OVERVIEW OF DISTRESSED DEBT SECURITIES

Investing in distressed debt securities involves a more comprehensive analytical skill set than more traditional securities investing—like Treasuries, municipals, and investment‐grade corporate bonds. While traditional investments require an investor to understand market risk and credit risk, distressed debt investors require additional skills depending upon the distressed debt scenario. The distressed debt investor may need to be a little bit research analyst, bankruptcy lawyer, accountant, cash flow modeler, forecaster, asset evaluator, and gambler. In addition, patience and confidence in their valuation methodology are essential qualities for distressed securities investors.

While there is no established definition of distressed debt securities, these securities are generally debt securities issued by corporations, governments, or municipalities that are undergoing severe financial stress and either are currently in bankruptcy proceedings or are in need of financial support, restructuring of debt, a reorganization of the company, and/or relief, which may include a plan of reorganization under Chapter 11 or a plan of liquidation under Chapter 7 of the U.S. Bankruptcy Code.^1,2 Factors that may place the issuers under such financial stress may include, but are not limited to, the following:

• The issuer has experienced operational difficulties due to competition, loss of customers, declining profit margins, customers being forced to cut back in orders, new government regulation, recession, and so on.
• Global market liquidity problems (e.g., financial crisis of 2008).
• Issuer is highly leveraged with a large amount of outstanding debt, which drains cash flow.
• The company is experiencing cash flow difficulties due to the timing on receipt of cash payments.
• Issuer is unable to make interest payments on debt or is expected in the near future to be unable to meet interest payment obligations.
• Issuer is unable to make principal payments on debt or is expected in the near future to be unable to meet principal payment obligations.
• Issuer's financial condition has made them unable to access the short‐term commercial paper markets for funding.
• Issuer's financial condition has made them unable to access longer‐term capital markets for funding.
• Issuer's financial condition has made them unable to access bank loan market for funding.
• Company has significant exposure to lawsuits and judgments (e.g., companies with asbestos liabilities).
• Accounting irregularities or restatements.
• Sovereign or municipal issuer cannot stimulate economic growth and increase private investment, employment, and/or tax revenue.
• Sovereign or municipal issuer generates consistent budget deficits and funds the deficits by issuing more debt.

Distressed debt securities are rated below investment grade by the two major ratings agencies, Moody's and Standard & Poor's. A below‐investment‐grade rating is below Baa3 for Moody's and BBB– for Standard & Poor's. The vast majority of these securities, if they maintain a rating, will be well below the investment‐grade breakpoint and are more likely to be rated C or D or be unrated due to default. Some of the securities may have been investment‐grade rated when they were first issued, but experienced financial difficulties and a significant downgrade after issuance to result in a below‐investment‐grade rating. Others may have been issued as “junk” bonds or below‐investment‐grade rated and experienced further financial difficulties to become distressed securities. They can be publicly traded securities that are held by all types of investors or privately issued securities that were issued under the private placement exemptions of the Securities Act of 1933 and are held by institutional investors. Bank loans, while not securities, can also constitute a portion of the distressed debt market.³

WHAT CONSTITUTES “DISTRESS”

For the vast majority of below‐investment‐grade companies, access to capital is a critical, everyday function. Once a company is classified as distressed, the willingness of investors or banks to either invest or lend is greatly diminished. While it is somewhat subjective as to whether a company is a distressed security while it is still paying its debt obligations, once a company misses an interest payment, principal payment, or declares a debt moratorium (i.e., a delay in the payment of its debt obligations), the debt clearly enters the realm of distressed debt.^4,5,6 For example, consider Company A with poor financial ratios (e.g., poor interest coverage, which is a ratio used to determine how easily a company's earnings can sustain its debt, and weak EBITDA—earnings before interest, taxes, depreciation, and amortization) results. Company A is a diversified chemical manufacturer with several noncore assets up for sale. The chemical industry is very cyclical and the company is at a downturn in the business cycle. Company A has enough free cash flow to remain current on interest payments but it is unlikely it will be able to make the principal payments it has coming due in six months. The company has several options:

1. Miss the principal payment and be in default.
2. Initiate an exchange offer to existing debt securities holders to extend the maturity (while presumably increasing the coupon) of the bond offering coming due in six months.
3. Sell noncore assets and use the money generated to remain current on the company's debt obligations.

