Oct. 23 (Bloomberg) -- The biggest leveraged buyouts from the takeover boom this decade are making a comeback in the debt market seven months after investors concluded they were almost certain to default, thanks to concessions from lenders.

KKR & Co. and TPG Inc. asked investors this month to swap $6 billion of debt for $4 billion in new secured notes in Energy Future Holdings Corp., taken private in 2007 in the biggest buyout. Casino operator Harrah’s Entertainment Inc., acquired in a $30.7 billion takeover in January 2008 by Apollo Management LP and TPG, cut its long-term debt by more than 16 percent to $19.3 billion during the six months ended June 30 by offering new notes with later maturities and less principal.

As recently as March, credit-default swaps showed Energy Future, Harrah’s and four of the other biggest buyouts since 2005 were poised to collapse, trading as if there were a 95 percent chance of default, as the high-yield, high-risk debt markets struggled with $1.74 trillion in new borrowings. Now, the average price of contracts to insure against failures has dropped by more than half as the economy recovers from the worst recession in 70 years.

“Private-equity holders feel there is a lot more upside to play for,” said William Cunningham, global head of credit strategies and fixed-income research at the investment unit of Boston-based State Street Corp., the world’s largest money manager for institutions. “It appears as if the private-equity holders and some of the management teams are more emboldened to try and get more out of the bondholders now. That is going to create greater tension going forward.”

Trimming Debt

Speculative-grade companies that faced $527 billion in loan maturities by the end of 2014 had trimmed that sum to $455 billion as of Aug. 7, according to Standard & Poor’s Leveraged Commentary and Data. Junk debt is rated below BBB- at S&P and less than Baa3 at Moody’s Investors Service.

Junk bonds returned 51 percent this year, even as companies sold the most high-yield debt since 2007 after the Federal Reserve and U.S. government spent, lent or committed $11.6 trillion to spur the economy and thaw frozen credit markets. The extra yield investors demand to own the securities rather than Treasuries plunged to 7.52 percentage points from a record 21.8 percentage points on Dec. 15, Merrill Lynch & Co. index data show. So-called spreads are the narrowest since July 2008.

Some $295 billion of cash has flowed into bond funds in 2009 as investors sought higher-yielding assets, Bank of America Corp. analysts wrote in a report last month, citing Lipper/AMG Data Services.

Trading at Discount

With demand rising, private-equity firms are asking creditors to extend maturities and refinance debt at discounted prices. Junk bonds are trading 8 percent below face value on average, according to Merrill Lynch indexes. In February 2007, they traded 1.7 percent above par.

“We’re seeing companies taking advantage of a good liquidity opening in the market and addressing” maturities in 2014 today, said David Stith, head of leveraged finance at Cantor Fitzgerald in New York. “No one is smart enough to know what those markets may look like when you get closer in.”

Companies are paring debt after raising more than $1.45 trillion of leveraged loans in the two years before August 2007, when credit dried up as the subprime mortgage market collapsed. About $294 billion of junk bonds were issued in the period.

LBO Surge

The high-yield market allowed private-equity firms to fund two-thirds or more of a buyout’s cost with debt. They were able to persuade creditors to limit standard investor protections, or covenants, such as restrictions on the amount of debt relative to cashflow. Companies including Realogy Corp., the Parsippany, New Jersey-based real-estate broker acquired by Apollo for $6.6 billion in April 2007, sold so-called pay-in-kind toggle notes that give borrowers the right to pay interest in debt or cash.

“We were seeing one of the most aggressive leveraging cycles we’ve ever seen, and it was short-circuited,” State Street’s Cunningham said.

Kristi Huller, a spokeswoman for KKR in New York, Kristin Celauro, a spokeswoman for TPG of Fort Worth, Texas, and Steve Anreder, a spokesman for Apollo, declined to comment.

Moody’s predicts the global default rate will rise to 12.6 percent at yearend, up from 1.4 percent in June 2007. The firm, which in February forecast the rate would peak at more than 16 percent next month, has ratcheted back its outlook as companies find investors willing to buy or restructure their debt. Moody’s said last month the rate may drop to 4.3 percent by August 2010.

Default Risk Falls

The average cost of credit-default swaps on the debt of six of the largest LBOs since 2005 has dropped 45 percentage points to 31 percent upfront since February, according to CMA DataVision in London.

That means it would cost an average of $3.1 million initially and $500,000 annually to protect $10 million of the debt from default, down from an average of $7.5 million almost eight months ago. The six companies are Harrah’s, Energy Future’s Texas Competitive Electric Holdings Co. unit, Realogy, San Antonio-based Clear Channel Communications Inc., Austin, Texas-based Freescale Semiconductor Inc. and Univision Communications Inc. in New York.

Credit-default swaps pay the buyer face value in exchange for the underlying debt or the cash equivalent if a company fails to meet its debt obligations.

