The worst recession since the Great Depression is prompting indebted companies to default, and increasingly more will do so in a way that’s harder for investors to detect.
Rating firms predict that more companies will pursue distressed debt exchanges, in which they try to overcome liquidity problems by swapping debt or buying it back at steep discounts. Such moves are less stark than missed payments and can fly under the radar for the general investing public, but often result in losses for creditors and are usually counted as defaults by rating companies.
Moody’s Investors Service forecasts an increase in the overall number of distressed exchanges amid the economic downturn stemming from the coronavirus pandemic and low oil prices. Fitch Ratings said the “price dislocation” in high-yield bond markets could lead to a surge in the practice. There have already been a handful of them this year, including Indonesian coal firm Geo Energy Resources Ltd. and Chinese business park developer Yida China Holdings Ltd.
“Distressed exchanges often are just ‘bandages’ and the firm eventually goes bankrupt,” said Edward Altman, a professor emeritus at New York University’s Stern School of Business and director of credit and debt market research at the NYU Salomon Center. Altman, who developed a widely used method called the Z-score for predicting business failures, estimates that up to 40% of distressed exchanges end in bankruptcy within three years.
Winners, Losers
The Covid-19 outbreak and unprecedented lockdowns prompted the International Monetary Fund to predict that the “Great Lockdown” recession would be the steepest in almost a century. If history is any guide, that means there will be a surge in distressed exchanges.
There was a spike in such practices during the global financial crisis, and cases have remained high in recent years as borrowers struggled under debt they had piled on in a decade of cheap money. Distressed exchanges as a share of total defaults rose from around 10% in the years before 2008 to roughly 40% subsequently, according to Moody’s in March.
In the practice, borrowers offer creditors new or restructured debt securities in exchange for the ones they hold. Companies can also offer cash to buy back notes at a substantial discount to the principal. In sum, the packages amount to less than what the firms originally owed.
Distressed exchanges can be acrimonious at times, as was the case for Chinese firm Asia Aluminum Holdings Ltd., where bondholders formed a group to oppose a buyback proposal in 2009, as they felt it was too low. The company eventually canceled the bond buyback and liquidators were appointed.
Investors may agree to distressed exchanges for a variety of reasons: they might believe the borrower just needs time to turn things around, or they may feel they would lose more if the company were immediately pushed into liquidation.
In some instances, investors even initiate the discussion with the company to buy back bonds as they are keen to liquidate their holdings and can’t find other buyers, according to Xavier Jean, senior director for corporate ratings at S&P Global Ratings.
While the exchange price may be higher than the current market price, it is important for investors to look beyond short-term mark-to-market gains as they don’t get their principal back, according to Raymond Chia, head of credit research for Asia-excluding Japan at Schroder Investment Management.
The winner in distressed exchanges is “always the company” and the loser is the investor, he said.
