With interest rates so low for so long and even the riskiest companies being able to find eager lenders, the opportunities for distressed debt investors have been few and far between for some time. But now, as inflation kicks in and the Fed begins aggressively raising rates to keep it in check, everything is changing.
Data compiled by Bloomberg showed that, as of 9 September, corporate bonds and loans traded at distressed levels had risen to $ 189 billion, up 6.4% from just a week earlier, and that 59 U.S. companies had filed for bankruptcy so far this year. Three of these, each with over $ 50 million in liabilities, also occurred during the first week of September. The most significant of these was Cineworld Group, Plc., The second largest film chain in the world with over 500 theaters in the United States under the name of Regal Cinemas. That company, which has approximately $ 4.8 billion in debt excluding leases, will not benefit from the meme stock rally that previously bailed out AMC Entertainment.
What happens to the Regal Cinemas chain as Cineworld works its way through bankruptcy will be a film worth watching, but a more interesting story for the troubled debt follower is Revlon.
In 2020, Revlon sought to refinance and replace some of its old debt with new issues. This created a new problem for the company, which impacted its bankruptcy proceedings. Citigroup
Citigroup demanded that the money be returned, but a group of funds that held approximately $ 500 million in debt refused. They claimed that the refinancing that Citigroup was working on with Revlon was unfair. Earlier this year, a judge agreed with them, ruling that the law allowed them to withhold the money because, in part, they had no reason to believe the payment was wrong. Citigroup filed a pre-emptive subrogation request with the bankruptcy court stating that the bank owed at least $ 500 million and, if not repaid, had the right to become a bankruptcy plaintiff for that amount. In its filing, the company told the court that this litigation was hampering its efforts to raise capital because it was unable to identify its creditors.
Some clarity emerged on the situation earlier this month when the United States Court of Appeals of the Second Circuit in New York overturned the previous ruling and said that Citigroup could recover the money. It remains unknown how much of that half a billion misdirected funds are actually returned. Among the repaid creditors are Caymanian-based hedge funds, and some of them may have been liquidated along the way. But regardless of how it turns out for Citigroup, the new ruling clarifies Revlon’s bankruptcy and will let it know who its creditors are before proposing a bankruptcy plan that is expected to be filed in court by mid-November.
The Cineworld and Revlon failures are two of the most high-profile events in the world of distressed investing, but recent macro events seem to indicate that there is much more to come.
First, Jerome Powell’s speech in Jackson Hole indicated the Fed’s willingness to continue raising interest rates to moderate inflation. He said: “We will continue until we are sure that the work is done.” And although Powell did not mention it in his remarks, the Fed will also likely continue to try to reduce the size of its balance sheet.
Then there is what happened with the junk headlines. Last year, a report released by JP Morgan showed junk paper trading with returns in many cases below 5% to maturity. In practical terms, this indicated that the price of fixed income securities had skyrocketed and even the riskiest borrowers were able to borrow at rates below 5% and, in some cases, even below 2%!
That was then. We are now starting to see a big reset. Each bond has fallen in price with corresponding increases in yield at maturity. It is now much more common to see prices between 7 and 9% for junk-rated bonds. Those with problems or difficulties are trading at much higher yields, some as high as 30% or more. With what the Fed said, that trend still has room to go as a normal level for junk paper is rightfully double digits, not single high digits.
Based on these indicators, it is reasonable to assume that we will see much more distress in the coming months. It may not be high-profile names like Revlon or Regal, but there will be other companies that have gorged themselves on debt over the past decade and are now forced to grapple with the new environment. We see this everywhere in fixed income. Since the beginning of the year, general fixed income indices have fallen sharply. Treasury indices are also down 20% – the highest ever recorded in a year – and most fixed income securities are priced lower than their benchmark government bonds.
If the problems in the fixed income market like the ones we have seen this year continue, this guarantees that you will have much more difficulty. This is because, as companies hit their debt maturity dates, there is less and less demand for the new bonds they need to issue to refinance maturing debt. And for some of them, the window may be completely closed. We are seeing large year-to-date outflows from bond mutual funds and ETFs as investors have suffered such large losses in those markets this year. As the market recovers over the long term, there will likely be more and more opportunities to selectively find attractive value investments amid the growing carnage of distressed debt.
For individuals, it is very difficult to invest in the distressed debt of a company like Revlon or Cineworld. Even so, companies like these can be exceptional long-term investments if you can buy at the right price through a professional wealth manager. Separately, Revlon has publicly traded the shares, which means that investors may be able to play a game by short selling its shares.
In fact, short selling has become an increasingly interesting opportunity right now. There are many companies whose business plans are completely reversed due to inflation, supply chain bottlenecks, Covid-related problems, and uncertain commodity prices. And companies affected by those conditions that are also overly indebted are far more likely to go bankrupt, particularly if we’re in a recession. For investors who don’t have the ability or appetite to do it themselves, now may be a great time to choose an experienced investment manager to help them navigate these troubled waters.
Revlon could also offer long-term investor patients an edge because it’s a good deal. It has big brands and strong cash flows and revenues even though it has a temporarily over-indebted capital structure.
There are likely to be numerous other companies that will be in trouble in the coming months. However, investors should be cautious, not only of troubled companies, but also of their regular equity investments, unless they can find some with short-term cash returns. These are companies that are cheap at first, but also have short-term plans to return money to shareholders through large dividends and / or share buybacks.
As we stated earlier, even in the saddest markets, there are usually some opportunities for investors willing to do their homework to find them. Right now, a good place to look is in the energy space. Some companies that produce oil or natural gas are earning so much right now that they can reward their shareholders by giving them back their capital quickly.