Distressed debt swaps are all the rage. They’re arguably good for companies, at least in the short term. They’re great for the biggest investors, who stand to get more of their money back.
They can be terrible for the smallest investors, who can be left empty-handed.
Here’s how these exchanges work: Institutional investors agree to forgive some of a company's debt in return for a better claim on the borrower’s assets during bankruptcy negotiations. There were 45 of these transactions involving $23.7 billion of debt last year, according to Moody’s data. That's the greatest amount of such deals since 2009 and comes on the heels of plunging crude oil prices, which brought many producers and drillers to their knees.
Smaller investors, however, usually can't participate in these transactions because they're not considered qualified institutional buyers. The result is that individual bondholders stand to get back less and less as bigger institutions help companies stave off insolvency with debt swaps.
"These debt exchanges can be short-term positives for companies" because they give borrowers more time before they default, wrote Jody Lurie, an analyst at Janney Montgomery Scott in a report on Monday. But "they have another effect: the recovery prospect for senior unsecured bondholders plummets closer to zero."
As the U.S. credit cycle sours, a $317 billion pool of distressed debt has become a battleground for institutions that are jockeying for better positions heading into restructuring court. Janney Montgomery’s Lurie notes that defaults globally have reached the highest levels since 2009.
This may end up being a terrific opportunity for the biggest distressed debt investors, who have teams of lawyers, cash on hand to buy deeply discounted bonds of troubled companies and the patience to hang on during drawn-out negotiations. Prices on distressed bonds fell to an average 51.8 cents on the dollar in January from as high as 75.6 cents in 2015, eliminating billions of dollars of market value from the books of investors big and small, Bank of America Merrill Lynch index data show. Average prices have since risen to 64.2 cents as oil prices recovered some losses and investors looked for bargains.
Distressed-debt firms aren't doing anything wrong by gaining an upper hand within the bounds of contract law. In fact, some argue they’re providing a service to markets by creating demand for beaten-up debt that many investors don’t want or can’t afford to hang onto.
But the fact that smaller investors are locked out of the process, without a say in the matter, doesn't seem fair. Lurie has a point when she says, "Retail investors may be passively discriminated against, despite the retail investor group as a whole possibly being as large as any individual institution."
As more indebted American companies struggle, debt exchanges will benefit the companies and big institutions, but they threaten to leave many of the smallest bondholders behind.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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