Bondholders of "cusp" credits--those teetering on the lowest rungs of investment grade--are increasingly getting stung when such companies have to renegotiate credit facilities with commercial banks. Bondholders often find themselves pushed further below the commercial banks in the capital structure as banks demand collateral, or stricter covenants as part of a refinancing package. In other situations, banks are extending loans contingent on the completion of a bond deal if the deal does not get done, making a company a serious default risk. Refinancing difficulties at IMC Global (Ba2/B+) resulted in a four-notch downgrade from Standard & Poor's, sending the 73/8% of '18 down from $77 on May 2 to $56 on May 4. More recently, the agency downgraded U.S. Industries (Ba2/CCC+) two notches, driving bids on the71/8% of '03 to 77 last week, down from 92 before the downgrade. Market pros expect the trend to continue and say investors need to be on alert.
"Keep a close eye on upcoming bank refis for credits in the low triple-Bs and the cusp of non-investment grade," says Glenn Reynolds, a senior analyst at Creditsights. Reynolds cites Dana Corporation (Ba1/BBB), a vehicle parts manufacturer, and wireless equipment maker Motorola (A3/A-), as examples of companies with credit facilities due to mature in the next few months that will face serious scrutiny from their banks. The Dana 6.5% of '09 were trading at 353 basis points over treasuries last Tuesday, and Motorola 75/8% of '10 were at 306 over. Reynolds observes that U.S. Industries was a fully investment-grade credit in March of this year, and believes it could earn the dubious distinction of going from investment grade to default in less than a year.
Joseph Princiotta, a senior investment-grade analyst at Bear Stearns who follows basic industries, points out that tripped covenants also create an opportunity for banks to come back to the table and demand further security. He believes Equistar Chemicals (Ba1/BBB-) will trip a covenant in the third quarter, sending the bond price down below its current level. Last Tuesday, the 8 3/4% of '09 was at $92, down from $97 on May 4. He sees two or three other chemical companies facing a similar situation, though he declines to name them.
Carolyn Gibbs, a senior portfolio manager at Aim Funds in Houston, Texas, notes that all of the above mentioned companies, as well as many others that have suffered downgrades for similar reasons, began as (and in some cases still are) investment grade. She says high-yield investors demand that their place in the capital structure be protected, because they are more sensitive to the risk of having senior debt come in on top of them after a bond is issued. Investment-grade bonds typically do not contain those protections, she says, adding, "banks come in and get what they want because they can."
Refinancings don't always spell doom for companies' outstanding bonds. Though bonds can widen on rumors of a difficult refinancing, spreads can tighten back in again once the deal gets done, saysJames Dunn, basic industries and forest products analyst at Banc of America Securities. Paper products company Caraustar Industries (Baa3/BB+) 7 3/8% of '09, which are highly illiquid senior notes, were quoted at more than 600 basis points over treasuries earlier this year on concerns over a maturing $400 million revolver. But much of the revolver was redone as a $285 million senior subordinated bond, and last week, the senior notes had narrowed in to 425 basis points over Treasuries.