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Getting Out of a Bind
Sunday 2, September 2018

Getting out of a Bind.

YaniqueF_1

In life, businesses and individuals alike, sometimes go through periods of financial difficulty.  Most of us are familiar with the way that an individual may approach financial difficulty.  They may attempt to refinance existing loans, they may beg for help from family and friends, or they may just stop servicing their debts and change their phone numbers.  However, what happens when a company or country has borrowed too much money (over leveraged)?  What are the avenues available to these entities?

An entity can choose to simply renege on their debts, but if they hope to continue in business, doing so can severely impact their ability to raise funding in the future.   Therefore, this is a serious step, and should be considered only as a last resort.  Companies and countries have been forgiven once investors are convinced that there is a genuine turnaround, however, many times this is years in coming.  Argentina defaulted in 2001 and had a long and complicated process for resolving the numerous lawsuits and the acquisition of the debt by “vulture funds”.  They triumphantly returned to the capital markets but that was in 2016 (15 years later!).

There are other ways of approaching overwhelming debt.   Entities may choose to extend the debt and/ or reduce the interest rate.  This approach would be similar to the debt exchanges conducted in 2010 and 2013 in Jamaica.  This is probably one of the kindest approaches, as the investors still get back something, however, for anyone who had expenses that they were planning to match with the income from these bonds, this would be a nightmare scenario.

Entities may opt to enter a debt for equity swap.   What this would mean is that they would use a defined conversion rate to convert your bonds into equity in the company (stocks).  This is the approach that Peabody Energy, a coal company based in St. Louis took to their debt recently. The value of the stocks will depend on the viability of the company.  So, if the company manages to effect a turnaround, this would be great, as the value of the stock could increase considerably.  However, if the company continues to decline, the stock is likely to become worthless. 

A company may also ask their bondholders to take a haircut.  A “haircut” in finance is not a trip to the salon, but instead a percentage of the debt is written off and not repaid.  For example, if you are owed 100,000, the company may impose a 30% haircut, which leaves you with 70,000 face value of bonds.  You would forfeit the 30,000 because of the haircut.  This is permanent, meaning the company is only going to give you the 70,000 at maturity, even though you were originally owed 100,000.

A proactive company when issuing high interest bonds, may decide to make them callable.  This means that they can buy them back from you at a preset price, and issue new cheaper bonds (at a lower interest rate).  Most investors dislike this scenario, as they were getting their coupon payments at a nice high rate, and then they must adjust to a lower rate.  This is likely to happen when rates are decreasing, meaning, other companies are paying lower rates to investors.

Last but not least, an entity may choose to exchange the debt to extend the maturity and give the company more time to repay the debt.  In this scenario you give up your existing bond and in exchange for a new bond.  As we speak, Digicel announced an exchange of two of their notes (bonds).  The purpose of it is to extend the maturity date of the bonds. Their 8.250% Notes due 2020 will now mature in 2022 with no change in the interest rate.   The 7.125% Notes due 2022 will have the maturity date extended to 2024.

If you find yourself facing this scenario as an investor, it is best to speak to your financial advisor to explore what options, if any, are open to you.  It is also important to fully understand the implications that it may have on your investment and ultimately your portfolio.


Yanique Leiba-Ebanks, CFA, FRM is the AVP, Pensions & Portfolio Investments at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback:  If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm


 

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