Inflation, rising rates, the US presidential election in less than a year, war in the Middle East and Ukraine are geopolitical realities that are likely to adversely impact the bond market or at least increase the volatility in those markets. Over the past 2 years as the Fed has pushed short term rates up, longer term yields have been remarkably stable in the 4-5% range for the 10-year benchmark US Treasury bond as investors seem satisfied that inflation is tamed at least in the short run.
However, the rapid transition from Zero Interest Rate Policy (“ZIRP”) to a real base rate risk-free rate is not without risk. It is likely to catch several corporate management teams and private equity firms offsides as they struggle to refinance and/or service the heavier debt service that comes with a materially higher risk- free rate. This month, we will look at the implications for investors and management from this sea change.
Despite the relatively low level of corporate defaults, there have been some large high profile defaults including WeWork while J&J’s talc powder business is facing the weight of tort claims. Even in the higher risk, higher yielding sub-investment grade debt world, there is a massive distinction between performing and non-performing credit. Most companies, even highly leveraged ones, remain solvent and out of Chapter 11 or 7. However, when a company misses financial projections or has a large legal liability, the debt often trades at distressed levels. Traditionally, stressed/distressed has been defined as corporate debt that trades 1000 basis points wide of treasuries. This topic is especially noteworthy given the explosion in private credit issuance and a likely jump in defaults (which has yet to occur).
A corporate board of directors has a complicated job when the company gets into financial distress. For one, they may bear some if not most of the responsibility for enabling the deteriorating financial condition. They hired the CEO, approved budgets and capital spending and debt levels, etc. However, the real conundrum is to what part of the capital structure they owe allegiance. In normal times, the answer is simple – the stockholders. Putting aside the loaded term of “stakeholders,” shareholders are where a board’s real fiduciary duty lies.
When corporate debt starts to trade down materially (prices in the 70s and below are usually signs of material stress) and coupons and principal are missed, the board and management team face numerous conflicts. The debt holders will become the new equity holders either via a debt-equity swap or via a forced conversion in bankruptcy. Debtholders may want to sell the company, fire the management, and replace the board. They may even want to litigate against the board and management to replace them and collect on the Directors and Officers Insurance policy. The board’s primary fiduciary obligation is to enhance and preserve equity value, until almost every avenue is exhausted. When an exchange or Chapter 11 becomes inevitable, a board should change its allegiance.
Given the complexities of debt restructuring, the conflicts between equity and debt holders and between senior and junior creditors for control and value maximization are at the heart of every deal/case. As we see more issuance – especially by private credit funds not used to workouts, the process is likely to get far messier. This lack of experience can increase the cost of capital for High Yield issuers and investors will demand higher rates and tighter covenants to compensate for increased event risk and the cost of inter creditor battles that inevitably arise as different tranches of debt (secured vs. unsecured for example) fight over a fixed or even shrinking corporate pie as legal expenses mount.
Next month, we will profile the new year and what US elections could mean for the bond markets.
This document does not constitute or form part of any offer of asset management products or services in any jurisdiction. Furthermore, this document does neither constitute an offer of asset management products or services.
The value of investments and any income generated may go down as well as up and is not guaranteed. You may not get back the amount originally invested. Past performance is not necessarily a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.
The information and opinions contained in this document are for background purposes only, and do not purport to be full or complete. No representation, warranty or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by any of Appomattox Advisory, Inc., its partners or employees and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions. As such, no reliance may be placed for any purpose on the information and opinions contained in this document.
Significant differences in returns, risks and correlations may occur within sub-periods of the periods shown. Historical investment performance and market characteristics may not be indicative of future investment performance or market characteristics. There are frequently sharp differences between the hypothetical performance results and the results subsequently achieved by any particular trading or investment program.
