By some measures, Radio Shack took a long time to die for a traditional, close-to- centennial retailer of consumer electronic products, many of which were becoming obsolete.
There is good reason to believe that Radio Shack’s bankruptcy protection filing in early February in Delaware says little about either the state of the US economy or the credit markets and is more idiosyncratic than symptomatic of a larger malaise. Investors clearly think this is the case.
High-yield bonds have been star performers so far this year. As of the end of the third week in February, junk bond funds attracted almost $10bn, in contrast to all of 2014, when investors pulled nearly $24bn from these funds.
High yield “is the best performing fixed income sector year to date and just 1 per cent away from its all-time highs”, noted analysts at Merrill Lynch in a recent report. Indeed, many investors think credit is safer than ever, precisely because zero interest rates make the burden of debt far lighter to bear.
That may be a miscalculation, however. After a relatively long period in which credit default swaps were not a factor, once again these derivatives are playing a big role in determining both the fate of troubled companies and the timing of any eventual demise.
Alternative investment funds, distressed investors and so-called “loan to own” funds (investors that buy existing bank loans at big discounts to their face value and work to take over the companies by swapping their debt for equity) are once again turning to the derivatives market to place complicated bets on weaker companies like Radio Shack and Caesars Entertainment, where the face amount of the CDS far eclipses the outstanding debt.
And it is precisely because the junk bond market presents two, contradictory faces that the positioning of these credit funds may be particularly effective and may make credit investing more perilous going forward.
Today, the high yield market appears liquid. That is because in a zero interest world, everything seems correlated. The values of almost all financial assets (barring a few exceptions such as energy) march up in tandem. The predilection for index trades and exchange traded funds reinforces that impression. It is easy to trade in and out of the 100 biggest credits in the sector.
Staff at banks like JPMorgan note that there is vast demand for hedging through index products and far less demand for hedging through the market for single name credit default swaps.
But there are both fundamental and technical reasons why investors should turn more cautious soon. The fact that the burden of debt appears low and the lack of any terms and conditions in these “covenant lite” structures makes it ever easier to layer more debt on companies. But it also means that when rates do rise, however gradually, the impact may prove graver. Unsecured creditors who bought bonds may have little or no recovery when weaker companies finally hit the wall.
Moreover, the lack of liquidity in relatively smaller names means that once their bonds start to drop, the fall can turn into a rout. Executives at companies like KKR say they are already receiving calls from investors wishing to sell who complain that when they try to transact at values the dealers post, the offers vanish.
The fate of Radio Shack is hardly a typical case, yet it does represent a cautionary tale for investors, as shown in litigation filed in mid-February. The suit brought by unsecured creditors charges that certain shareholders cut a deal with funds that sold protection on Radio Shack. These funds wished to avoid substantial losses by postponing any filing — to the ultimate detriment of the company, which found itself in a much bigger hole when it finally ran out of time. The unsecureds were left with nothing.
One of the assumptions of credit investors is that when rates rise, it will be because economic growth is strong and therefore they do not have to worry about being repaid since the companies whose debt they hold will be able to grow and generate the cash flow needed to service that debt. But this may be too optimistic.
Credit investors are supposed to be a dour lot whose best case is to get back 100 cents on the dollar. Those lulled into a less pessimistic stance by easy money may soon rue listening to the siren song of the central banks.
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