Recent market volatility following a prolonged period of tightening across most corporate bond sectors serves to highlight the importance of an active and discerning eye toward the fundamentals in credit investing. Portfolio decisions should take into account not only the price of an investment, but where in the credit structure that investment has been made. Understanding the fundamentals of a company’s business and the sector in which it operates is a necessary though not sufficient level of analysis for successfully investing across the credit quality spectrum and throughout the credit cycle.
At PIMCO, we have hard-coded this degree of rigorous analysis into our investment and risk management processes. The nuances among seemingly similar issuers and issues that end up leading to very different investment outcomes are a great part of why we believe active credit management matters.
Investors in distressed credits – or in credits at risk of becoming stressed in the future – should delve still further: Along with fundamental analysis, they should actively evaluate the unique features of the bond structures and related derivative contracts (such as credit default swaps, or CDS). The degree of effort and expertise involved explains why distressed credit has historically been the province of specialized investors. They scour the details of every investment across the capital structure, reading indentures, covenants, trigger guidelines, and more in an effort to understand how each security is likely to react in the event a company becomes stressed. Equally important, investors should know what rights they have (or don’t) in the event the company begins to deteriorate fundamentally. Investors who do not understand the specifics for each security and in turn manage the risks and fully exercise their rights may see lower-than-expected payouts if the company undergoes stress or bankruptcy.
Coercion, consents, covenants: key risks in distressed credit
Once an entity becomes stressed, recovery is rarely straightforward and requires detailed fundamental and legal analysis. This is most prevalent in capital market structure arbitrage. Investors in notes and other debt obligations risk impairment in trading prices and recoveries when issuers/borrowers undertake strategies such as “coercive debt exchanges” or “exit consents,” or the aggressive use of available “covenant baskets.”
Coercive debt exchanges involve the issuer/borrower soliciting investors to exchange or amend their debt for replacement debt on different (and often less advantageous) terms. These exchanges typically require such investors, as a condition to the exchange, to consent to material amendments or waivers that negatively affect the terms of the debt that is not exchanged. Investors who abstain or vote against the exchange, or are not provided the opportunity to participate in the exchange, may be left with devalued debt due to the modification of material terms. However, certain provisions in debt agreements typically may not be amended without the consent of every affected investor; these so-called sacred rights usually include principal amount, interest rate and payment/maturity dates. Recently, some issuers/borrowers have tried to coerce consent in several ways:
- Layering of unsecured notes with new secured notes that mature before the unexchanged notes (e.g., Goodrich Petroleum, Halcón Resources, Lightstream Resources, American Energy Partners)
- Releasing parent company guarantees and transferring parent company assets to a new entity that would issue securities (debt and equity) only to consenting creditors
- Eliminating or modifying covenants from non-exchanged debt (e.g., Midstates Petroleum, iPayment)
Issuers/borrowers may also seek to aggressively interpret debt documents and use covenant baskets in ways potentially detrimental to investors:
- Issuing secured debt that would have the effect of repaying unsecured debt before secured obligations (e.g., Norske Skog)
- Using permitted investment baskets to transfer valuable assets to unrestricted subsidiaries, which can be used as collateral for new debt obligations (e.g., J. Crew)
- Funding discounted market buybacks of debt that are prohibited under the debt documents
Not all of the above attempts were successful, but many investors found that defending against such issuer/borrower actions involved significant effort and expense. These strategies also potentially drain value from the issuer/borrower.
Of note, in a recent decision that affects public bonds, a U.S. court decided that statutory provisions that prevent core payment terms (e.g., principal amount, interest rate and maturity date) from being amended without the consent of each affected bondholder do not apply to amendments that amend other terms. As a result, issuers/borrowers can modify other covenants that can negatively affect a bondholder’s practical ability to receive payment.
CDS and stressed credits
Credit default swaps positioning can also at times have a material impact on the ultimate structure of debt restructurings for stressed credits. This more often happens when the net notional of CDS far exceeds an issuer’s debt outstanding, or where CDS positions in the front ends of curves are large relative to the amount of near-term refinancing needed. Such dynamics over time have been fairly symmetric in their market impact. They can lead to incentives to either trigger or “orphan” CDS, and tend to have a far greater impact on the CDS curve shape of such issuers than on the “on the run” five-year CDS levels and spreads tracked by the CDX indexes.
For example, if a concentrated group of investors has sell protection positions in short-dated CDS and they also hold a position in the bonds, they may be willing to term out existing debt at far more attractive pricing than what would appear to be available in the market. In such cases, the gains on the large notionals of short-dated CDS are expected to far exceed the “overpaying” for the new debt instruments (RadioShack and Toys R US provide recent examples). Along similar lines, such positions also incentivize exchanges that attach new debt incurrence to an entity different from the one referenced by CDS.
While it is less frequent, cross holdings in distressed bonds and CDS can also create the incentive to engineer debt restructurings that trigger CDS. This happens when similarly concentrated holders hold a portion of the debt stock and a far greater notional of short-dated CDS buy-protection positions (Codere and Hovnanian are examples). The recent Hovnanian situation garnered media attention for its CDS angle, but it is really more emblematic of the very wide range of potential restructuring outcomes in complex capital structures.
We note that a CDS auction is designed to prevent large discrepancies between CDS recovery and actual bond prices via an open auction where anyone can buy or sell bonds. Sellers of protection can always elect to physically settle in an effort to guard against a small number of obscure bonds having an undue impact on the settlement price.
Once issuers become stressed, a large number of other elements require careful analysis: capital structure, bond covenants and indentures, the motivations of management and private equity sponsors, and credit derivative positioning and technicals. The interplay of these factors – via distressed exchanges, asset transfers or priming of existing debt – can lead to outcomes far different from what a cursory view of leverage and earnings may suggest.
In distressed credit investing, shades of nuance may have major effects over time. In order to maximize performance potential and seek to protect against principal loss, careful legal and capital structure analysis must go hand in hand with fundamental corporate analysis, bolstered by an active management approach.
Learn about credit default swaps as an active management tool in our Understanding Investing series.