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U.S. default rates remain subdued owing to a variety of factors. Economic indicators point to continued growth, and while interest rates are rising, the absolute level of rates is low and capital is plentiful. Less-obvious factors are also important. The seemingly interminable loosening of debt covenants lessens the risk of profitability declines triggering restructurings, and collateralized loan obligation (CLO) funds - large and growing players in the market - are less likely to force companies to recapitalize as compared to traditional bondholders. An even more obscure factor has also helped to dampen default rates: the continuing and growing prevalence of liability management transactions. These transactions significantly impact market participants of all parts of the credit risk spectrum.
Let's begin by broadly defining liability management transactions as being those that seek to proactively address company debts and obligations through negotiated solutions outside of a traditional in-court restructuring process but involve more than a traditional capital markets solution. Examples can range from discounted debt buy-backs and minor covenant resets to aggressive, coercive modifications of debt documents and combination new money/up-tier exchanges. These transactions can be viewed as defensive or offensive depending on the perspective of the constituent involved, and they can preemptively address capital structure issues that might otherwise result in a restructuring, as shown in the diagram.
While a traditional restructuring is often associated with cutthroat creditor constituencies fighting over fixed consideration, with out-of-the-money owners receiving little to nothing, liability management is proactive by design and can provide win/win scenarios where both creditors (at least certain groups) and owners win. For example, a group of debtholders could agree to loosen their debt-covenant package in exchange for an increase in interest rates or fees. The subject company's owners could trade an increase in cost of capital for additional flexibility.
In other instances, liability management transactions can be just as aggressive as full-blown restructurings and result in clear winners and losers, with one party gaining additional protections, seniority, runway, etc. at the expense of - and, in many instances, over the objection of - another party. For example, suppose there is a $500 million unsecured bond that trades at 50 cents on the dollar and has particularly onerous debt covenants. While certain debt terms (so-called "money terms," like...