Markets

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

Bond investors are playing a tricky game with lower-rated U.S. retailers, and they appear to be losing. 

Here's how it goes: Investors buy beaten-up bonds of struggling store operators and earn big regular payments for as long as they can. The bond buyers win if the companies remain solvent for longer than expected or even improve their outlooks. They can also win if the debt is relatively high in the capital structure and they're able to recover more money than they put in if the company goes bankrupt.

On the flip side, they lose if the borrowers' condition deteriorates, even if the downturn is drawn out. That's what's happening now for store owners such as Toys "R" Us Inc. and Bon-Ton Stores Inc., which both hired advisers to help them restructure their debt, according to reports this week. More broadly, these companies are among retailers that are bumping along as their outlooks slowly worsen. 

Toys "R" Us, for example, has been in a fragile financial state for years, but it appears to have taken a turn for the worse. The heavily leveraged retailer this week enlisted lawyers at Kirkland & Ellis to help restructure its $5 billion in longer-term debt, with a particular emphasis on $400 million in debt coming due next year, according to Bloomberg News

Despite the fact that Toys "R" Us hasn't had what could be considered a long-term viable business model for several years, the move seemed to catch some bond investors by surprise. Its debt sank this week, with its $208.3 million of bonds maturing in 2018 plunging to nearly 70 cents on the dollar Friday from near par just days earlier.

Free Fall
Prices on Toys "R" Us bonds plunged on the news that the company had hired a restructuring adviser
Source: Finra's Trace bond-price reporting system

The best move for Toys "R" Us would be to clean its financial slate, perhaps by filing for a full bankruptcy, and take an entirely new approach that emphasizes both online sales and a more bespoke element. But there's a hitch. The company is one of the numerous retailers that were purchased by private equity firms and then loaded up with debt that they're now struggling to repay. The owners of Toys "R" Us would lose a bunch of money in any bankruptcy, and they're still holding out some hope for improvement in the business in other parts of world.

Bon-Ton, meanwhile, has been losing money for years and reportedly just hired PJT Partners to help it grapple with its more than $900 million of debt. Prices on its bonds maturing in 2021 have fallen 25 percent this year.

Downward Dog
Bon-Ton bonds have steadily fallen this year as it struggles with its debt
Source: Bloomberg

These two retailers are not alone. Prices on high-yield bonds tied to U.S. retailers have dropped about 2.5 percent so far this year, with investors demanding yields as high as 9.9 percent on average earlier in 2017. Some of the biggest losers include bonds of Neiman Marcus Group Ltd., which have lost nearly 25 percent year to date, and notes of David's Bridal Inc., which have fallen more than 13 percent. Junk-rated retailer bonds now pay close to the highest yields relative to the broader U.S. high-yield index.

Expensive Debt
Investors are demanding a hefty cushion of extra yield to own U.S. junk retail bonds
Source: Bloomberg Barclays index data

So what happens during the endgame? Perhaps some bond investors will get paid enough money in coupon payments to offset their losses during any restructuring, but the chances of ending up on the winning side are getting slimmer.

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