What does it mean to Buy Debt?

I am a bit of a noob to the i-banking world (I'll admit it), but am gradually getting the hang of industry lingo. Say an investment firm buys another company's debt at a discount. First, what does this mean to buy the other company's debt? Also, I understand that buying the debt at a discount often occurs because the company who currently has the debt wants to dump it and must sell it at a discounted price if it wants to get it off its hands. However, hows does buying the debt at a discount affect the eventual return. Obviously the return has the potential to be greater, but how does face value, maturity, etc. work? Sorry if this seems elementary to some of you.

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Comments (25)

Jul 30, 2008 - 11:03am

Buying debt means you're loaning money. When companies issue debt, they sell bonds. Investors buy these bonds (buy the company's debt), which is effectively loaning the company money. The return you get from loaning this money is called the yield. Bonds define a fixed payout, so if you pay less for this future payout, you're getting a higher yield on your money.

Before you worry about lingo it'd probably be more worthwhile to learn about basic concepts like discounted cash flow.

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Jul 30, 2008 - 12:54pm

Actually, I don't think he's referring to buying bonds in the primary or being part of the participation in a debt syndicate, like you guys are suggesting. He's asking about buying funds or investors who buy bonds on the secondary at a discount and what that does to yield, at least that's how I read the question. So to answer it, take for example you have a bond who has an annuity or coupon at a fixed rate with a certain face value (i.e. 100). Any discount that the bond is trading at to par equates to more yield for you, since you're essentially purchasing the bond at a cheaper face value, collecting the coupon and then at the bond's maturity, you're receiving the full face value of the bond at par. More applicable to my situation in private equity, buying back portfolio company debt that is trading at a discount in the secondary market (whether it be bank debt or bonds) can reap big rewards in two ways - allowing unfriendly banks to unload their position at the current fair market value, and provide a higher yield than one would normally get by holding the same bank debt at par. You also have the advantage of insider information for the company, although you give up voting rights, so the only advantage you have is being able to justify purchasing the debt in the first place.

Jul 30, 2008 - 6:40pm

The main debt they are talking about is a securitised group of loans made to individuals or companies (if you are talking about all this credit crisis stuff). Basically, 1000 people owed the bank their mortgages, but because nobody knows how many of those people will default (i.e. not pay their mortgages) the credit rating on these securitised groups of loans has been a problem.

This package of loans (securitised debt) is typically packaged up by investment banks then sold on to investors. As the credit crisis has hit, this secondary market of people willing to buy these loans has collapsed (for sub-prime loans) and the price has cratered accordingly.

When Merrill sold off their loans for a $3bn write-down today, they were washing there hands of a big chunk of securitised loans that they just wanted to get rid of. The price they sell the loan at (I think it was like $7bn instead of $10bn) has no effect on how much those underlying people owe to their mortgages. It is simply a valuation put on the loans (value of mortages adjusted for default rate).

Jul 31, 2008 - 1:22pm

Bad Debt Buybacks (Originally Posted: 02/26/2011)

It has been almost two weeks since Standard and Poor's released an intriguing report for Wall Street and Main Street, alike.

The nation's largest credit rating agency claims that the banking industry may have to spend more than $60 billion to buy back troubled mortgages.

The six largest banks face the brunt of the potential liabilities with Bank of America and J.P. Morgan having the highest exposure.

This should not be a catastrophic event for banks by any stretch of the imagination.

After all, though they may be playing their cards close to the vest, bulge brackets are as flush with cash as they've ever been.

Normally, I wouldn't even pay much attention to this sort of smoke-screen news. This time, however, there is an actual chance the punitive situation may occur...this is pretty big news.

The pressure is coming from three separate but equally pesky sides:

1) The private investors who bought mortgage-backed securities.

2) The companies which insured the mortgage bonds .

3) Fannie and Freddy, the GSEs still digesting the abundance of America's mortgage hangover.

Shockingly to absolutely no one, Fannie and Freddie could ultimately cost Wall Street $31 billion in demand buy backs. Bank of America announced in January that it paid more than $2.5 billion to buy back troubled mortgages from Fannie and Freddie, meaning that a large scale motion in this direction may have already begun.

This brings up a very interesting question...

Would these mortgage buybacks actually be a boom for the banking industry?

Think about it...

