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At first glance, 2019 might look like a quiet year for distressed-debt investors, judging by the small list of troubled bonds coming due. But the light schedule may be obscuring how quickly some issuers will unravel.
As Toys 'R' Us demonstrated, weak sales and nervous trade creditors can bring down a company long before the maturity dates for loans and bonds.
What’s more, secured debt isn’t as secure as it used to be: Top-heavy capital structures and loose covenants could leave little for junior creditors to recover if an issuer goes bust.
Even first-lien holders may have to lower their expectations because of loopholes that weaken their claims on collateral, according to Jeanne Manischewitz, co-head of North American credit at York Capital Management.
"There’s this question mark of how much money is going to be lost before you even reach the courthouse steps," said Manischewitz, whose firm manages $18.2bn.
That may partly explain why distressed-debt indexes are now showing negative returns for the year, but it also creates potential bargains. "You have a lot more dislocated credit and debt that trades at a price that’s below par, which creates more opportunity for total return," she said.
The raw numbers look like this:
Only $80bn of loans and $105bn of speculative-grade bonds will mature through 2020, according to Fitch Ratings. Look for trouble at companies saddled with lots of floating-rate debt and shaky business models, Fitch says.
The default rate for US speculative-grade corporate debt as measured by S&P Global Ratings is forecast to drop to 2.25% by June, from 3% a year earlier. The retail and restaurants sector is worst off, with 15 issues in distress - six of them from JC Penney Co. Covenant quality as tracked by Moody’s Investors Service has been hovering at its weakest levels for 19 months.
Moody’s is among the voices warning that recoveries could be lower than historical averages for first-lien debt in the next downturn because of more loan-only structures, particularly at issuers owned by private equity firms. Apollo Global Management LLC, one of the biggest investors in troubled companies, is playing both sides of covenant risk, according to founder and Chief Executive Officer Leon Black, who says credit markets are in "bubble status".
At companies that Apollo controls, the private equity firm tries to get as much "covenant-less" or covenant-lite debt as possible, preferably with fixed rates, Black said at a December 5 investment conference.
As a lender, though, "we’re on the opposite side of that equation, and most of what we do is fairly senior in the capital structure," he said. "It always has covenants, and we try to play a more conservative, cautious role."
Credit markets aren’t entirely shut for troubled companies, but stress is showing for "small, mid-market companies who are the first to lose access to capital in uncertain environments," said Steve Zelin, who heads restructuring at PJT Partners. "It’s not only a maturity issue, but a constraining cash flow issue and an inability to access the debt markets to solve liquidity concerns."
The shortage of distressed companies is encouraging a more activist breed of creditors to scour credit documents for technical violations that might amount to defaults, similar to cases such as PetSmart, Neiman Marcus and Windstream Holdings.
Those revolve around assertions that asset transfers weakened creditor claims on collateral. All three may come to a head in 2019. A legal defeat in Windstream’s case is unlikely, the company says, but the stakes are high: a loss could trigger a bankruptcy.
Some issuers find the odds tilted against them when activist creditors show up already organized and demanding information, before the company even thinks it has a problem, according to Josh Sussberg and Jon Henes, partners at law firm Kirkland & Ellis.
"One of the things that we tell the companies all the time: You want to move into these processes on your toes, not on your heels," Sussberg said. If there’s no contingency plan in place, "creditors are effectively running the show".
Some of the bigger distressed debtors still have maneuvering room left in 2019. Here are the issues they’re facing, how they might cope, and responses from those that answered requests for comment:
Frontier Communications
Among North American issuers, this telecom company has the most deeply distressed debt (yields topping 20%), at about $12bn. Back in September it told analysts, "We have the ability to comfortably manage our debt maturities over the coming few years," and Bloomberg Intelligence says Frontier can meet about $700m of payments for 2019 through 2020 with its revolver and free cash flow.
After that, GimmeCredit wonders how Frontier can meet obligations in 2021-22. Fundamental pressures include erosion of voice, video and broadband revenue.
Community Health Systems
It’s selling under-performing hospitals to cut its debt load of more than $13bn. Refinancing deals narrowly averted a restructuring, according to BI’s Mike Holland.
Even then, he wrote, "We remain skeptical of the company’s ability to make enough credit-accretive sales to grow into its capital structure, and believe that future debt refinancings will be challenged by Ebitda erosion amid excessive leverage."
Neiman Marcus
The first round of restructuring talks ended in stalemate, with negotiators tangling over the transfer of MyTheresa, the promising online unit. Marble Ridge Capital has sued, but the company says the transaction was "expressly permitted" by its debt documents.
Talks are likely to re-start in the new year; the court case in Dallas federal court is just getting started. About $5bn of debt is involved. All of Neiman’s stores show positive Ebitda, it’s complying with all debt requirements and there’s ample time to refinance, Neiman said in an emailed statement. "We view these negotiations as an ongoing process that will likely take time," Neiman said.
"We believe a mutually beneficial solution can be reached."
JC Penney
The retailer is saddled with around $4bn of debt and weak sales; it didn’t help that the chain was leaderless for months. The new team is "comfortable" with liquidity and maturities, and Bloomberg Intelligence sees enough flexibility and vendor support for Penney to finish dumping old inventory and refreshing its offerings.
But not all bondholders are so confident; yields on some notes top 20%. J.C Penney has a "manageable maturity schedule" and "clear runway" for the next several years before its next meaningful debt maturity in 2036, a representative said in a statement.
