Because interest rates had been so low for so long and even the riskiest companies were able to find eager lenders, there were few opportunities for ailing debt investors for some time. But now, as inflation kicks in and the Fed begins to aggressively raise interest rates to keep it under control, all that is changing.
Data collected by Bloomberg shows that on Sept. 9, corporate bonds and loans that traded at distressed levels had risen to $189 billion, up 6.4% from just a week earlier, and so far this year. American companies have filed for bankruptcy. Three of those, each with more than $50 million in commitments, also took place in the first week of September. Chief among these was Cineworld Group, Plc., the second largest film chain in the world with more than 500 movie theaters in the US under the name Regal Cinemas. That company, which has about $4.8 billion in debt excluding leases, won’t benefit from the meme stock rally that saved AMC Entertainment earlier.
What happens to the Regal Cinemas chain as Cineworld makes its way through bankruptcy will be a movie worth watching, but a more interesting story for the nuanced follower of ailing debt is Revlon.
In 2020, Revlon attempted to refinance some of its old debt and replace it with new issues. That created a new problem for the company, with consequences for the bankruptcy proceedings. Citigroup
Citigroup asked for the money back, but a group of funds that had about $500 million of debt refused. They claimed that the refinancing Citigroup was working on with Revlon was unfair. Earlier this year, a judge agreed with them, ruling that the law allowed them to keep the money because they had no reason to believe the payment was incorrect at the time. Citigroup filed a preemptive subrogation claim in bankruptcy court stating that the bank owed at least $500 million, and if not repaid, it had the right to become a bankruptcy claimant for that amount. When filing the application, the company told the court that this process hampered its efforts to raise capital because it was unable to identify the creditors.
Some clarity came to the situation earlier this month when the Second Circuit US Court of Appeals in New York overturned the earlier ruling and stated that Citigroup could recover the money. How much of that half billion in misdirected funds is actually returned remains unknown. Among the repaid creditors are Cayman-based hedge funds, and some of them may have liquidated along the way. But however it plays out for Citigroup, the new ruling clears up Revlon’s bankruptcy and allows it to know who its creditors are before proposing a bankruptcy plan expected to go to court in mid-November.
The Cineworld and Revlon bankruptcies are two of the most notable events in the world of ailing investment, but recent macro events seem to indicate that there is much more to come.
First, Jerome Powell’s Jackson Hole speech pointed to the Fed’s willingness to continue raising interest rates to dampen inflation. He said, “We’ll keep going until we’re sure the job is done.” And while Powell didn’t address it in his comments, the Fed will most likely continue to try to reduce the size of its balance sheet as well.
Then there’s what’s going on with junk bonds. Last year, a report from JP Morgan showed that junk-rated paper was trading, with yields in many cases below 5% to maturity. In practice, that meant that pricing for fixed income securities had gone through the roof, and even the riskiest borrowers could borrow at rates below 5% and in some cases even below 2%!
That was then. Now we are starting to see a major reset. Each bond has fallen in price with a corresponding increase in yield to maturity. It is now much more common to see prices in the 7-9% range for junk-rated bonds. Those in trouble or distress trade at much higher returns, some up to 30% or more. With what the Fed has said, that trend still has room to go, as a normal level for junk-rated paper is rightly in the double digits, not the high single digits.
Based on these indicators, it is reasonable to assume that we will see much more misery in the coming months. They may not be high-profile names like Revlon or Regal, but there will be other companies that have been inundated with debt for the past decade and are now forced to reckon with the new environment. We see it everywhere in fixed income. Year-to-date, broad fixed income indices have fallen sharply. Even Treasury indices are down 20% – the highest number ever in a year – and most fixed income securities are priced against government benchmark securities.
If the problems in the fixed income market, as we have already seen this year, continue, you will be guaranteed a lot more misery. That’s because, as companies reach their debt maturity dates, there’s less and less demand for the new securities they need to issue to refinance maturing debt. And for some of them, the window may be completely closed. We are seeing large YTD outflows from bond funds and ETFs as investors have suffered such large losses in those markets this year. As the market recovers over the longer term, there will likely be more and more opportunities to selectively find interesting value investments among the growing ailing debt slaughterhouse.
It is very difficult for individuals to invest in the distressed debts of a company like Revlon or Cineworld. Still, these types of businesses can be excellent long-term investments if you can buy in at the right price through a professional asset manager. Separately, Revlon has publicly traded shares, meaning investors may be able to short sell their shares.
In fact, short selling has become an increasingly interesting opportunity right now. There are many companies whose business plans are being turned upside down due to inflation, supply chain bottlenecks, Covid problems and uncertain raw material prices. And companies that are affected by these conditions and that are also over-leveraged are much more likely to file for bankruptcy, especially if we’re in a recession. For investors who can’t or don’t want to do this themselves, now might be a good time to choose a wealth manager with experience to help them navigate these tumultuous waters.
Revlon can also offer some benefit to patient long-term investors because it is a good thing. It has great brands and strong cash flows and income, even though it has a temporarily overloaded capital structure.
Many other companies are likely to find themselves in trouble in the coming months. Still, investors should be careful not just of distressed companies, but their regular stock investments, unless they can find one with short-term cash returns. These are companies that are cheap to start with, but also have plans to return cash to shareholders in the short term through large dividends and/or share buybacks.
As we mentioned before, even in the bleakest of markets, there are usually some opportunities for investors willing to do the homework to find them. Right now is a good place to look in the energy space. Some companies that produce oil or natural gas are currently making so much cash flow that they can reward their shareholders by giving them back capital quickly.