In Movies, Makeup, And Markets, Distress Comes Roaring Back

With interest rates being so low for so long and even the riskiest companies able to find eager lenders, opportunities for investors in bad debt were few and far between for some time. But now that inflation is setting in and the Fed is beginning to aggressively raise rates to keep them under control, that’s all changing.

Data compiled by Bloomberg showed that defaulted corporate bonds and loans had risen to $189 billion by Sept. 9, up 6.4% from just a week earlier, and that 59 US companies have fallen so far this year have filed for bankruptcy. Three of these, each involving more than $50 million in liabilities, also occurred in the first week of September. The most important of these was Cineworld Group, Plc., the second largest movie chain in the world with more than 500 theaters in the US under the Regal Cinemas name. This company, which has about $4.8 billion in debt excluding leases, won’t benefit from the rally in meme stocks that AMC Entertainment previously bailed out

What happens to the Regal Cinemas chain as Cineworld makes its way through bankruptcy will be a movie worth seeing, but a more interesting story for the nuanced distressed debt devotee is Revlon
. This company filed for Chapter 11 protection in June with $3.3 billion in debt. Revlon is a 90-year-old, well-known branded cosmetics company. Still, it’s struggled in recent years, as emerging celebrity-owned lines like Kylie Cosmetics and Fenty Beauty have attracted younger consumers. It has also been plagued by the same problems as so many other retail brands – supply chain disruptions and Covid-related issues, along with excessive leverage.

In 2020, Revlon attempted to refinance some of its old debt and replace it with new issuance. This created a new problem for the company, which affected the bankruptcy proceedings. Citigroup
who was Revlon’s debt agent, intending to pay creditors $9 million in interest, mistyped a few zeros and instead paid $900 million to a group of syndicated lenders.

Citigroup demanded the money back, but a group of funds holding 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, partly because at the time they had no reason to believe the payment was in error. Citigroup filed a precautionary subrogation in bankruptcy court, finding that the bank was owed at least $500 million and, if not repaid, had the right to file for bankruptcy for that amount. In its filing, the company told the court that this litigation hampered its efforts to raise capital because it could not identify its creditors.

Some clarity came to the situation earlier this month when the Second Circuit US Court of Appeals in New York overturned the earlier ruling, declaring that Citigroup could recover the money. How much of this half-billion misallocated funds will actually be repaid remains unknown. Cayman Islands-based hedge funds are among the repaid creditors, and some of them may have been liquidated en route. But regardless of how Citigroup fares, the new ruling clarifies Revlon’s bankruptcy and will allow it to know who its creditors are before proposing a bankruptcy plan, which is expected in court by mid-November.

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

First, Jerome Powell’s Jackson Hole speech showed the Fed’s willingness to continue raising interest rates to curb inflation. He said, “We’re going to keep going until we’re confident that the job is done.” And while Powell didn’t elaborate on that in his remarks, the Fed will in all likelihood continue to try to reduce the size of its balance sheet.

Then there’s what’s going on with junk bonds. Last year, a report issued by JP Morgan showed that trading in junk-rated paper was in many cases below 5% to maturity. In practice, advertised fixed income prices had gone through the roof and even the riskiest borrowers were able to borrow at rates below 5% and in some cases even below 2%!

That was then. Now we see a big reset. Every bond has fallen in price with corresponding increases in yield to maturity. It’s now much more common to see prices in the 7-9% range for junk-rated bonds. Those with problems or distress trade for much higher returns, some as high as 30% or more. With what the Fed has said, this trend has room to grow as a normal level for junk-rated paper is rightfully in the double digits, not the high single digits.

Based on these indicators, it is reasonable to assume that we will see much more hardship in the coming months. They might not be big names like Revlon or Regal, but there will be other companies that have racked up debt over the past decade and are now forced to reckon with the new environment. We see it everywhere in fixed income securities. The broad bond indices have fallen sharply since the beginning of the year. Even Treasury indices are down 20% – the sharpest in a year – and most fixed income securities are priced against benchmark government bonds.

If the troubles in the bond market like the ones we’ve seen earlier this year continue, you’re guaranteed to be a lot more stressed. That’s because as companies reach their debt maturity, demand for the new securities they have to issue to refinance maturing debt diminishes. And for some of them, the window might be closed entirely. We’re seeing large outflows from bond funds and ETFs year-to-date because investors have suffered such large losses in these markets this year. As the market resets over the longer term, there will likely be increasing opportunities to selectively find interesting assets among the growing carnage of distressed debt.

It is very difficult for individuals to invest in the distressed debt of a company like Revlon or Cineworld. Still, companies like this can be excellent long-term investments if you can buy into them at the right price through a professional money manager. Regardless, Revlon has publicly traded stock, which means investors could potentially be able to short their shares.

In fact, short selling has become an increasingly interesting opportunity right now. There are many companies whose business plans are being turned upside down due to inflation, supply chain shortages, Covid issues and uncertain commodity prices. And companies affected by these conditions, which are also heavily indebted, are much more likely to file for bankruptcy, especially when we have a recession. For investors who don’t have the ability or inclination to do it themselves, now could be a good time to select an investment manager with experience to help them navigate these choppy waters.

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

Numerous other companies are likely to find themselves in trouble in the coming months. Still, investors should be wary not only of distressed companies but also of their regular stock investments unless they can find ones with short-term cash returns. These are companies that are cheap initially, 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 bleakest markets there are usually some opportunities for investors willing to do the homework to find them. Right now, the energy room is a good place to look. Some companies that produce oil or natural gas are currently generating enough cash flow that they can reward their shareholders by returning capital to them quickly.

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