Markets

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

Billionaire hedge-fund manager Bill Ackman isn’t alone in his dogged faith in Valeant Pharmaceuticals.

The embattled company also has a friend in collateralized loan obligations, the biggest buyers in the $800 billion U.S. syndicated loan market. Like Ackman, they're sticking it out -- perhaps with little choice -- for now.

These CLOs, which pool speculative-grade corporate loans and slice them into pieces of various risk, own about 31 percent of Valeant's $11.6 billion of loans, according to a report on Wednesday by Wells Fargo analyst David Preston. The funds made an additional net purchase of $30 million of Valeant debt in the first two months of the year, Preston said.

Freefallin'
Shares of Valeant have dropped below $30 from a high of $262 last summer
Source: Bloomberg

Shares of Valeant, the maker of toe-fungus treatments and female Viagra, have dropped below $30 from a high of $262 last summer as it faces numerous challenges with its business model of borrowing money to buy rivals and jacking up drug prices.

Then, it seemed to run into some basic forecasting trouble, with a "staggering, billion-dollar-plus cut to its 2016 revenue" this week, according to my colleague Max Nisen. It was all the more staggering because the company failed to give any hint of the huge dose of bad news in the days leading up to its statement.

Through all of that, Pershing Square founder Ackman has stood by the company and continues to do so. Joining him in recent months have been managers of the $430 billion universe of CLOs.

While the move in Valeant stock grabs the most attention, the company's debt tells the true story. Its bond prices have plunged almost 14 percent this year. It's the seventh-biggest component of the Bank of America Merrill Lynch's U.S. high-yield index, and its almost $12 billion of loans are among the biggest holdings of many CLOs. 

Deep Dive
Valeant's bond prices have plunged after it postponed its annual earnings filing
Source: Bloomberg

It's hard to know what's motivating these managers to own so much of this debt and continue to buy it, though they could strangely be in a relatively good spot right now because some loan covenants may require Valeant to in effect sell holdings and pay down some loans early.

Stayin' Alive
Valeant's loan prices haven't fallen nearly as much as the company's bonds or stock
Source: Bloomberg

In fact, the company's bankers have already started reaching out to some lenders to see what they would want in return for waiving a default because of Valeant's delayed release of its earnings filing, Bloomberg News reporters Michelle F. Davis and Sridhar Natarajan wrote in a article on Friday. Valeant was required to file its 10-K annual report before Wednesday and failed to do so, closing off its remaining credit line. 

But that all speaks to a company in crisis, which is rarely good for debt investors.

Valeant exposes what can be fundamental flaw in credit markets: Investors often prefer companies that sell a lot of debt and don't question their motivations until it's too late. Many funds, including the biggest high-yield bond exchange-traded funds, count Valeant debt among their biggest holdings simply because they're trying to mirror a benchmark index. These indexes typically weight bonds according to how much debt companies have, not which are most creditworthy.

Also, debt investors tend to like bonds and loans that are sold in big batches because they are usually easier to sell afterward if the buyers change their minds.

The problem is, investors in these big slices of debt often find themselves in an even worse situation if there's a rush to sell because so many debt investors own the same securities and thus want to sell at the same time. Recall what happened with Sprint last year when it was downgraded several notches at once. Its bonds have not fully recovered.

While CLO investors are in a much better spot right now than Ackman, who is the third-biggest owner of Valeant's stock, they're also almost certainly more on guard. For now they appear to largely be hanging tight, but should they start to reassess, the rush to the exits could get ugly in a hurry.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Lisa Abramowicz in New York at labramowicz@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net