Buying Bonds in the Expectation of Technical Default

I’m at the Harvard Club today, for a Debtwire conference on distressed debt. The editor of Debtwire, Matt Wirz, just mentioned something very interesting, which he says he’s never seen before: traders and speculators are deciding to buy leveraged loans which were very much a creature of the credit bubble – in the expectation that the loans’ covenants will be busted. Normally, if you expected a technical default on a loan, you would short the loan, or buy credit protection on it. But as we’ve seen over and over again, these are not normal times. And in fact there are reasonably good reasons to go long such debt.

For one thing, the debt’s cheap, of course – but so is debt which you think is going to perform well. More to the point, loans get restructured when covenants get broken. And in exchange for loosening the covenants, investors are likely to get an increase in coupon or some kind of cash payment.

If you’re looking at a company which has reasonably healthy fundamentals but which risks breaking its covenants just because the debt markets have seized up right now, then there’s a good chance you can make money on two fronts with this trade: the price of the bonds will rise in any case as the fundamentals of the company assert themselves and as the current dislocation passes, while at the same time the company will be forced to make extra payments for breaking the covenant.

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