Obtaining a bank or syndicated bank loan is not a viable option because the company's ability to pay its obligations will be severely discounted, resulting in either no banks being willing to provide loans or, in the unique case where a bank or bank syndicate (or hedge fund) will loan funds to this company, the interest rate and terms of loan being so egregious as to prevent the company from accepting such terms. In options 1 and 2, Company A would no doubt be considered a distressed issuer. In option 3, though, the sale of assets may help the company raise cash and the amount of such funds may enable the company to make such a principal payment. If it makes such a principal payment, Company A's prospects will look better to investors, presumably justifying a tighter trading spread compared to U.S. Treasuries or an equivalent benchmark.

TRADING MARKET FOR DISTRESSED DEBT

The distressed debt investor is willing to assume a greater amount of risk than most traditional investors. They are looking for a much greater yield that a traditional investment‐grade investor and in some cases a “homerun” investment, so they are willing to assume greater risk in search of the greater reward with large upside on their investment.

Distressed debt securities have very poor market liquidity. The financial problems of the issuer have scared away traditional investors. In addition, most mutual funds, pension funds, and retirement plans cannot own distressed debt securities. Hence, the illiquidity leads to the main investor base being hedge funds and “vulture investors”—those looking to capitalize on another's problems. The bid–offer spread on distressed securities—which is indicative of the liquidity and risk involved in investing in such securities—can be very wide and range anywhere from 2 to 5 points for the more liquid names up to a 10‐point bid–offer spread for the extremely distressed or illiquid. In addition, these securities generally trade on a dollar price rather than a yield to maturity. This is reflective of the intrinsic value that the investor sees in the securities and/or assets of the company in a recovery scenario and the fact that the investor does not believe that the securities will continue to pay interest and/or principal until maturity. Distressed securities trade at a significant discount to par and may trade as low as cents on the dollar (e.g., $5, $10, $30, $40 to a $100 par price depending upon the specific credit, liquidity, and risk involved), although exceptions may exist. These securities generally trade on a spread over Treasuries, or their equivalent benchmark, of more than 1,000 basis points.

The distressed debt investor is looking for a high return scenario and sees opportunity where others view dire straits. While these scenarios are highly speculative and differ from situation to situation, generally, the distressed investor has the necessary resources to do the research and investigative work needed to arrive at a potential value of the issuer's securities and/or its assets. The investor can then calculate a probability analysis of each scenario occurring and the likely value within each scenario. Again, this is highly speculative investment and the investor base needs the “stomach” to withstand the rollercoaster ride that can occur with investments in distressed debt securities.

If the distressed debt investor believes that the distressed issuer may be able to withstand the current financial stress and become profitable, then purchasing equity securities may be the better investment. However, if the investor believes that there is a likelihood that an issuer may have to restructure and/or file bankruptcy, then debt securities are the preferred investment exposure to the issuer as debt securities will have priority of payment over equity securities when an issuer files bankruptcy. The equity securities holders will be wiped out in a Chapter 7 or 11 bankruptcy filing. This does not guarantee that the distressed debt investor will receive full payment under the debt instrument or even return of their original investment. It is possible that the issuer may have claims (such as tax liability) that have a priority over the debt securities in the payment of claims under the U.S. Bankruptcy Code and could use up all of the cash that is generated from a liquidation of assets. It is up to the distressed debt securities investor to understand the company's financial situation, total assets and liabilities, amount of claims and tax liability, the amount of debt outstanding, the priority of the debt securities over other claims and tax liability, and the estimated value of the assets and liabilities after payment of prioritized claims in determining what value would remain to pay the debt securities.^7,8,9

