Wave of Coming Bankruptcies Likely to Devastate Corporate Bondholders

Bondholders Lucky to Get 10 Cents in Looming Defaults
By Caroline Salas

April 23 (Bloomberg) -- The looming wave of bankruptcies is unlikely to be kind to bondholders. And they have only themselves to blame.

Rather than receiving the historical average recovery of 42 cents on the dollar in a default, owners of a third of high- yield, high-risk bonds rated B+ or lower may get no more than 10 cents, according to New York-based Fitch Ratings. About 22 percent are likely to get 11 cents to 30 cents.

Bond investors from Pacific Investment Management Co. to Capital Research & Management Co. may pay the price for allowing themselves to be subordinated by junk-rated companies that borrowed a record $2.2 trillion of bank loans in the past three years. Unsecured creditors of Fedders Corp. and Buffets Inc. have lost almost all their money as lenders lay claim to the companies' assets. Standard & Poor's says Burlington Coat Factory Warehouse Corp. and Univision Communications Inc. bondholders may meet a similar fate in a default.

''There've been some disappointments,'' Paul Scanlon, team leader for U.S. high yield and bank debt at Putnam Investments, said in a telephone interview from his Boston office. Putnam manages $66 billion in fixed-income, including bonds of Univision. ''As people look back over the last 24 months, there are many transactions in portfolios that people have hoped the outcome might have proceeded differently than it has.''

More Crucial

Bondholder recovery rates are becoming more crucial as the U.S. economy slows. Chapter 11 business bankruptcies rose 16 percent in the first quarter, according to court records compiled by Jupiter eSources LLC, and Moody's Investors Service said last week that the number of companies at risk of running out of cash is the highest since at least October 2002.

''When leverage was so ample, private equity firms were able to buy companies at multiples that didn't make sense,'' said James Keenan, who oversees $20 billion of high-yield debt as co- head of leveraged finance at BlackRock Inc. in New York. ''Most people use the assumption senior unsecured bonds are going to recover 40 percent. I don't think you're going to see that.''

The amount of debt in Merrill Lynch & Co.'s U.S. High Yield Distressed Index has swelled to $206 billion from $4.8 billion a year ago. The index contains non-defaulted bonds with yields of 10 percentage points or more above Treasuries.

Defaults to Rise

Moody's anticipates defaults will quadruple to 5.9 percent in 12 months. That assumes a ''mild'' recession. Judging by the amount of distressed debt, investors expect an 8 percent default rate, said Martin Fridson, head of high-yield research firm FridsonVision LLC in New York.

''I'm inclined to take the market at its word,'' said Fridson, who previously led a research group at Merrill that won first place for high-yield strategy in Institutional Investor's survey nine years in a row.

Junk bonds lost 3 percent in the first quarter, the worst start to a year on record, according to Merrill's U.S. High Yield Master II Index. The extra yield, or spread, investors demand to own the debt instead of Treasuries has risen to 7.07 percentage points from 5.92 percentage points at year-end, Merrill data show. High-yield, or junk, debt is rated below Baa3 by Moody's and lower than BBB- by S&P and Fitch.

Of about 100 issuers rated B+ and lower by Fitch, 24 percent may recover 51 cents on the dollar or more. B+ is the fourth- highest of 12 junk bond levels. Asset-rich companies such as Dallas-based Energy Future Holdings Corp., the former TXU Corp., which is the largest electricity producer in Texas, may be among those that would generate above-average recoveries, Keenan said.

Covenant-Lite

Along with the surge in bank loans came covenant-lite loans, which typically don't limit the amount of debt a company can have relative to earnings. A record $141 billion of covenant-lite loans was made last year, according to S&P.

The value of companies with those loans is likely to be 25 percent less when they ultimately default than if they'd been forced to restructure earlier, Fitch estimates.

Univision, the largest U.S. Spanish-language broadcaster, received $7.45 billion of covenant-lite loans last year to finance the New York-based company's $12.3 billion takeover by a buyout group including Chicago-based Madison Dearborn Partners LLC and billionaire Haim Saban.

S&P, which cut Univision's credit rating to B- in March and may downgrade it further, predicts investors in its first-lien bank loans will get from 70 percent to 90 percent of their money back in a default while owners of Univision's $1.5 billion of 9.75 percent notes due in 2015 may get nothing.

Capital Research owns the Univision notes, which have lost about 31 percent in the past year, filings and data compiled by Bloomberg show. Abner Goldstine, fund manager at Los Angeles- based Capital Research, didn't return calls seeking comment.

Hawaiian, Burlington

As of Dec. 31, Goldstine's $12.2 billion American High- Income Trust also owns bonds of Burlington, New Jersey-based retailer Burlington Coat Factory, phone company Hawaiian Telcom Communications Inc. of Honolulu and mobile-phone chipmaker Freescale Semiconductor Inc. notes, based in Austin, Texas.

Pimco, the manager of the world's biggest bond fund, owns Hawaiian Telcom and Freescale. Putnam owns Freescale.

Bonds of all those companies are trading at distressed yields and noteholders will get no more than 10 cents on the dollar back in defaults, S&P predicts.

Mark Porterfield, spokesman for Pimco in Newport Beach, California, declined to comment. Putnam's Scanlon declined to comment on specific companies.

''Over the past few years you had a large growth of aggressive deals coming to market,'' said William May, senior director in credit market research at Fitch. ''The unsecured creditors are the ones who are most at risk.''

Limited Recoveries

Bondholders already face limited recoveries from companies that filed for bankruptcy.

Unsecured creditors of Liberty Corner, New Jersey-based air conditioner maker Fedders are suing lenders including Goldman Sachs Group Inc. and Highland Capital Management LP in addition to executives and directors. A $90 million loan taken out by the company in March 2007 wiped out the value of the stakes of creditors, they allege. Fedders filed for bankruptcy in August.

''They were saddling the company with secured debt that could never be repaid and the end game for them was prolongation of job security for upper management and putting off the inevitable,'' Jeremy Coffey, partner at Brown Rudnick Berlack Israels LLP in Boston, who represents unsecured creditors, said.

Goldman spokesman Michael Duvally declined to comment. Jack Yang, a partner at Highland, declined to comment.

Fedders Prelude

The Fedders fight may be a prelude to more battles between loan and bond investors as defaults rise. Typically, those spats have been reserved for subordinated bondholders, who rank behind bank lenders and the owners of senior notes.

''Whereas in the last recession it was more common perhaps to see the inter-creditor fights between subordinated unsecured creditors and the senior unsecured creditors, it may very well be that in this cycle that will have moved up a level in the priority chain,'' Andrew Rahl, a partner in commercial restructuring and bankruptcy at Reed Smith LLP in New York, said.