Toys R Us made an interesting financing move last week in the form of an upsized bond deal.

The toy retailer issued high yield bonds in order to refinance two real estate loans and put itself on better footing for the year ahead. And sources said we could see more such refinancings.

The Wayne, N.J.-based toy retailer upsized its proposed $650 million deal and priced $725 million in 8.5% senior secured notes due 2017. Bank of America Merrill Lynch, Goldman Sachs, Deutsche Bank and Wells Fargo were the joint bookrunners on the deal. The notes priced with an OID of 98.57 to yield 8.75%, which was in line with price talk.

The company issued the new bonds through a subsidiary, Giraffe Properties, which it renamed Toys R Us Property Co. II. Toys R Us will use the funds to repay its existing senior secured real estate loan and security agreement and related mezzanine debt totaling $600 million as well as a subsidiary’s senior secured real estate loan and security agreement worth $200 million. This marks the rare occasion that a corporate issuer has tapped the junk market to refinance CMBS.

Credit Market’s Bad Situation

The CMBS market has been hit hard by the recession. The default and delinquency rate for CMBS loans has risen to 4.52% from 0.8% since this time last year, and from 3% in the second quarter, according to Reis, a data provider for the commercial real estate market.

Defaults may top 6% by the end of the year. Overall, U.S. commercial real estate values have fallen about 40% from their peaks in 2007.

“From a liquidity perspective, it’s a big positive,” said Charles O’Shea, a senior analyst with Moody’s Investors Service. “[CMBS maturities were] one of the things we were concerned about. ... They didn’t mature until next August, but we were looking at a 13-month window, and we knew the CMBS market was pretty dicey.”

It was the second time this year that the toy seller had come to the high yield market. This past summer, Toys R Us issued $950 million in 10.75% senior notes due 2017. The bonds priced with an OID of 97.40, netting the company $925.3 million and bringing the total yield to 11.25%, which was slightly above the price talk of 10.75% to 11%. Banc of America Securities, Deutsche Bank, Goldman Sachs and Wachovia were the joint bookrunners.

In addition to the debt issued this year, Toys R Us has $500 million in outstanding 7.625% senior notes due 2011, $400 million in 7.375% senior notes due 2018 and $400 million in 7.875% senior notes due 2013. It also has a senior secured term loan due 2012.

Thanks to its addressing these upcoming debt maturities, the company earned upgrades in its outlook from both Moody’s and Standard & Poor’s. Moody’s rated the notes 'Ba2' and upgraded the company’s outlook to positive. S&P assigned a 'B+' rating to the new bonds and upgraded the outlook to stable from negative.

Toys R Us finds itself refinancing CMBS because, unlike most large retailers, it owns much of its own real estate. “Most retailers do not own a lot of real estate, but Toys R Us does, so they are able to pledge those as security,” said Ana Lai, an analyst with S&P. She points out that while this keeps the company’s costs lower, by using its properties to securitize debt it is now effectively paying rent on them, which neutralizes what would normally be an advantage for the toy store operator.

But while the company may have lost its property advantage, it has taken steps to make itself more competitive in today’s market.

“Toys has taken the best body punches that Wal-Mart and Target can dish out and is still standing,” O’Shea said.

While Wal-Mart and Target have grabbed a larger share of toy sales over the last several years, Toys R Us has adapted by streamlining its inventory, expanding into shopping malls, and appealing to high-end customers able to buy out of the big box retailers’ price range. Toys R Us has done a better job promoting its babies business, improving the layout of its stores and increasing its operating discipline, O’Shea said.

A Rare Giraffe

That the company issued new high yield bonds to refinance its CMBS debt may set it apart from others. But that’s not to say that other retailers or companies with CMBS holdings won’t tap the junk market to refinance. “People who are under pressure with their capital structures will seek the market that will solve their problem,” said Robert Grien, managing director and head of the finance and restructuring advisory group for TM Capital. “And if the high yield market can solve their problem, smart issuers will take advantage of that and live to play another day.”

Grien adds that the strong flows of capital heading into high yield make it more likely to be the market refinancing different types of debt instruments. “Where you’ve had large corporate borrowers using CMBS-type structures, you might see them coming to high yield,” he said. “More capital has been flowing into the high yield market than the loan market, and in the current environment it seems like it’s going to persist for a while.”

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