TRADING STRATEGY ON THE DISTRESSED DEBT

The distressed debt investor may be seeking different objectives depending upon the issuer's scenario. For example, Issuer A may be a company that the distressed debt investor believes to be able to withstand short‐term financial difficulties and the investor believes has securities that are undervalued. In this case, the investor may be waiting for the company to have a few quarters of positive results under the belief that the market will digest this news and the securities will rise in value and the investor can then sell the securities at a profit. In another scenario, the distressed debt investor may see a company that is highly leveraged. The company may have a good, viable business with growth and valuable assets and growing revenue, but it is saddled with high interest debt. The distressed debt investor may look to buy all of the outstanding debt and control the company's debt securities. In this case, the investor may believe it could negotiate with the company to exchange its debt for equity—and now you have a company with revenue and growth that is no longer saddled with payment obligations on high‐interest debt securities. In the alternative, maybe the investor believes they can negotiate with the issuer to reduce the interest rate or swap a certain amount of outstanding principal on the debt securities for equity whereby the company now has reduced debt and the investor now still controls the debt but also owns equity in the issuer. It's also possible the distressed debt securities investor has in mind to change management or gain some control on the board of directors to influence company management and will use their control of the debt securities to pressure the company to implement corporate change. These are simplistic scenarios as outlined, and in most real‐life scenarios the issues are much more complicated, but the scenarios outline what an investor may be seeking under various distressed debt situations.^10,11,12

PUERTO RICO: A DISTRESSED SITUATION

Puerto Rico is a commonwealth territory of the United States and its debt securities trade in the municipal securities market. Puerto Rico debt securities were attractive investments due to their triple‐tax‐exempt status—they are exempt from federal, state, and local income taxes—in all 50 states. Puerto Rico General Obligation bonds were investment‐grade rated by both Moody's and Standard & Poor's as recently as early February 2014. Since then, both rating agencies have downgraded Puerto Rico's debt multiple times to Caa3 by Moody's and CC by Standard & Poor's. Puerto Rico has defaulted on certain debt securities and has indicated that it will not be able to make the interest or principal payments required under its bond issuances and will default on more issuances in the future (with July 1, 2016, looming as another possible default date as of the time of this writing). Currently, Puerto Rico securities trade as low as the price of 50 (with a par of 100). Investors who purchased their bonds at par are left with the prospect of having the value of their investment portfolio reduced to a fraction of their original investment. In addition, with Puerto Rico now in default, they are left with the possibly of having to accept reduced interest payments over a longer period of time or possibly a reduced principal amount under a plan of debt restructure. However, distressed debt investors view Puerto Rico as an opportunity and the vast majority of bonds trading today are between hedge funds and large, institutional customers.

How did Puerto Rico get in a situation where its debt securities trade as distressed? It began when tax breaks to U.S. companies with operations in Puerto Rico ended and these companies began to move back to the United States or other tax‐beneficial locations, resulting in a loss of tax revenue and jobs. Unemployment in Puerto Rico has reached approximately 12% as compared to the overall U.S. unemployment rate at just under 5%. High unemployment and a stagnant economy has forced many of its citizens to take advantage of their U.S. citizenship and move to the mainland United States for employment. With declining corporate and personal income tax revenue, Puerto Rico resorted to issuing debt to balance its budget. The addition of this method of deficit financing to Puerto Rico's already heavy debt burden has pushed the total amount of the debt outstanding to over $70 billion. Given the dwindling tax base, declining per‐capita income, and the continuing population exodus, it is clear that Puerto Rico will be unable to meet its obligations to its bondholders as well as its pension liabilities and other creditors. The only possible resolution is for a massive restructuring of all of Puerto Rico's debt and the imposition of austerity measures in the budgeting process.^13,14

