With interest rates so low for so long and even the riskiest companies able to find willing lenders, opportunities for distressed debt investors have been scarce for some time. But now, as inflation sets in and the Fed begins to aggressively raise rates to control it, all of that is changing.
Data compiled by Bloomberg showed that as of September 9, corporate bonds and loans traded at distressed levels had reached $189 billion, a 6.4% increase from the previous week and that 59 US companies have filed for bankruptcy so far this year. Three of them, each involving more than $50 million in debt, also happened in the first week of September. The largest of these was Cineworld Group, Plc., the world’s second largest cinema chain with over 500 theaters in the United States under the Regal Cinemas name. This company, which has approximately $4.8 billion in debt excluding leases, will not benefit from the meme stock rally that previously saved AMC Entertainment.
What happens to the Regal Cinemas chain as Cineworld goes through bankruptcy will be a movie worth watching, but a more interesting story for the nuanced follower of struggling debt is Revlon.
In 2020, Revlon attempted to refinance and replace some of its old debt with new issues. This created a new problem for the company, impacting its bankruptcy proceedings. Citigroup
Citigroup demanded repayment, but a fund group that held about $500 million in debt refused. They claimed that the refinancing Citigroup was working on with Revlon was unfair. Earlier this year, a judge agreed with them, ruling the law allowed them to keep the money because, in part, they had no reason at the time to believe the payment was wrong. Citigroup filed a precautionary subrogation petition in bankruptcy court stating that the bank owed at least $500 million and that if it was not repaid, it was entitled to become a plaintiff for that amount. In its filing, the company told the court that this litigation hampered its efforts to raise capital because it was unable to identify its creditors.
Some clarity came to the situation earlier this month when the United States Court of Appeals for the Second Circuit in New York overturned the earlier ruling and said Citigroup could get the money back. How much of this half billion in misdirected funds is actually returned remains unknown. Among the paid off creditors are Cayman-based hedge funds, and some of them may have been liquidated along the way. But however it plays out for Citigroup, the new ruling clarifies Revlon’s bankruptcy and will allow it to know who its creditors are before proposing a bankruptcy plan which is expected in court in mid-November.
The Cineworld and Revlon bankruptcies are two of the highest profile events in the world of distressed investing, but recent macro events seem to indicate there will be much more to come.
First, Jerome Powell’s speech in Jackson Hole indicated the Fed’s willingness to continue raising interest rates to moderate inflation. He said: “We will continue until we are satisfied the job is done.” And while Powell didn’t mention it in his remarks, in all likelihood the Fed will also continue to try to reduce the size of its balance sheet as well.
Then there’s what happened with junk bonds. Last year, a report by JP Morgan showed that junk rated paper was trading with yields in many cases below 5% to maturity. Concretely, this indicated that the prices of fixed income securities had exploded, and even the riskiest borrowers could borrow at rates below 5% and, in some cases, even below 2%!
That was then. Now we are starting to see a big reset. Each bond fell in price with corresponding increases in yield to maturity. It is now much more common to see prices in the 7-9% range for junk-rated bonds. Those in trouble or distress are trading at much higher yields, with some reaching 30% or more. With what the Fed has said, this trend still has room, because a normal level for risk paper is rightly in the double digits, not the high digits.
Based on these indicators, it is reasonable to assume that we will see much more distress in the months ahead. It might not be big names like Revlon or Regal, but there will be other companies that have racked up debt over the past decade and are now forced to reckon with the new environment. We see it everywhere in fixed income. Since the start of the year, the major bond indices have fallen sharply. Even Treasury indices are down 20% – the most on record in a year – and most fixed income securities are priced relative to benchmark government securities.
If the problems in the fixed income market, like the ones we have already seen this year, continue, this guarantees that you will have a lot more difficulty. Indeed, as companies reach their maturity dates, there is less and less demand for the new securities they must issue to refinance maturing debt. And for some of them, the window might be completely closed. We are seeing significant year-to-date outflows from bond mutual funds and ETFs because investors have suffered such big losses in these markets this year. As the market resets in the longer term, there will likely be more and more opportunities to selectively find attractive value investments amid the mounting carnage of distressed debt.
For individuals, it is very difficult to invest in the distressed debt of a company like Revlon or Cineworld. Even so, companies like these can be exceptional long-term investments if you can buy at the right price through a professional asset manager. Separately, Revlon has listed shares on the stock exchange, which means investors might be able to play by shorting its shares.
In fact, short selling has become an increasingly attractive opportunity these days. There are many companies whose business plans are completely upside down due to inflation, supply chain bottlenecks, Covid issues and uncertain commodity prices. And companies affected by these conditions that are also overleveraged are much more likely to file for bankruptcy, especially if we have a recession. For investors who don’t have the ability or inclination to do this themselves, now may be the time to choose an experienced investment manager to help them navigate these choppy waters.
Revlon could also offer benefits to patient long-term investors, because it’s good business. It has big brands and strong cash flow and revenue, even though it has a temporarily overleveraged capital structure.
There will likely be many more businesses in distress in the months to come. Nonetheless, investors should be cautious not only of distressed companies, but also of their regular equity investments, unless they can find some with short cash yields. term. These are cheap companies to start with, but also have very short-term plans to return money to shareholders through large dividends and/or share buybacks.
As we’ve said before, even in the darkest markets there are usually opportunities for investors willing to do their homework to find them. Right now, a good place to look is in energy space. Some companies that produce oil or natural gas are currently freeing up so much cash that they can reward their shareholders with a quick return of capital.
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