Bond Traders Aim to Separate Distress from Doom

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Great thoughts from Brian Chappatta, about sifting through US corporate bonds and sorting out the companies that are merely distressed from those that are ultimately doomed. Utilize Overbond’s Market Surveillance and Fundamental Momentum tools to separate great buys from looming downgrades. 

Source: Bloomberg

Investment-grade bonds have become almost a commoditized asset class, given the Federal Reserve’s $750 billion pledge to purchase a broad index of securities to support “market functioning” and provide direct financing to companies as a last resort. Investors have grown so comfortable with this arrangement (which is supposed to end after September but could easily be extended) that the average yield on high-grade corporate debt fell below 2% on July 16 for the first time in the 48-year history of Bloomberg Barclays data. If policy makers succeed in reviving the U.S. economy, that might not even cover inflation.

t’s a different story in the speculative-grade debt markets. The number of companies rated B3 or lower by Moody’s Investors Service reached 414 at the end of June, or 27.5% of all high-yield borrowers, compared with the prior peak of 291 (26.1% on a percentage basis) during the 2008-2009 financial crisis. A B3 rating is six steps below investment grade and is something of a cutoff below which investors have to start seriously thinking about restructuring and recovery rates. The growth of this list slowed toward the end of last quarter, but not for a “good” reason — Moody’s said in a report last week that it was “mainly attributable to defaults.” The credit-rating company also noted that for the first time ever, it doesn’t have a positive outlook for any industry.

This is a sobering but realistic backdrop for investors in U.S. high-yield bonds and leveraged loans as they look ahead to the remainder of 2020. The narrative of Covid-19 lockdowns that were offset by huge fiscal and monetary actions has been replaced with questions about the viability of a patchwork system of reopening the world’s largest economy. Ultimately, the longer the pandemic lingers in America, the more likely struggling companies will see bankruptcy and default as the only path to the other side.

Just this week, Briggs & Stratton Corp., the world’s biggest maker of gasoline engines for outdoor power equipment, sought court protection, citing pressures from the Covid-19 pandemic that “have made reorganization the difficult but necessary and appropriate path forward to secure our business.” That sounds fair enough to an outside observer, but it’s a crushing blow for the insurers and mutual funds that own some of its $195 million of bonds that were issued in 2010 and were set to mature in December. They trade at 8 cents on the dollar after changing hands at 100 cents earlier this year, according to Trace data.

This is hardly a new phenomenon, of course. Just this month alone, well-known retailers Brooks Brothers Group Inc., Lucky Brand Dungarees and Muji USA opted for bankruptcy. They joined filings from amusement companies like Cirque du Soleil Entertainment Group, whose 2017 leveraged loan is worth about 49 cents on the dollar, down from 95 cents in February; rental-car company Hertz Global Holdings Inc., whose bonds trade at less than 40 cents on the dollar after spending eight months through February above par; and energy behemoths California Resources Corp. and Chesapeake Energy Corp., whose bonds have been fetching pennies on the dollar for months.

Still, the Fed’s new facilities have served to support the shakiest borrowers, if only by encouraging private investors to take more risk. Average leveraged-loan prices are close to the highest since March, based on the S&P/LSTA Leveraged Loan Index. A Bloomberg Barclays index of triple-C corporate bonds jumped 9.1% in the second quarter, the biggest gain in four years. It’s up an additional 2.6% this month, similar to the double-B and single-B indexes.

Is this sustainable? Probably not on the central bank’s actions alone. Make no mistake, giant profits await those who can sift through this basket of 330 ultra-risky bonds, which yields 11.3% on average. But a closer look reveals the potential pitfalls as well. 

Seven different bonds from Noble Holding International Ltd. are included in the triple-C index , for example. But not for long: It chose to skip an interest payment of about $15 million due last week and is discussing a potential consensual restructuring transaction with certain creditors. The longest-dated debt now trades at 2 cents on the dollar. Just about all of the most deeply distressed debt in the index comes from energy companies — some have gone bust, like frack sand pioneer Hi-Crush Inc., while others are on the verge of doing the same. Even with oil prices recovering gradually, it’s hard to make a strong case for these companies staving off bankruptcy.

The calculus gets tricker in the middle. Would you buy a bond from American Airlines Inc., due in March 2025, at a yield in excess of 22%? On the one hand, it’s no stranger to bankruptcy, having sought court protection less than a decade ago. Yet those who patiently held the debt back then ultimately reaped a gigantic windfall as American’s merger with US Airways Group Inc. sent prices soaring.

What about debt from Golden Nugget Inc. that matures in five years and yields 26%? Sure, the outlook for Texas billionaire Tilman Fertitta’s businesses is fraught, but if investors were willing to move forward with a leveraged-loan deal in early April, when uncertainty was near its peak, it suggests some degree of confidence that the empire will outlast the coronavirus pandemic. 

And believe it or not, there’s still a market for the triple-C rated junk bonds from WeWork Cos. at about 59 cents on the dollar, for a yield of 22%.

Meanwhile, fellow startup Uber Technologies Inc. is also rated in the triple-C tier but has bonds that trade at 105 cents on the dollar to yield 6.5%. The company came to market in May and saw such demand that it increased its offering to $900 million from $750 million. Uber’s creditors range from BlackRock Inc. and DoubleLine Capital LP to the California Public Employees’ Retirement System and Japan’s Government Pension Investment Fund, data compiled by Bloomberg show.

Uber’s story is relatively rare. The problem for many of these low-rated companies is they’ve been comparatively shut out of funding. As Bank of America Corp. strategists noted last week, companies with triple-C ratings have issued just $5.6 billion, or 2.7%, of outstanding bonds with those grades, compared with $135 billion of securities rated in the single-B and double-B tiers, which is 11.4% of their index size. Perhaps more than anything else, access to capital has been a crucial factor for gauging whether a company has a chance of getting through the coming months.

That makes the challenge of sifting through the triple-C ranks for potential bargains that much harder. Even in leveraged loans, Citigroup Inc. strategists recently recommended single-B debt to pick up yield, “but continue to caution against moving further down given the uncertain macro outlook, depressed prospects for recovery rates, and the lack of retail demand.”

Given the steady rally in bonds from blue-chip companies, it’s tempting to just ride the momentum. However, going into markets where others don’t dare to tread could wind up being the secret sauce for total-return investors in the coming months. It’s not “easy money” by any stretch. But separating distress from default is one of the few ways left for those who still believe in credit analysis to distinguish themselves from the “follow the Fed” herd.