There are corporate-bond documents that are written in pen, and then there are those that might as well be written on an Etch A Sketch given that they end up looking more like a suggestion than a contract as soon as borrowers run into trouble.
A growing number of debt holders are making this discovery and taking part in distressed exchanges, which are becoming more prevalent in the speculative-grade bond market. The increase points to some deep pain in the U.S. high-yield market, which will probably be borne most by the least-aggressive investors.
Here’s how the exchanges typically work: Troubled companies promise investors a better spot in line to receive recoveries in the case of a bankruptcy. In return, investors give the borrowers some relief by writing down principal or accepting a lower yield.
These transactions, at first glance, may sound like a raw deal for investors. It’s akin to putting money down to buy a shiny new car and instead getting a 5-year-old automobile that may have serious electrical problems. The buyer gets a car, but it’s a far cry from what they wanted.
Yet these transactions are becoming more popular than they were before 2008, thanks in part to weaker investor protections that are hallmarks of the post-crisis era. Distressed-exchange transactions have accounted for 44 percent of U.S. non-financial defaults this year tracked by Moody’s Investors Service, a similar proportion as in the direct aftermath of the 2008 financial crisis. That compares with about 15 percent of defaults in the almost two decades leading up to 2007.
Nine oil-and-gas companies, including Halcon Resources and SandRidge Energy, announced $5.2 billion in debt-exchange deals through the end of October, Moody’s data show. Even Puerto Rico is getting in on the game by trying to negotiate an exchange offer that creates a “superbond” to take the place of billions of dollars of debt that the commonwealth can’t repay or even maintain.
This is significant for several reasons. It shows that investors recognize a growing level of desperation among companies in the energy sector in particular and also more broadly throughout the speculative-grade market. It also means that bond investors are probably going to get back much less than they originally expected, especially if they’re not activists who bought the debt at a discount and are seeking controlling stakes in troubled companies.
So why are investors agreeing to such arrangements? For private-equity and activist owners, it’s a way to retain control of their companies. In fact, they may jump at the option to engage in one of these exchanges. For other investors, it’s often presented as a choice between the lesser of two evils. Either they’ll have to try their luck in a near-term bankruptcy restructuring, or they can make some concessions to have a higher claim on the company’s assets in the case of insolvency.
It’s a Faustian bargain for non-activist bond investors, especially if the company is facing a rather dire outlook. They’ll probably receive more money back if the borrower remains solvent for a longer period of time instead of filing for bankruptcy sooner. However, they stand to recover less if the company runs into trouble again.
Given that they are not in control of the dials on the bond-market Etch A Sketch, these investors have little recourse but to go along when the screen gets shaken, but they’re probably not having much fun. And there’s more like it on the way.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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