Distressed US companies are increasingly resorting to debt restructurings to avoid expensive bankruptcy proceedings, but many borrowers ultimately end up in court anyway — with their deals amounting to little more than “can-kicking” exercises.
Almost three-quarters of US corporate debt defaults last year were out-of-court “distressed exchanges”, where a company offers creditors assets worth less than their original bonds or loans, according to a report by Moody’s this month. That is up from roughly half in 2020, the rating agency said.
Moody’s predicts that far-reaching private equity ownership of companies with very weak ratings will further fuel the growth of distressed exchanges because this type of restructuring can protect such backers’ investments.
“Private equity sponsors heavily favour distressed exchanges as a debt restructuring tool of choice because it helps them sidestep bankruptcy and preserves their equity,” Moody’s said.
However, many businesses default again following such restructurings. The “re-default” rate monitored by Moody’s currently stands at 47 per cent.
Some companies are “just kicking the can” with distressed exchanges and merely delaying an inevitable bankruptcy, said Sinjin Bowron, head of high-yield and leveraged loans at Beach Point Capital Management.
“In the event that there’s a distressed exchange at a company, not only are you potentially losing asset value as a lender” he said. “But also, if the company is having operational difficulties, then it doesn’t necessarily fix those problems.”
Of the companies tracked by Moody’s that defaulted a second time, the majority ended up in bankruptcy. Mattress company Serta Simmons entered bankruptcy proceedings in January. KKR-backed Envision Healthcare is also reportedly considering filing for bankruptcy, according to the Wall Street Journal, while retailer Bed, Bath and Beyond — not backed by private equity — filed for Chapter 11 on Sunday after a distressed exchange in 2022.
Envision did not respond to a request for comment.
The accelerating trend underscores the challenges faced by distressed companies that face a combination of rising borrowing costs and a slowing economy. These difficulties, and investor scrutiny of such businesses, are likely to intensify this year against a backdrop of rising recession fears.
Rating agency S&P sees the US junk-grade default rate reaching 4 per cent by December, from a rate of 2.5 per cent in the 12 months to March. Moody’s anticipates a US rate of 5.6 per cent by next March, up sharply from its own figure of 2.7 per cent as of March 31.
As more companies are forced to renege on their borrowings, some may opt for exchanges because they believe “the business overall is sustainable” with a lower debt load, said Matt Mish, head of credit strategy at UBS. “Heading into a more difficult financial environment, they want to resize the capital structure,” he added.
The proliferation of distressed exchanges follows a dealmaking frenzy when buyout groups took advantage of cheap borrowing costs to pile leverage on to lowly rated companies with already creaking balance sheets, funding billions of dollars’ worth of mergers and acquisitions.
In recent years, much of this debt has comprised leveraged loans, instruments sold by “junk” grade businesses, whose coupons move with prevailing interest rates. These were considered attractive when monetary policy was ultra-loose — with issuance roughly doubling to $615bn between 2019 and 2021 as interest rates plunged early in the Covid pandemic, according to data provider LCD — but have lost their appeal as the Federal Reserve embarked on its most aggressive campaign of interest rate rises in decades to tame inflation.
High-yield or sub-investment-grade corporate bond issuance also picked up as interest rates were slashed after the outbreak of Covid, reaching $465bn, compared with $263bn in 2019, according to Refinitiv data.
Historically, unsecured bonds — debt not backed by company assets — were usually restructured in distressed exchanges. However, since the start of the pandemic, the rising number of defaulting “loan-only” borrowers without bonds has changed that dynamic.
At first glance, distressed exchanges can be appealing to lenders who typically recover a greater proportion of their outlay than they would in a bankruptcy, according to Julia Chursin, senior analyst at Moody’s.
But the current repeat rate for defaults means that often, “you get hit once, then a second time — your recovery rate deteriorates”, Chursin said.
Historical data for unsecured bonds indicates that if a company goes through a distressed exchange, then files for bankruptcy, “[creditors’] losses can accumulate and it can be worse than just filing for bankruptcy”.
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