THE SOVEREIGN DEBT CRISIS

Another well publicized distressed debt scenario that made headlines over the past few years has been the Greek debt crisis. During the global financial crisis in 2008 and 2009, certain European countries experienced a sovereign debt crisis. The most widely known countries were Portugal, Italy, Ireland, Greece, and Spain—also referred to as the PIGS. These euro member states were unable to repay or refinance their debt. In addition, they were unable to bail out the troubled banks within their home country. They required the assistance of the European Central Bank (ECB), The International Monetary Fund (IMF), and other European countries. Each country had its own problems that led to its sovereign debt crisis. Whether it was a real estate bubble that left banks with huge amounts of defaulted loans, ballooning government debt and deficits, poor management of fiscal policy and economic growth programs, the financial crisis and recession of 2007–2012, failure of the Eurozone countries to react and implement stimulus packages, or a combination of these factors, these countries faced significant financial difficulties and fear spread that a contagion of defaults in sovereign debt could occur without bailouts of these countries' debt and the debt securities of the PIGS began trading as distressed debt.¹⁵

GREECE

In this section, we will focus on the issues surrounding Greece's sovereign debt crisis, the bailouts, and the fears of default on its sovereign debt, all of which causes Greece's sovereign debt to trade as distressed debt. Greece is part of the European Union (EU) and has implemented the euro as its currency. This means that the EU—via the European Central Bank (ECB)—sets monetary policy (i.e., interest rates), but each member country sets fiscal policy (i.e., amount of debt outstanding). The issue this created is that the smaller European member countries that may have previously issued debt at higher interest rates now effectively had the ability to issue debt at lower rates. Whether it was the perception that Greek credit was stronger as part of EU or the market simply chasing higher yields in sovereign debt, Greece was issuing debt at lower interest rates than it could when it was not an EU member. Greece—which has high pension liabilities, a stagnant economy, and low tax receipts—ran up deficits year after year. These factors, along with the effects of the financial crisis of 2007–2008, the severe recession, and low foreign investment and wages, all lead to a lack of economic growth, large deficits, and a huge amount of debt. As interest rates made it cheap to borrow money, Greece continued to borrow money by issuing debt via the sovereign debt market to finance these budget deficits. The combination of these factors along with a crisis of confidence in the Greek government, both with their inability to reverse the trends of a failing economy as well as the lack of accuracy of Greek economic statistics being released by the government, led to downgrades in Greek debt to “junk” status in 2010. The capital markets began to digest all this news and the market for Greek debt froze under fears of a sovereign default of Greece under the mountain of Greek debt. Subsequently, multiple bailouts have been necessary by the ECB, the IMF, and certain European countries. The terms of these bailouts required strict austerity measures that required the Greek government to implement cutbacks in spending. All of this has led to worsened economic conditions and the need for further bailouts. At this time, it appears that the distressed debt investors will eventually have to deal with restructured terms that will include reduced interest, extended maturities, lower principal amount returned, and/or a combination of all of these.^16,17,18,19

FINAL THOUGHTS ON DISTRESSED DEBT SECURITIES

As we have seen throughout this chapter, distressed debt investors have a number of issues to consider when deciding to invest in a certain security. They must understand the credit, be able to value the security and the underlying assets, have the ability to understand the implications of the U.S. Bankruptcy Code, and have the ability to compute a value that the debt securities have, both from the market that the securities trade in and in a restructuring or liquidation scenario, and have an exit strategy for any such investment. They must also be able to withstand the lack of liquidity such securities may have in the market as well as the great deal of uncertainty that comes with trafficking in distressed debt securities. Even with the great research and valuation tools that an investor may have with respect to a specific issuer, its assets, and the market for the issuer's securities, there can be a tremendous amount of risk and uncertainty transacting in the distressed debt market and there are plenty of highly sophisticated investors in the distressed market who have been wrong on a distressed credit and wish they had the opportunity to reverse the decision to invest or the price at which they invested.