In movies, make-up and markets, anguish comes roaring back

With interest rates so low for so long and even the riskiest companies able to find willing lenders, opportunities for investors in distressed debt were few and far between for some time. But now, as inflation soars and the Federal Reserve begins aggressively raising rates to keep them in check, all that is changing.

Data compiled by Bloomberg showed that as of September 9, corporate bond and loan trading at distress levels had risen to $189 billion, a 6.4% increase from just a week earlier and that 59 US companies were have declared bankruptcy so far this year. Three of them, each with more than $50 million in liabilities, also occurred during the first week of September. The most important of these was Cineworld Group, Plc., the world’s second largest movie chain with more than 500 theaters in the US under the Regal Cinemas name. That company, which has about $4.8 billion in debt not counting leases, won’t benefit from the rally in meme stock that previously saved AMC Entertainment.

What happens to the Regal Cinemas chain as Cineworld makes its way through bankruptcy will be a movie worth watching, but a more interesting story for the nuanced follower of struggling debt is Revlon.
. That company filed for Chapter 11 protection in June with $3.3 billion in debt. Revlon is a 90 year old brand name cosmetics company with strong name recognition. Still, it has struggled in recent years, as new celebrity-owned lines like Kylie Cosmetics and Fenty Beauty have attracted younger consumers. It has also been plagued by the same issues as so many other brands in the retail space: supply chain disruption and Covid-related issues, along with excessive leverage.

In 2020, Revlon attempted to refinance and replace some of its previous debt with new issues. That created a new problem for the company, which affected its bankruptcy process. Citi Group
who was Revlon’s debt broker, when he intended to pay creditors $9 million in interest, he missed a couple of zeros and instead paid $900 million to a group of syndicated lenders.

Citigroup asked for the money back, but a group of funds that held about $500 million of the debt refused. They claimed that the refinancing that Citigroup was working on with Revlon was unfair. Earlier this year, a judge agreed with them, ruling that the law allowed them to keep the money because, in part, they had no reason at the time to believe the payment was wrong. Citigroup filed a preemptive subrogation lawsuit in bankruptcy court stating that the bank was owed at least $500 million and, if not paid, was entitled to become a bankruptcy plaintiff for that amount. In its filing, the company told the court that this litigation was hampering its efforts to raise capital because it was unable to identify its creditors.

The situation became somewhat clear earlier this month when the US Court of Appeals for the Second Circuit in New York reversed the earlier ruling and declared that Citigroup could recover the money. How much of that half a billion in misdirected funds is actually returned is unknown. Among the creditors repaid are Cayman Islands-based hedge funds, and some of them may have been liquidated along the way. But however it turns out for Citigroup, the new ruling clarifies Revlon’s bankruptcy and will let it know who its creditors are before it proposes a bankruptcy plan that is expected in court in mid-November.

The Cineworld and Revlon bankruptcies are two of the most high-profile events in the world of distressed investing, but recent macro events seem to indicate that there is much more to come.

First, Jerome Powell’s Jackson Hole speech indicated the Fed’s willingness to continue raising interest rates to temper inflation. He said, “We’ll keep doing it until we’re sure the job is done.” And while Powell didn’t address it in his comments, in all likelihood, the Fed will also continue to try to reduce the size of its balance sheet.

Then there is what has been happening with junk bonds. Last year, a report issued by JP Morgan showed trading in junk-rated paper with yields in many cases below 5% to maturity. In practical terms, that indicated that fixed income security prices had skyrocketed, and even riskier borrowers could borrow at rates below 5%, and in some cases even below 2%!

That was then. Now we are starting to see a big reset. Each bond has fallen in price with corresponding increases in the yield to maturity. It is now much more common to see prices in the 7-9% range for junk-rated bonds. Those with problems or difficulties are trading with much higher returns, some as high as 30% or more. With what the Fed has been saying, that trend still has room to go, as a normal level for junk-rated paper is rightly in the double digits, not the single high digits.

Based on these indicators, it is reasonable to assume that we will see much more distress in the coming months. They may not be high-profile names like Revlon or Regal, but there will be other companies that have saddled themselves with debt over the last decade and are now being forced to reckon with the new environment. We are seeing it everywhere in fixed income. So far this year, broad fixed income indices have dropped considerably. Even Treasury indices are down 20%, the biggest drop in a year, and most fixed-income securities are priced at government benchmarks.

If the problems in the fixed income market continue like we have seen this year, that guarantees that you will have a lot more difficulties. This is because, as companies reach their debt maturity dates, there is less and less demand for the new securities they need to issue to refinance maturing debt. And for some of them, the window could close completely. We’re seeing big YTD outflows from bond mutual funds and ETFs because investors have taken big losses in those markets this year. As the market resets for the long term, there are likely to be more and more opportunities to selectively find interesting value investments among the growing carnage of distressed debt.

It is very difficult for people to invest in the distressed debt of a company like Revlon or Cineworld. Still, companies like these can be outstanding long-term investments if you can buy them at the right price through a professional asset manager. Revlon, on the other hand, has publicly traded shares, meaning investors could make a play by selling their shares short.

In fact, short selling has become an increasingly interesting opportunity right now. There are many companies whose business plans are in flux due to inflation, supply chain bottlenecks, Covid issues, and uncertain commodity prices. And companies affected by those conditions that are also over-leveraged are much more likely to go bankrupt, especially if we have a recession. For investors who don’t have the ability or the appetite to do this on their own, now might be a good time to choose an experienced investment manager to help them navigate these choppy waters.

Revlon might also offer some advantages to long-term, patient investors because it’s a good deal. It has great brands and strong cash flows and revenues despite having a temporarily leveraged capital structure.

Many other companies are likely to face problems in the coming months. Still, investors should be wary, not only of struggling companies, but also of their regular stock investments, unless they can find some with short-lived cash returns. Those are companies that are cheap to start with, but also have very short-term plans to return cash to shareholders through large dividends and/or share buybacks.

As we’ve said before, even in the gloomiest of markets, there are usually some opportunities for investors willing to do their homework to find them. Right now, a good place to look is in the energy space. Some companies that produce oil or natural gas are generating so much cash flow right now that they can reward their shareholders by returning their capital quickly.

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