Meet the Street: Assessing the Debt Landscape

Among the things we hopefully bid adieu to last year was the record level of telecom credit defaults. And what a year it was. The default rate for high-yield telecom debt was one in four issues, while the previous high was one in 10 back in 1991 during the last recession.

Glenn Reynolds, Debt Analyst, CreditSights

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The record number of defaults has meant it's been a busy time for Glenn Reynolds, a debt watchdog for CreditSights, an independent New York-based research shop. Reynolds has been keeping track of bankruptcies, bond buybacks -- where companies feel their limited cash reserves are best used to repurchase their junk bonds -- and convertible debt deals, in which companies desperate for cash sell bonds that generally pay a high interest rate and also can be converted into shares.

Here he discusses the reasons for the rise in convertible issuance and bond buybacks, and warning signs that a company may be at risk of default.

TSC: Glenn, one of the trends we saw take off last year was convertible debt deals. They seemed to start with distressed tech companies like Lucent and eventually spread across the financial community. We saw Best Buy turn in a $350 million deal Wednesday. What's behind that trend? And is it a sign of weakness or strength?

Reynolds: A wide range of companies have done it. Some companies are growth companies, others are fallen angels. There are all different strategic backdrops for the different issuers, but the point is it's a strong source of demand and a very well-established asset class now because a lot of money is flowing into the market.

There are a lot of strong companies doing it, but you could probably say most are not mainstream corporate debt issuers. The bulk of the market tends to be tech, biotech and high-yield companies trying to fix their balance sheets. It was good for Lucent to do it. It was their lifeline. If they didn't do it, they would have been pricing headstones.

As to what's behind it, in theory this could be the world's greatest asset class if you know how to put your money to work. The folks that operate in convertibles have the ability to effectively manage their risk by playing the stock off the debt. It's the ultimate connection point finally between the world of debt and the world of equity. Hedge funds will often hedge or balance out the credit risk by shorting the equity.

TSC: What do you think of companies that use their cash to buy back bonds?

Reynolds: If a company is able to buy back their bonds well below par, then they are retiring debt at a fraction of face value. If a company has the flexibility to do that, then they are probably taking positive steps. But if it's coercive and they are forced to buy back bonds, they are probably in some form of restructuring.

TSC: It's been argued that if a company is teetering on the brink of bankruptcy, it's best for it to restructure early while it can still salvage the business. Where do you stand on that?

Reynolds: It's a tactic of a last resort. If you wipe out your equity, you wipe out your incentive programs for management and employees. In the world of tech, that would promote brain drain, and you could easily destroy a company by doing that.

But there's a difference between service companies and tech companies. In tech companies, the value is your intellectual capital, and losing your talent could be the kiss of death. For service companies, it's another story. Once an idea is up and running, you could make a case it would preserve your liquidity to restructure your debt and give new options to the management team. Once you get in a situation where a business isn't generating enough cash to service the debt, then early bankruptcy makes sense.

TSC: What should shareholders be aware of so they can avoid watching their investment go to zero? What signs should they be looking for from the debt side of a company?

Reynolds: One thing to keep an eye on is the credit issues. If a company is in the convertible bond market and you start to see their credit quality erode, it will quickly get signaled down into the stock market. Hedge funds and people who are more plugged into the credit side of the story use credit risk as a leading indicator and will short the equity. One of the risks of the rapid growth of the convertible bond market is you have a lot more equity players who've become very sophisticated about credit risk. It used to be that people assumed the stock leads the debt, but that's not always the case anymore.

One of the worst early signs for Lucent was when the banks forced them to pledge assets when they were still investment grade back in the first quarter of last year. That was the beginning of the end. It showed a distinct lack of confidence from their lenders.

TSC: Of the companies you look at, which are the top three most at risk for default?

Reynolds: I'll start with our favorite, Lucent. While they did a good job of restructuring and shoring up cash flows, accessing the convertible market and selling assets whenever they could, they still have billions of dollars worth of debt splashing around with reduced bank credit lines. At some point they are going to have to pay down some of that financial risk. And that means throwing out free cash flow or issuing new stock. They still have a long way to go.

Motorola is another. They have a lot of cash and balance sheet liquidity because they keep issuing bonds, but they also have a debt-laden balance sheet that they are going to need to address.

And the other is Nortel. Though they aren't a Lucent lookalike yet, their credit is on the cusp of going below investment grade.