Energy Future

Energy Future, the Texas electricity provider formerly known as TXU Corp., was bought by KKR and TPG for $43 billion in October 2007. The cost of financing the buyout increased so- called leverage at Energy Future to about 8 times earnings before interest, taxes, depreciation and amortization costs at the time of the deal. The company’s senior unsecured debt is rated Caa3 by Moody’s, the third-lowest level.

The Dallas-based firm said Oct. 5 it was seeking to cut debt by $2 billion by swapping as much as $6 billion of bonds due from 2014 to 2034 for $4 billion of 9.75 percent senior secured notes maturing in 2019. If bondholders reject the offer their securities may be subordinated by new debt, meaning they would have a lower claim on assets in a bankruptcy, according to fixed-income research firm CreditSights Inc.

“Many of the savvy private-equity shops have aggressively taken advantage of the credit crisis and the massive decline in bond values to force some recapitalization and force the debt holders to share pain,” said Fred Joseph, the former chief executive officer of Drexel Burnham Lambert Inc. who’s now managing director and co-founder of New York investment bank Morgan Joseph & Co.

Energy Future has $44.5 billion of loans and bonds, including $22.5 billion coming due in 2014.

‘Sacrifice’ Principal

KKR may think “if it can get rid of enough debt and hang on long enough, it could come out a winner,” CreditSights analysts led by Dot Matthews said in an Oct. 6 note to clients. “We seriously doubt that KKR will come out a big winner, but we do note that bondholders are being asked to sacrifice a good deal of their principal and being offered absolutely no upside other than the faint hope the bonds might pay off on maturity.”

Bondholders have formed a group to block the offer, two people familiar with the matter said Oct. 8.

The proposed debt exchange “will give bondholders some security,” Energy Future spokeswoman Lisa Singleton said Oct. 7. She cited an Oct. 5 report from Fitch Ratings saying the offer isn’t coercive because there’s little probability that the company would file for bankruptcy if the swap fails. Singleton didn’t respond to a request for comment.

Day of Reckoning

Companies may be postponing their day of reckoning by a few years, said Oleg Melentyev, an analyst at Bank of America in New York. While amending loan terms and extending due dates has trimmed about $9.26 billion off maturities through 2013, they added $4.58 billion to the amount due in 2014, LCD data show.

Borrowers need to refinance about $100 billion of leveraged loans and $115 billion of high-yield bonds by the end of 2012, according to data from LCD and Moody’s. The amount of loans maturing jumps to $140 billion in 2013 and $215 billion in 2014.

Even with the biggest drop in credit swaps prices, the contracts are still higher than they were before credit markets froze in August 2007. Harrah’s contracts last month reached the lowest since April 2008. Contracts on Realogy touched an almost two-year low in September, CMA prices show.

“At least they kick the can a little bit down the road; but the problematic part is they kick it down by an average of two years and that just puts them to where we already have a lot of maturities,” said Melentyev, who is warning clients of another jump in defaults as the deferred debt comes due. “It just adds to the problem in those years.”

Harrah’s

Harrah’s, with casino revenue falling, reduced its long- term debt to $19.3 billion as of June 30 from $23.1 billion at the end of 2008, according to regulatory filings. The casino company exchanged about $5.5 billion of existing debt in April for $3.4 billion in new notes and $102 million in cash.

Holders of $45.6 million of Harrah’s notes due in 2010 and 2011 accepted an offer to tender them for between 95.5 percent and 98 percent of face value, the company said yesterday in a statement. Harrah’s had said it would buy as much as $160 million of the notes.

“Their actions improved overall liquidity and helped creditors but in terms of the exchanges they’re asking the bondholders to make the sacrifice rather than the equity holders,” said Chris Snow, an analyst at CreditSights.

Harrah’s, which has “deftly managed this process,” may end the year with about $1.5 billion in liquidity, sufficient to fund all its notes maturing before 2013, Snow said. Harrah’s spokeswoman Jacqueline Peterson didn’t respond to requests for comment.

Debt Rallies

The company’s 10.75 percent notes due in February 2016 have soared 70 cents on the dollar since Feb. 23 to 83 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Realogy, the owner of Century 21 and Coldwell Banker, is seeking to cut debt costs to avoid breaking terms of its loans. It has raised $650 million of second-lien term loans in the last two months to reduce borrowings under its $750 million revolving credit facility due in 2013 and replace existing bonds.

Realogy’s 11 percent toggle notes due April 2014 have jumped 56 cents on the dollar since Feb. 26 to 68 cents, Trace data show.

Mark Panus, a Realogy spokesman, declined to comment.

“Not too long ago, Chapter 11 looked to be almost inevitable for Realogy as the likelihood of getting a capital markets transaction completed seemed remote,” Citigroup Inc. analysts led by John Fenn wrote in an Oct. 2 note to clients. “Yet, as with many other companies, dramatic improvements in the capital markets returned and Realogy has been aggressively trying to enact a solution to its overly levered balance sheet.”

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Richard Bravo in New York at rbravo5@bloomberg.net

Last Updated: October 23, 2009 09:16 EDT