Even if bulge brackets end up shelling out $150 billion for the bad loans (the higher end of analyst estimates), they would still wind up holding over $2 trillion worth of shoe gunk.

This means that at the predicted 5 to 10 cents on the dollar acquisitions, they can still make their money back tenfold...if they can just find some takers.

Does this make sense?

More importantly, is it something that we want going forward?

I would like to think that we have all learned to be a bit more prudent and a bit less greedy over the last few years. This purported punitive action is almost looking like a reward wrapped up in a shiny wrist slap.

You get to buyback the turds you were selling as strip steaks for pennies on the dollar?

How do you guys look at the future of the remaining toxic waste, XYZ tranche, balance sheet breakers?

Will financial stocks be a good buy any time in the near future?

Can we expect the industry to police itself better as a result of these fines?

Will the fines never come down?

Or will we (as I fear) be looking at another financial crisis a few years down the line, as a result?

Things seem poised to get interesting as the supposed recovery continues on its 2% steamroll.

Jul 31, 2008 - 1:23pm

The government should not be in the business of promoting homeownership. No need for Fannie or Freddi, nor should there have ever been a need. Shut the doors and let things be.

Renters typically live closer to work. Fannie and Freddie allowed Americans to move to suburbia. In the new economy, you need to be flexible and mobile. Owning a home is a boat chain around your neck.

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Jul 31, 2008 - 1:25pm
ANT:
The government should not be in the business of promoting homeownership. No need for Fannie or Freddi, nor should there have ever been a need. Shut the doors and let things be.

Renters typically live closer to work. Fannie and Freddie allowed Americans to move to suburbia. In the new economy, you need to be flexible and mobile. Owning a home is a boat chain around your neck.

Suburbanization is one of the greatest economic and ecological disasters in the history of man.

We have irreparably destroyed some of the finest farmland on Earth so that we can pave it over with minimalls and McMansions whose inhabitants have to commute on 1950s-built highways intended to handle 1/8 the traffic.

Best Response
Jul 31, 2008 - 1:26pm

Excellent point ivoteforthatguy. Not to mention creating generations of alienated, isolated Americans who are culturally inept.

As for this being a prize for the banks, it depends on what is actually in this junk. I still don't believe that the housing market has bottomed. With interest rates raising (at least until June, when the Fed pulls the carpet out from underneath QE2), less buyers will be in the market. Take a look at this article from Bloomberg Businessweek. Investor purchases are up, and first-time buyer sales are down to 29% from 40%. First-time buyers are needed to enter the market so existing home owners can move up to a McMansion (and drive new home sales). Inventories are slightly down but I think this is again the result of higher investment purchases, and not real demand.

If home prices continue to fall this junk will continue to be worthless. More homeowners will be owing more than the house is worth and will have no incentive to keep the property. Case-Shiller has been trending down as well for a few months. If the banks want to profit they will have to figure out which properties will pay, and then buy securities holding those properties, which I don't see happening if they have to buy $150 billion of this doo-doo.

looking for that pick-me-up to power through an all-nighter?
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Jul 31, 2008 - 1:27pm

Glad I didnt get raped for my statements.

I really think it is bullshit how the government favors homeowners vs rents. I realize that homeownership adds a lot to GDP, but when you think of the costs associated with having millions of little towns, miles of roads, and a less mobile population, it looks like a wash.

My parents own a monster house which they will never be able to sell. I grew up in one economic class and then saw technology put my family into another class. Had my parents been renters, they could have adjusted more swiftly or downgraded to reflect their new economic reality. Unfortunately this was not the case.

Me, I would rather rent and bank the rest. Being mobile and close to work is ideal for me. I value my time too much to commute. I don't want to be stuck in an area when jobs move. I want to have the smallest carbon foot print available.

I honestly think that we will see a drive towards this. Not only have banks gone back to where they used to be with mortgage lending, but they have gotten even more restrictive. Add to that, people are scared shitless to own a home. Millions of Americans have watched their credit get ruined also.

Look at Michigan. Jobs are not coming back there yet you don't see people moving. North Dakota can't fill jobs. Immobility of the labor force. Yeah yeah, North Dakota fucking blows. But you know what blows more than ND? Being out of work for 2 years in Michigan.

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Jul 31, 2008 - 1:28pm
ANT:
Glad I didnt get raped for my statements.

