Out from Under

Deeply discounted corporate debt may tempt companies to buy it back or exchange it, but such deals are far from easy.

“We have a competitive group,” she says. “They didn’t want to sell their bonds just to find out that the other guy didn’t tender.”

It would be a mistake to think that Metaldyne held investors’ feet to the fire, however. Iwasaki left it among the bondholders to negotiate what the payout would be among holders of subordinated and senior debt, for example. And when bondholders balked at signing a lockup agreement, committing them to the tender offer before it was announced, Iwasaki backed off.

One element of buying back debt that is not negotiable is the tax bill. If a company buys back a loan or bond at a discount, the Internal Revenue Service considers that a cancellation of debt, which is taxable income, says John O’Neill, U.S. leader of bankruptcy and restructuring tax for Ernst & Young. Were a third party — such as a special-purpose subsidiary — to purchase the debt, the income would still be taxable. However, if a company is in bankruptcy, debt-forgiveness income is not taxable. If insolvent — defined by the IRS as the fair-market value of a company’s assets being less than its liabilities — the income is excluded only to the extent of the insolvency, O’Neill says.

Loan Rangers

Despite being taxable and more complex than bond deals, buying back loans at a discount is another restructuring option for CFOs. In fourth-quarter 2008, $4.9 billion of leveraged-loan assets were for sale, according to Standard & Poor’s, and the average loan bid was 71 cents. “It might not be a bad move,” says Thomas Bonney, founder of CMF Associates, of buying back corporate loans. “The bank and its investors may just need to get out, because they have pressure somewhere else in their organization.” In this economy, buying back a loan might also be the best use of excess cash, Bonney says.

Still, loan purchases are decidedly tricky. In the loan market, more so than with bonds, lenders have always assumed they will get paid back at par. Credit agreements don’t allow borrowers to buy bank debt at below par without approval from a majority of lenders. Although generally banks and asset managers like deleveraging stories, they are finding many current offers distasteful. “Ultimately, it comes down to the form and substance of the amendments, which run from plain vanilla to aggressive,” says Seth Katzenstein, an alternative-asset manager at GSC Group.

Buybacks that fail usually contain provisions that force banks to take all the pain, Katzenstein says. Some companies try to buy loans at steep discounts and demand that the purchase count toward the “free cash flow sweep” provision, which requires the company to pay a certain portion of year-end excess cash flow to lenders. Other companies try to buy operating-level debt at the holding-company level, which does not deleverage the operating company’s balance sheet.

Preemptive Strike

With debt markets so dislocated, finance chiefs are better off weighing the option to buy or exchange debt sooner rather than later. Since bonds are pricing in default rates that may be 10 to 20 percent higher than the actual number of companies expected to fail in 2009, some issues are probably oversold, experts say.

In its fiscal fourth quarter, Morgan Stanley bought $12.3 billion of bonds at a discount, in what CFO Colm Kelleher calls a “debt defense.” Kelleher says that letting the debt continue to trade at distressed levels “would have sent a very bad signal.” Morgan Stanley also recorded a $2.1 billion gain from the open market transactions. Similarly, last December, Glencore, a Swiss commodities trader, announced plans to buy some of its bonds after the spread on its credit default swap spreads soared. The intention: to assure investors of the firm’s creditworthiness.

Although buying back debt may not in itself signal “all’s well,” as a share buyback does, “if there’s buying in the market, it will tend to increase the price of the debt,” says Meyer of Squire Sanders.

A company’s bond price could be a mountain too heavy to move, however. Unless a dramatic turnabout occurs, few corporate bonds will fetch higher prices this year. Debt restructurings, on the other hand, will be rampant. “We’re in the third inning of a nine-inning game,” says CMF’s Bonney. “There’s a lot more of this to come in 2009.”

Vincent Ryan is a senior editor at CFO.

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