While this week’s chart may appear to be out of date, the story behind it could not be more relevant today. The implications of the Momentive court cases, one of which concluded last week, will have lasting effects for fixed income investing. What happened and why do we care about it today?
In the spring of 2014, Momentive Performance Materials, a ~$3 billion specialty chemical producer of silicones, filed for bankruptcy protection due to its large and unsustainable debt burden. Upon filing for bankruptcy, the market price of the MOMENT 8.625% 1st Lien Notes due 2020 were very resilient (as judged by its market price). This resiliency was due in part to the first lien security interest, the senior position in the capital structure and the enterprise value being substantially larger than the amount of first lien debt. First lien creditors were expecting, at the very least, to recover all of their principal back with interest.
After negotiations amongst the different bondholders with the company and its equity owner, however, the company was able to force a “cram down” to the first lien secured lenders. As seen in the chart of the week, on August 26, 2014 the judge ruled that the company could replace the 8.625% coupon with a below-market 3.88% coupon, dramatically impairing the recovery value of the first lien bonds.
The importance of this ruling cannot be understated. Essentially, first lien lenders, who are generally the most senior lenders to a company and should receive the highest recovery, will now be at greater risk of not receiving all of their principal back in the event of a bankruptcy. All else being equal, a first lien creditor should receive all of their money back before any junior lender receives any recovery; however, this did not happen with Momentive.
Fast forward to today, first lien lenders have appealed the ruling, and the appeals court found that the bankruptcy court potentially made an error in determining the coupon’s market rate. Of note, the appeals court has asked the bankruptcy judge to determine if there was a market rate and what that rate should be, rather than using its formula approach which resulted in a clearly below-market coupon.
The bankruptcy judge’s upcoming ruling on the case will be critical in how fixed income lenders price risk in the market. If the original ruling holds, and the below-market formula approach is the new precedent, then first lien secured lenders would need to have higher rates to compensate for higher risks going forward. If a market rate is applied, however, not only will the first lien lenders in Momentive feel vindicated, but first lien lenders across the U.S. market will be able to breathe a sigh of relief. The bankruptcy judge’s ruling will certainly be a momentous one.
 “Cram down” in bankruptcy is when a judge imposes a restructuring of debt despite objections from a creditor class.
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