Debt-for-Equity Swaps Threaten to Change Bond Funds
Alot of smart people on Wall Street always said that high-yield junk bonds were really more like stocks than bonds. Now, a growing number of junk bond mutual funds are getting ready to call a spade a spade: They’re ramping up to take what could be significant equity stakes in troubled companies.
If you own shares in a junk bond fund, the potential change in investment approach is of more than passing interest. It may mean you’ll no longer own a pure bond fund. Part of your money will be betting on the long-term appreciation of shares in ailing firms rather than producing income.
For most funds that end up with equity stakes, it will happen this way: Troubled companies that have issued junk bonds will ask bondholders to transform the debt into equity. The companies’ goal will be to buy the time necessary to work out their problems. Basically, the bondholders will be asked to give up the interest income they were promised in exchange for stock that could appreciate sharply--if the companies succeed in restructuring themselves.
Such debt-for-equity swaps may offer the only way out of the soup for many deeply indebted companies that can no longer afford to pay 13%-plus junk yields. The swap idea isn’t novel, but it is taking on new importance as bond defaults soar.
Few junk funds now have large equity stakes, but fund managers clearly are getting ready for the inevitable. For example, Los Angeles-based Pacific Horizon High Yield fund is planning to notify shareholders of a change in the wording of the fund’s bylaws. Now, the fund can hold up to 10% of its assets in stock. But such shares can be received only as part of bond offerings (some bonds are sold with stock as a sweetener).
Tom Nugent, manager of the Pacific fund, wants to change the bylaw wording so that he can accept stock in exchange for bonds already in the portfolio. “Given market conditions, bond managers have to take another look” at their options, Nugent said.
Limits vary on what funds can eventually own in stock. Fidelity High Income fund, a $1.1-billion junk fund, can have up to 20% of its assets in stock, said spokesman Neil Litvack. The Mid-America High Yield fund in Cedar Rapids, Iowa, can have up to 49% of assets in stock.
Martin Wiskemann, manager of the Franklin AGE High Income fund in San Mateo, is ecstatic about the chance to change some troubled bonds into stock. “We would love it,” said Wiskemann, whose fund has no limitations on equity holdings. “We’d love to have 5% or so in equity. And if it grows into a large amount, that would be great.”
Wiskemann and other fund managers are betting that equity stakes will pay off in a big way over the long term. Typically, when a money manager agrees to help an ailing firm, the price is steep: The investor often wants the refinancing structured so that its equity stake will return 30% or more, annualized, assuming the firm recovers.
The catch is that those returns aren’t realized for many years--when the equity can be sold to someone else or back to the company. And if the firm doesn’t make it, the equity can vanish.
Some junk fund managers aren’t comfortable with the idea of owning a lot of stock. David Halfpap, who runs the Mid-America fund, said he would “rather not have any equity. . . . People bought this as a high-yield fund.” Even fund managers such as Wiskemann, who welcomes equity, say their funds will remain primarily income investments.
The bottom line for junk fund shareholders: Be sure you know your fund’s plans for equity investments. In many cases, a fund may not have much choice but to accept stock for bonds, because many sickly junk bonds simply aren’t salable these days. Even so, you have a right to know what kind of equity you may end up owning, and how much.
Junk Warning No. 2: If you haven’t sold your junk bond fund shares by now--after all the market has been through since last fall--it’s probably because you figure the worst is over.
Don’t bet your lunch money on that.
The Ames Department Stores bankruptcy filing Thursday raised the total of rated corporate bonds in default to $9.3 billion year-to-date, says John Lonski, economist at Moody’s Investors Service. So we’ve nearly surpassed the $9.4 billion in rated bond defaults for all of 1989. And there still are eight months to go. (Rated bonds are those tracked by services such as Moody’s. The figures don’t even include the junkiest defaults, because those bonds don’t get ratings.)
Lonski figures there’s a “very good chance we’ll see $20 billion in defaults this year.” And with every tick up in interest rates, which are rising again, default risk grows for more borrowers.
There’s another cloud over the junk heap too. The National Assn. of Insurance Commissioners, representing state insurance regulators, is in the process of writing tighter restrictions on junk bond ownership by insurance companies.
The NAIC’s working group on new regulations will meet May 10 in Washington to look over the proposals. The biggest change would be to force some insurers to set more money aside in reserve to offset the risk of certain junk bonds.
Some junk market analysts fear that by raising reserve rules, the regulators would make junk bonds even less palatable to insurers--potentially sparking a new round of bond dumping.
Terence Lennon, chief examiner of the New York State Insurance Department and chairman of the NAIC working group, scoffs at the notion that higher reserves would prompt insurers to sell their bonds. “Who are they going to sell them to?” he asks, noting the illiquid state of the junk market.
“The fact that they don’t have anyone to sell to is part of the reason for this,” he said, referring to the proposals. But he also said the NAIC is willing to work with insurers to make sure the final rules don’t cause major damage. “We’re not interested in turning the industry on its ear,” he said.
Big on SmallCap: Capital Research & Management, the Los Angeles-based money management titan (assets: $40 billion), has scored big with its new SmallCap World Fund. The fund, which will invest in small-company stocks worldwide, has attracted $673 million in investors’ money through Thursday. That makes it the second-biggest launch ever for an open-ended stock mutual fund. Only the Gabelli Value Fund drew more ($1.1 billion in its launch last year). The SmallCap fund now is closed to new investors, and won’t sell new shares again before Jan. 1.
Briefly: Allergan, the Irvine-based eye-care products company spun off from SmithKline Beckman last July, continues to attract new fans. Prudential-Bache Securities recently issued a “buy” signal on the stock, as did the Street Smart Investing newsletter in Brewster, N.Y. Allergan’s earnings have been weak of late because of soft sales in some markets, but Pru-Bache says the stock is cheap, based on estimated 1991 earnings per share of $1.60. Allergan rose 87.5 cents to $16.125 Thursday. . . .
Xerox Corp., a recent subject in this column, Thursday reported disappointing first-quarter earnings. While operating earnings in the company’s copier business rose 20%--a healthy showing--Xerox’s insurance arm performed miserably. Overall, operating earnings per share fell 28% from a year ago, to $1.06. The stock fell $1.25 to $51, showing that more Xerox shareholders see little hope of a turnaround soon. . . .
In a new report, Paine Webber includes Southland-based companies AST Research, Vons Cos. and International Lease Finance among 15 favored stocks that the brokerage says have developed strong niches in their markets and thus should fare well in any economy.
THE JUNK EXPLOSION The volume of so-called distressed securities outstanding--including junk bonds--is mushrooming. And so is investor interest in those securities. Here’s a snapshot, using estimates by Edward Altman, a New York University professor who has spent years researching the subject:
* The face value of distressed corporate debt securities--including bonds, troubled bank loans and trade claims--was about $300 billion at Jan. 31.
* Publicly held corporate debt securities that are yielding more than 18% total $75 billion. A lot of those bonds aren’t in default but are distressed enough that the companies that issued them may ultimately be forced to exchange them for new securities.
* There is at least $5 billion under active management by investment firms hunting for opportunities in distressed securities. Those investors expect a very good return for the risk they are taking. A survey of 56 big investors in distressed securities showed that one-third of the investors expect a 30% annual return. About two-thirds expect a minimum return of 20% to 25%.
