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Qwest's (Q) debt-swap pitch cleared a legal challenge, putting bondholders' vote on the controversial deal on track for Friday.

U.S. District Judge Denny Chin on Wednesday denied a request to block Qwest's proposed $12.9 billion bond refinancing plan. Four bondholders had sought an injunction, claiming that the deal was a coercive in that it forces investors to either accept a reduction in principal amounts outstanding or risk being bumped down the credit hierarchy.

That prospect isn't pleasing to Qwest bondholders, who are already concerned about whether they'll get repaid when their paper comes due. "The whole deal appears to be legal, albeit dicey," says debt watchdog Glenn Reynolds of CreditSights.

Qwest applauded the decision and plans to complete solicitation for the tender offer by midnight Friday.

The scandal-plagued, financially strapped Denver-based local phone giant hopes to persuade creditors to tear up the old bonds and take new bonds that mature five to 12 years from now. While the debt exchange will free Qwest from some near-term maturities and help reduce its $26 billion in total debt, the new bonds carry interest rates between 13% and 14% -- nearly double the old rates.

In fact, if Qwest gets 100% participation in the swap, it will actually increase the company's annual interest expenses by about $90 million, or 10%, according to estimates by J.P. Morgan debt analyst Avi Benus.

The bond swap is the second major move by Qwest to mend its financial structure. In August, Qwest

agreed to sell its yellow pages business in two parts for $7 billion to help pay off some lenders and stay afloat.

Among the bondholders, opposition to the swap has largely come from two camps. One group, bondholders who bought the now heavily discounted paper at par, don't want a trade because it means they would be pushed toward the back of the creditors' line by the new buyers. This could be a crucial matter in the event Qwest becomes insolvent.

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"This tender is coercive, with the club being the fact you get will get so structurally subordinated, your seat will be in the alley if they filed Chapter 11, while the banks would be up in the leather chairs," says CreditSights' Reynolds.

The other group is that of the more recent Qwest bond buyers who snapped up the paper at 30 to 40 cents on the dollar. These folks have seen their investment appreciate substantially from earlier lows. For many in this group, the swap would crimp higher profits.

Of course, to sweeten the exchange, Qwest had to offer to nearly double its interest rates, but observers say it's also likely that collateral and perhaps some cash could be thrown in if necessary to swing the deal.

Some bondholders also complain that the swap does more for the equity holders than for the creditors. By lowering the overall debt and pushing out maturities, Qwest squeezes the bondholders but improves its overall financial picture. To support that contention, bondholders point out that Qwest's stock is up 24% since it proposed the debt swap last month.

Debt experts such as Gimme Credit analyst Carol Levenson say that given the acrimony created by this offer, Qwest may not find the bond market altogether friendly in the future.

"I guess," says Levenson, "Qwest isn't planning on ever tapping the public bond market again."

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