Bring On The Battered Debt
Lots of smart people think the junk-bond boom of the past few years is about to end with a series of defaults, and they're lining up to cash in. Billionaire Wilbur L. Ross Jr. and other storied vultures are quickly raising giant funds to invest in troubled companies, while heavyweight investors such as the California Public Employees' Retirement System are rushing to invest. "When the distressed business is good, we can get about net 20% returns," says Panda Hershey, portfolio manager at CalPERS.
The signs of a coming buyer's market for distressed debt seem abundant. The percentage of new junk bonds rated B- or lower -- just four notches above the bottom of the heap -- reached a 20-year high of 34.2% in 2004, according to Merrill Lynch & Co. (MER ) Historically such surges are followed by a rising number of defaults within two or three years.
And many of these issues came complete with red flags: Companies sold the bonds just to pay big dividends or cover old debt, or the bonds carry floating rates that will rise as interest rates do. Fund managers also are eyeing the huge growth in second-lien loans -- in which lenders are second in line for repayment in a bankruptcy -- and in loans used to finance leveraged buyouts.
The default rate is still low, but if it starts accelerating, the new funds are making sure they're ready. They'll deploy their money to buy up a flood of junk bonds gone bad -- often for pennies on the dollar. The bet is that if the bonds default, that will allow the funds to gain control of a viable business once it emerges from Chapter 11.
Investors like the bet. They've poured some $6.3 billion into these funds over the past 12 months. When Ross's firm, New York-based WL Ross & Co., set out to raise a new fund this past spring, it aimed to pull in only $500 million. But on June 30 the firm capped its fund at $1.1 billion. "We turned away about as much as we took in," says Ross. CalPERS, the nation's largest public pension fund, put $50 million into Ross's fund and $75 million into another $1 billion fund raised by New York's Avenue Capital Group. CalPERS, in fact, advised Avenue to set the fund up. "The reason we raised money now is that we think the cycle will start over the next six to 12 months," says Marc Lasry, Avenue's founder and managing partner.
At the same time, new players are jumping in. Distressed-debt managers at Credit Suisse First Boston (CSR ), Deutsche Bank (DB ), and elsewhere have recently left to raise their own funds. "Guys who are starting funds now are saying, 'This is a low point for defaults, but let's get our buying power assembled,"' says Martin Fridson, CEO at high-yield bond researcher FridsonVision.
Opportunity is already at hand for distressed-debt mavens. "One sector we've gotten quite interested in is auto parts," Ross says. Along with other firms, WL Ross has bought most of the $750 million in bank debt owed by Troy (Mich.) car-parts maker Collins & Aikman Corp. (CKC ), which filed Chapter 11 in May. At least 10 other auto-parts companies have entered bankruptcy this year. Several others are teetering on the brink. Ross could try to roll up the best of the bunch and sell them at a profit, as he has done with steel, textile, and coal companies.
Until default rates rise, it's not clear which other sectors are ripe for Ross and other vultures. "We keep looking at airlines but haven't figured out the right way to play a constructive role," explains Ross.
Auto-parts makers typify recent junk-bond frothiness. Over the past two years several issued bonds that added no cash to their coffers; the proceeds instead went to refinance existing debt or stave off defaults. Goodyear Tire & Rubber Co. (GT ), for example, last year sold $650 million in junk bonds to pay off a $583 million bank loan and to reduce other looming obligations. "We feel very committed that we are going to meet our obligations," says Goodyear spokeswoman Tricia C. Ingraham.
Private equity firms have contributed to the glut of debt with a controversial stratagem. They recover chunks of their equity investment fast by getting companies they own to issue junk bonds and then pay out dividends from the proceeds. In December, 13 months after acquiring Warner Music Group (WMG ) for $2.6 billion, private equity firms Thomas H. Lee Partners, Bain Capital, and Providence Equity Partners had the company sell $700 million in junk bonds to pay a dividend. When the company went public in May, investors looked askance at the dividend deal, forcing Warner to lower its offering price to $17, from a range of $22 to $24 a share.
Rising interest rates also could stretch some companies to the breaking point. To entice investors, junk-bond issuers last year began offering floating-rate notes, exposing themselves to the same kind of payment shock that homeowners with adjustable-rate mortgages fear. Energy company Calpine Corp. (CPN ) last year issued $680 million of seven-year floating-rate notes. With four times more debt than equity on its balance sheet, Calpine is still highly leveraged, although it is getting its finances under control, selling assets and cutting debt by $3 billion to $15 billion this year. "We feel pretty comfortable," said Chief Financial Officer Robert Kelly in July.
The explosion of second-lien lending has created another opportunity for the vultures. "That is the next big distressed market," says Mark K. Holdsworth, managing partner at Tennenbaum Capital Partners, which recently closed a $1 billion fund. Often used as rescue financing for companies, second-lien loans typically have the same rights and covenants as bank loans, except that they don't get repaid first. New issues of such loans grew last year to a record $12 billion, up from $3.3 billion in 2003, according to credit-rating agency Standard & Poor's.
Loans used to finance leveraged buyouts also are on the shopping lists of distressed-debt investors. Last year such loans to companies rated below investment grade surpassed $50 billion, the highest level since the 1980s, according to researcher Loan Pricing Corp. As deal sizes have increased, banks have grown more lenient about the amount of leverage they allow companies to use.
Reaping big returns from bad debt is not exactly a cinch. Cheap bonds may only get cheaper, causing a fund to lose money. And funds may miss the jackpot if they get outmaneuvered in bankruptcy court by other creditors and fail to win control of the company.
Not everyone thinks a wave of bad debt is coming. For now companies are still servicing their bonds: The junk-bond default rate was only 1.7% at the end of July, barely above its eight-year low. "We don't think the default rate will rise much, and not to double-digit levels over the near term," says M. Christopher Garman, global high-yield strategist at Merrill Lynch. S&P predicts it will creep up only to 2.5% by next April.
Nevertheless, distressed-debt investors are getting ready for the deluge. "We're not sure when it's going to crack, but it certainly has to," says CalPERS' Hershey. Their preparations may be the best indicator of a debt market headed for a correction.
By Justin Hibbard in San Mateo, Calif.