Can Bondholders Make a Profit When a Company Defaults?

Comment of the day comes from Gari N Corp, on yesterday's blog entry about credit spreads:

Hedge fund lenders, in particular, are said to pay much more attention to recovery rates, i.e. what they recover if they put a borrower into liquidation, than cashflow.

The thing that everybody seems to be looking at is LGD, or loss given default. Those losses are smaller than they've ever been, and recovery rates are higher than they've ever been. With me so far? Then why not try this on as a crazy hypothesis:

Hedge funds are buying up junk debt at incredibly low spreads because LGD rates can, in the context of the private-equity boom, actually be negative.

Here's how I'm thinking. First, take a junk-rated public company with a well-established management team who are underperforming the market. Buy the bonds, which pay a nice hefty coupon, and sit on your easy carry-trade profits. What's the downside? Default, of course. But "default" is basically just another word for "giving the equity in the company to the bondholders". If the company defaults, the bondholders take possession, and can make a nice profit by selling it off to a private-equity firm in a friendly, rather than hostile, deal. Everybody wins, except the old shareholders and the old management.

But isn't the boom in junk-rated debt largely being driven by companies which have already been taken private? Well, yes. But even there the same kind of dynamics can work. If a privately-owned company gets into difficulties, there is a possibility it will be bailed out by its parent, and bondholders will stay whole. On the other hand, if the parent company decides to write its whole investment off, then the bondholders essentially get all the equity in the company for free, along with all the time and money and effort that the private-equity buyers have already injected. At that point, they can either continue to run the company themselves, or they can sell it to some other PE shop.

Now, I'm not saying that this kind of dynamic is going to play out all the time, or even most of the time. But it could help to explain at least part of the frothy market in bond prices at the moment.