With interest rates so low for so long and even the riskiest of companies able to find eager lenders, opportunities for distressed debt investors were 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, that’s all changing.
Data compiled by Bloomberg showed that, as of September 9, corporate bonds and loans trading at distressed levels had risen to $189 billion, an increase of 6.4% from just a week earlier and that 59 U.S. companies have filed for bankruptcy so far this year. Three of those, each involving more than $50 million in liabilities, also occurred during the first week of September. The most significant of these was Cineworld Group, Plc., the second largest movie chain in the world with more than 500 theaters in the U.S. under the Regal Cinemas name. That company, which has about $4.8 billion in debt excluding leases, won’t benefit from the meme-stock rally which previously saved AMC Entertainment
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 distressed debt follower is Revlon
In 2020, Revlon tried to refinance and replace some of its old debt with new issues. That created a new problem for the company, impacting its bankruptcy proceedings. Citigroup
Citigroup asked for the money back, but a group of funds that held about $500 million of the 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, in part, they had no reason at the time to believe the payment was mistaken. Citigroup filed a pre-emptive subrogation claim in the bankruptcy court stating that the bank was owed at least $500 million, and if not repaid, it had the right to become a bankruptcy claimant 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 came to the situation earlier this month when the Second Circuit U.S. Court of Appeals in New York overturned the earlier ruling and stated that Citigroup could recoup 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, regardless of how it plays out for Citigroup, the new ruling clears up the bankruptcy for Revlon and will allow it to know who its creditors are before it proposes a bankruptcy plan which is expected in court by mid-November.
The Cineworld and Revlon bankruptcies are two of the highest profile events in the world of distressed investing, but recent macro events seem to indicate there will be a lot more to come.
First, the speech by Jerome Powell in Jackson Hole indicated the Fed’s willingness to keep raising interest rates to temper inflation. He said, “We will keep at it until we are confident the job is done.” And although Powell didn’t address it in his remarks, in all likelihood, the Fed will also continue to try to reduce the size of its balance sheet as well.
Then there’s what has been going on with junk bonds. Last year, a report issued by JP Morgan showed junk-rated paper trading with yields in many cases under 5% to maturity. In practical terms, that indicated pricing for fixed income securities had gone through the roof, and even the riskiest borrowers were able to borrow at rates below 5% and, in some cases, even lower than 2%!
That was then. Now we’re starting to see a big reset. Every bond has moved down in price with corresponding increases in yield to maturity. It’s much more common now to see pricing in the 7-9% range for junk-rated bonds. Those with problems or distress are trading at much higher yields, some as high as 30% or more. With what the Fed has been saying, that trend still has room to go since a normal level for junk-rated paper is rightly in the double digits, not the high single digits.
Based on these indicators, it’s reasonable to assume that we’ll 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 gorged on debt over the past decade and are now forced to reckon with the new environment. We’re seeing it everywhere in fixed income. Year to date, the broad fixed income indices are down sharply. Even Treasury indices are down 20% – the most ever in one year – and most fixed-income securities are priced off of benchmark governmental securities.
If trouble in the fixed income market like we’ve seen already this year continues, that guarantees you’ll have much more distress. 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 might be closed entirely. We’re seeing big YTD outflows from bond mutual funds and ETFs because investors have had such big losses in those markets this year. As the market resets over the longer term, there will likely be more and more opportunities to selectively find interesting value investments among the growing distressed debt carnage.
For individuals, it’s very hard to invest in the distressed debt of a company like Revlon or Cineworld. Even so, companies like these may be outstanding long-term investments if you can buy in at the right price through a professional asset manager. Separately, Revlon has publicly traded shares, which means investors might be able to make a play short-selling its stock.
In fact, short selling has become an increasingly interesting opportunity right now. There are lots of companies whose business plans are being turned completely upside due to inflation, supply chain bottlenecks, Covid issues, and uncertain commodity pricing. And companies affected by those conditions that are also over-levered are much more likely to file for bankruptcy, particularly if we have a recession. For investors who don’t have the ability or appetite to do this themselves, now might be a great time to pick an investment manager with experience to help them navigate these choppy waters.
Revlon might also offer some upside to patient long-term investors because it’s a good business. It’s got great brands and strong cash flows and revenues even though it has a temporarily over-levered capital structure.
There will likely be numerous other companies heading into distress in the coming months. Still, investors should be cautious, not just about companies in distress but also about their regular equity investments, unless they can find some with short-duration cash returns. Those are companies that are cheap to start with but also have very near-term plans to return cash to shareholders through big dividends and/or stock buybacks.
As we’ve stated before, even in the most dismal of markets, there are usually some opportunities for investors willing to do the 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 making so much cash flow right now that they can reward their shareholders by returning capital to them quickly.