State of Distressed: Davis Polk’s Resnick on Emerging LME Trends

Looming 2028 debt maturities are prompting borrowers to reassess liability-management strategies, with market participants debating whether to execute routine LMEs or pursue comprehensive balance-sheet fixes. Brian Resnick, head of Davis Polk’s Liability Management & Special Opportunities practice, flagged this on the State of Distressed Debt podcast, suggesting a potential rise in restructuring and liability-management activity as deadlines approach.

Analysis

The trade-off between incremental liability-management exchanges and a one-time comprehensive balance-sheet reset will drive two distinct market regimes: a prolonged, predictable refinancing calendar versus a concentrated wave of new, restructured paper. If a meaningful subset of mid- and high-yield issuers opt for a single reset, expect near-term issuance spikes (pushing primary spreads wider for 3–6 months) but materially lower rollover pressure thereafter, compressing forward credit risk and reducing future fee pools for banks in years 2–4.

Second-order winners will be active distressed-cap managers and CLO warehouses that can buy newly issued, covenant-reset bonds at structural discounts and re-syndicate into CLOs; losers include passive HY ETF holders and index-linked products that will suffer immediate mark-to-market on large notches of re-priced paper and face index reconstitution flows. Liquidity providers (prop desks and high-yield ETFs) will be stressed during the concentrated issuance window — expect bid/ask blowouts and dispersion opportunities across single-name CDS vs bond basis for 1–3 quarters.

Tail risks hinge on macro liquidity and legal sanctity of exchange mechanics: a Fed tightening or a sudden credit event could convert negotiated exchanges into defaults (2–6 quarters), while successful one-time fixes could reduce systemic refinancing demand and lower long-term spreads (12–36 months). Monitor quarterly covenant amendments, advisory RFP announcements, and bank trading inventories as high-frequency signals; reversals will come fastest from a spike in realized defaults or a regulatory clampdown on exchange-for-debt structures.

Key Decisions for Investors

• Buy a protective HYG 6–9 month put spread (buy 5% OTM put / sell 10% OTM put) to hedge a concentrated issuance / liquidity shock; limited premium risk (~1–2% of notional) with 2–4x payoff if HY spreads spike mid-term.
• Go long GS or MS via 9–12 month call spreads (buy 1x ATM call / sell 1x+25% OTM) sized for advisory fee exposure — skew toward GS if you prefer underwriting + ECM fee capture; payoff asymmetry benefits from a >6 month liability-management wave while capping downside to premium paid.
• Increase allocation to active distressed credit via a manager or publicly traded alternative (allocate 3–6% of credit sleeve to managers with warehouse capacity or to BAM) to capture new-issue discounts post-reset; expected IRR uplift 300–700bps vs passive HY over 12–36 months but illiquidity risk remains.
• Trade single-name cross-asset basis: buy CDS protection and simultaneously buy the newly issued restructured bond in names that announce comprehensive resets (capture eventual basis normalization). Target 3–12 month hold; entry when bond trades 200–400bp wide to CDS, aim for 200–300bp realized basis compression, size small and monitor legal documentation risk.