set expand due to the fighting, as rising interest rates and higher commodity costs impinge on cash flows — and therefore raise the refinancing risk — of highly leveraged companies.

S&P Global Ratings recently stated that “prolonged” combat in the Middle East could disrupt supply chains, raise inflationary pressures, and negatively impact business and consumer confidence, therefore “adding to credit strain.”

Capital Availability

Iran’s partial shutdown of the Strait of Hormuz has caused oil prices to skyrocket (at this writing, West Texas Intermediate is up 66% since Feb. 27). That, in turn, is driving yields higher as the US debt markets react to the prospect of rising inflation.

Josh Baumgarten, president and chief investment officer of asset manager Beach Point Capital, commented: “The yield curve has a steepening bias. The challenge for [high yield] markets is that the trajectory for intermediate and long-term yields is higher, and that is raising questions of capital availability and affordability.”

Baumgarten continued: “Unless something meaningfully changes, everything points to capital being not as available as before the war, and as a result, the cost of capital may rise. The lack of access to capital often leads to distress.”

Overall, Baumgarten believes the markets currently reflect investor expectations that the war will be relatively short-lived and ultimately have only a minimal impact on portfolios. “Although high-yield has widened somewhat, markets have not repriced expecting the conflict to be a drawn-out event,” he stated.

Baumgarten believes investors foresee an eventual V-shaped asset value recovery, similar to market behavior after other periods of weakness since the Global Financial Crisis in 2008-2009. Since the GFC, investors have learned that the most profitable strategy is to do nothing during times of trouble, he said.

But Baumgarten added that, if market players “recalibrate and begin thinking this will be a longer-term conflict,” then damage — and distressed opportunities — may ensue.

Peter Cecchini, principal and head of research at asset manager Axonic Capital, also sees the potential for capital flows to diminish. He noted that higher risk-free yields coupled with trouble in the private credit market may combine to compel banks to tighten lending standards and raise costs to consumers. In sum, he sees a potential “confluence of problems” in both consumer and business lending, possibly leading to reduced capital available for borrowers.

Tuck Hardie, managing director and restructuring banker at Houlihan Lokey, concurred that the private credit market is at risk because of the Iran war. He said that, since private credit investment funds are often leveraged, if the war causes the cost of capital to rise, the cost to the private credit community will rise as well, and “that will squeeze everyone.”

PitchBook LCD in mid-March pointed out that private credit firms are lending to both legacy suppliers and emerging start-ups in the national security supply chain, with the expectation that these companies should benefit from elevated spending, given the military action in the Middle East.

Commodity Bounce

Historically, wars have generally been positive for asset values, as inflation rises and industry cranks up to meet the material needs of combat. Some sectors are already seeing these positives.

“With commodity prices bouncing, chemical companies are using supply constraints to increase prices and profitability, a situation reflected by rising equity prices for those companies,” said Houlihan Lokey’s Hardie. In particular, he noted that distressed chemical sector companies may see “their potential restructurings deferred, or even change materially,” from what investors had anticipated before the fighting began.

Looking ahead to the conflict’s end, Hardie noted that global construction companies will ultimately benefit: “They’ll print money once combat ends, as the countries caught in the war spend on capital expenditures to replace damaged and destroyed facilities.”

K-Shaped Impacts

Regarding the US economy, Beach Point’s Baumgarten said that, at least for now, participants in the upper part of the current K-shaped economy are not yet being negatively impacted. But he cautioned that if the conflict lasts longer than investors currently expect, consumers in those upper economic tiers might start pulling back on spending. That could be another cause of a liquidity-tightening downward spiral, he said.

Houlihan Lokey’s Hardie pointed out that rising gasoline prices can be thought of as an added tax burden, one that consumers at the bottom of the K-shaped economy can ill afford to pay. As a result, he expects that “consumer discretionary businesses will be hit hardest.”

Supporting Hardie’s sector views, bids on performing loans to chemical companies within the Morningstar LSTA US Leveraged Loan Index have risen 68 basis points since Feb. 27 (as of April 3), while bids on performing loans in the household durables and the consumer staples distribution/retail sectors have declined by more than 1.25 points. Bids on container and packaging company loans have fallen by more than 2.25 points during the period.

Other businesses that Hardie anticipates being hurt by the fighting are the airlines — especially those that didn’t hedge fuel costs — and mid- to high-end restaurants. However, lower-end restaurants may benefit as consumers move down the price-point curve, he said. Hardie also foresees the casino/gaming sector struggling as “five-dollar gas takes slot machine money away from consumers.”

Meanwhile, PitchBook’s Institutional Research Group said in a March 30 report that energy, infrastructure and renewables companies would benefit from higher oil prices, while “leveraged non-energy businesses face compounding margin and financing pressure.”

Because of the combat, “defense will be a winner,” Beach Point’s Baumgarten said. However, he cautioned that the composition of winners in the sector may change as $100 million jets and $2 million missiles are deployed to shoot down inexpensive drones.

In a March 6 report addressing the war’s impact on defense and aerospace companies, PitchBook analysts said they see an opportunity for private equity to benefit through investing in, among other companies, missile component manufacturers and their supply chains.

Baumgarten also has his sights on Europe, saying, “Europe is wildly more exposed to commodity prices than the US, and businesses there are dealing with both increasing asset prices and rising cost of capital.”

Axonic’s Cecchini noted additional sectors at risk because of the war. “Consumer-facing businesses, like subprime lenders, retailers and homebuilders, are suffering from the conflict’s oil shock,” he said.