Bad Debt

Marilyn Cohen, Forbes Magazine, 04.14.03

Highly leveraged companies are offering to exchange bonds for other things. Do not take these deals. You're better off just selling the shaky paper.

Corporate America labors under the mountain of debt from the booming 1990s. Some companies--names you know and thought you loved--are in grave peril. Several companies, trying to lighten their debt burdens, have already force-fed restructurings to their bondholders in which the investors either had to forsake some of what was owed or accept worse consequences.

The ugly options debt-laden companies have are few: 1) sell the best assets to pay for debt reduction; 2) file for bankruptcy; or 3) restructure out of court, offering bondholders less than they have now. The difference between a Chapter 11 and an out-of-court restructuring is that bondholders have a little more clout outside bankruptcy, where the judge and the lawyers are big factors. In court someone always can move to liquidate the whole mess, leaving unsecured creditors with a pittance.

My advice for these situations is simple: If you hear that your debt issuer is even thinking about a restructuring, sell now. Take your losses, perhaps using them later to offset capital gains. If you hesitate, nothing but pain awaits you. Two issues that are worthy of sale on this score: Teco Energy and Sprint.

Sure those double-digit yields are alluring. Yet there's a good reason you're receiving them--namely, the bonds' elevated risk. A recent Merrill Lynch research report noted that 45% of all U.S. investment-grade bonds are in the BBB rating range. That's one measly notch above junk.

Gobs of fallen angels are candidates for bond restructurings. Formerly great companies like Xerox, Lucent and Nortel have junk ratings. Any number of investment-grade companies appear to be at high risk of becoming junk. I'd put Tyco, AOL Time Warner and Kroger in that category.

How did we get into this fix? Some companies issued too much debt to buy back equity; others borrowed too much to pay for lousy acquisitions. And as the stock market has suffered, corporate pension funds are coming up short and need new doses of cash--cash no longer available for interest.

Take heed of former highflier Qwest Communications. Late last year the company, which owns the regional Bell phone utility US West, asked bondholders to swap $12.9 billion of debt in a Tony Soprano-type offer: Take it or else. Bondholders who took the exchange turned $5.2 billion of bonds into $3.3 billion of new debt with higher coupons and more seniority. An instant 36% loss in face value. And the or-else crowd? Those who refused the deal became more subordinate in the capital structure.

So if Qwest ends up in bankruptcy court, the holdouts stand to collect even less of the meager leftovers than do the exchangers. Even if the company staves off Chapter 11 for now, the holdouts won't appreciate in lockstep with the senior paper. Some will have to wait until maturity (which may be as late as 2031), hoping all the while that the company will be able to keep paying interest and principal on the bastard bonds in the meantime. Such is the fate of the poor souls (holding 8% of the $325 million original issue) who snubbed XM Satellite Radio's exchange offer for bonds paying 14%, due March 2010. Exchangers got new obligations paying zero until December 2005 and then 14% until a 2009 maturity date, plus some warrants.

Sometimes the debtor offers an equity exchange, but that may or may not kick up their returns. Bondholders and other lenders to Sirius Satellite Radio were asked to swap $700 million of debt for 62% of the outfit's near-worthless equity. If not enough creditors took the rotten deal, then Sirius threatened to file for Chapter 11, where God knows what would happen.

In their heydays AOL Time Warner, Ford Motor and General Motors were as blue as blue chips could get. Now they are squirming. Ford Motor Credit, the carmaker's financing arm (see story, p. 60), has $150 billion in debt rated BBB by Standard &Poor's. This debt is backed by loans to car buyers. What happens if the car buyers get laid off and a glut of used cars depresses repo values? General Motors Acceptance Corp. owes $170 billion and its parent has a pension deficit of $19 billion. GMAC's rating is down from AAA in 1979 to BBB now, and it could go lower.

If sick sister AOL Time Warner sells assets to pay down its $24 billion in debt, things will be fine. That's how the story line in the financial press goes. Still, what will the company be after some of its best assets are gone?

Sirius and XM Satellite were dicey companies, but Qwest wasn't. Any company can slip into downgrades and restructurings. If you find yourself on that slippery slope, get off before you hit bottom.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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