Among the things we hopefully bid adieu to last year was the recordlevel of telecom credit defaults. And what a year it was. The default ratefor high-yield telecom debt was one in four issues, while the previous highwas one in 10 back in 1991 during the last recession.
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The record number of defaults has meant it's been a busy time for GlennReynolds, a debt watchdog for CreditSights, an independent New York-basedresearch shop. Reynolds has been keeping track of bankruptcies, bondbuybacks -- where companies feel their limited cash reserves are best usedto repurchase their junk bonds -- and convertible debt deals, in whichcompanies desperate for cash sell bonds that generally pay a high interestrate and also can be converted into shares.
Here he discusses the reasons for the rise in convertible issuance andbond buybacks, and warning signs that a company may be at risk ofdefault.
TSC: Glenn, one of the trends we saw take off last year wasconvertible debt deals. They seemed to start with distressed tech companieslike Lucent (LU) and eventually spread across the financial community. We sawBest Buy (BBY) - Get Best Buy Co., Inc. Report turn in a $350 million deal Wednesday. What's behind thattrend? And is it a sign of weakness or strength?
A wide range of companies have done it. Some companiesare growth companies, others are fallen angels. There are all differentstrategic backdrops for the different issuers, but the point is it's astrong source of demand and a very well-established asset class now becausea 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 markettends to be tech, biotech and high-yield companies trying to fix theirbalance sheets. It was good for Lucent to do it. It was their lifeline. Ifthey didn't do it, they would have been pricing headstones.
As to what's behind it, in theory this could be the world's greatestasset class if you know how to put your money to work. The folks thatoperate in convertibles have the ability to effectively manage their risk byplaying the stock off the debt. It's the ultimate connection point finallybetween the world of debt and the world of equity. Hedge funds will oftenhedge or balance out the credit risk by shorting the equity.
TSC: What do you think of companies that use their cash to buy backbonds?
If a company is able to buy back their bonds well belowpar, then they are retiring debt at a fraction of face value. If a companyhas 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 ofbankruptcy, it's best for it to restructure early while it can stillsalvage the business. Where do you stand on that?
It's a tactic of a last resort. If you wipe out yourequity, you wipe out your incentive programs for management and employees.In the world of tech, that would promote brain drain, and you could easilydestroy 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 yourtalent could be the kiss of death. For service companies, it's anotherstory. Once an idea is up and running, you could make a case it wouldpreserve your liquidity to restructure your debt and give new options to themanagement team. Once you get in a situation where a business isn'tgenerating enough cash to service the debt, then early bankruptcy makessense.
TSC: What should shareholders be aware of so they can avoid watchingtheir investment go to zero? What signs should they be looking for from thedebt side of a company?
One thing to keep an eye on is the credit issues. If acompany is in the convertible bond market and you start to see their creditquality erode, it will quickly get signaled down into the stock market.Hedge funds and people who are more plugged into the credit side of thestory use credit risk as a leading indicator and will short the equity. Oneof the risks of the rapid growth of the convertible bond market is you havea lot more equity players who've become very sophisticated about creditrisk. It used to be that people assumed the stock leads the debt, but that'snot always the case anymore.
One of the worst early signs for Lucent was when the banks forced themto pledge assets when they were still investment grade back in the firstquarter of last year. That was the beginning of the end. It showed adistinct lack of confidence from their lenders.
TSC: Of the companies you look at, which are the top three most atrisk for default?
I'll start with our favorite, Lucent. While they did agood job of restructuring and shoring up cash flows, accessing theconvertible market and selling assets whenever they could, they still havebillions of dollars worth of debt splashing around with reduced bank creditlines. At some point they are going to have to pay down some of thatfinancial risk. And that means throwing out free cash flow or issuing newstock. They still have a long way to go.
is another. They have a lot of cash and balance sheetliquidity because they keep issuing bonds, but they also have a debt-ladenbalance sheet that they are going to need to address.
And the other is
. Though they aren't a Lucent lookalike yet,their credit is on the cusp of going below investment grade.