I really think it is bullshit how the government favors homeowners vs rents. I realize that homeownership adds a lot to GDP, but when you think of the costs associated with having millions of little towns, miles of roads, and a less mobile population, it looks like a wash.

Owned homes do not add to GDP. Homes owned by banks, which people occupy and dutifully pay the note on...add to GDP. Until we start being honest with ourselves about this, no steps can be taken in the right direction. The illusion of "The American Dream" starts with this fallacy.

ANT:
My parents own a monster house which they will never be able to sell. I grew up in one economic class and then saw technology put my family into another class. Had my parents been renters, they could have adjusted more swiftly or downgraded to reflect their new economic reality. Unfortunately this was not the case.

Your parents and people like them, do not fall into a voting block. They are just decent people trying to thrive and survive. Where this was once the definition of the vast majority of the American public. Today, it is only those who unionize (in some manner of speaking) and lobby, that aren't ignored.

ANT:
Me, I would rather rent and bank the rest. Being mobile and close to work is ideal for me. I value my time too much to commute. I don't want to be stuck in an area when jobs move. I want to have the smallest carbon foot print available.

It's comments like these that get people labeled as tea baggersor worse yet...anti-social.

Just consider the subtext.

ANT:
I honestly think that we will see a drive towards this. Not only have banks gone back to where they used to be with mortgage lending, but they have gotten even more restrictive. Add to that, people are scared shitless to own a home. Millions of Americans have watched their credit get ruined also.

Agreed. But since none of the chief contributors to the crisis (I'm talking bout the con men and their all too willing to get taken, victims) have gotten adequately penalized. What's the incentive not to go back to doing dumb shit? I don't see any.

ANT:
Look at Michigan. Jobs are not coming back there yet you don't see people moving. North Dakota can't fill jobs. Immobility of the labor force. Yeah yeah, North Dakota fucking blows. But you know what blows more than ND? Being out of work for 2 years in Michigan.

Better yet, look at Cleveland. In the 30's it was the fastest growing American city, reaching almost a million in population. Today it's less than 300K. For the record, I'd love to live in North Dakota. I may even be able to use the 1st and 2nd Amendment at the same time out there. Now how many states can stake that claim and pull it off completely?

Jul 31, 2008 - 1:30pm

Agreed! I would also pull my mortgage calculator and rationally think if I can pay it in the next 10-20 yrs adjusted to CPI.

ivoteforthatguy:
I'll be renting for a long damn while. Unless I can finance a house that comes close to break-even on the rent yield, not going to buy.
Jul 31, 2008 - 1:31pm
Midas Mulligan Magoo:

This means that at the predicted 5 to 10 cents on the dollar acquisitions, they can still make their money back tenfold...if they can just find some takers.

Who in their right mind would take the other side of that bet? Fool me once shame on you but fool me twice...

More importantly why would someone absorb that risk at this present moment? If China increased the value of their currency against good 'ole Ben Frank I can maybe see us moving forward, even that is a far stretch of the imagination.

...What recovery?

good post

Please don't make me talk to you like an asshole...
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Jul 31, 2008 - 1:32pm

These notes are still secured by first rights to the property, right? I think we're forgetting what we're working with here.

I'd buy them at 90-95% discounts, hell I'd probably buy them at 75% discounts. I'd buy a few single family homes and a few townhomes. If they continute to pay the mortgages - GREAT, if not I'll get them booted and have positive cashflow properties. Except for the time and effort to kick out the current owners this is a huge Win-Win.

While I agree with everyone about renting being a better option for most, I would jump all over these kids of discounts

twitter: @CorpFin_Guy
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Jul 31, 2008 - 1:33pm

Debt Buyback/Exchanges (Originally Posted: 08/28/2015)

Hey guys,

Was just wondering if anyone had any good resources, articles, or personal experience they could share regarding debt exchanges/buybacks. I've seen some public companies do this when they get distressed (buy back/exchange debt at a discount to face to lower leverage and improve interest expense/coverage), but have also heard that PE shops often perform this type of activity if an LBO goes sideways on them.

Interested to understand the process from both sides - a regular company and a PE owned LBO-fund company. Any and all insight appreciated. Thanks.

Jul 31, 2008 - 1:36pm

Debt exchanges are done to reduce a company's interest burden and/or increase liquidity runway. You need a sufficient amount of participants and range b/w trading prices between the senior capacity / junior debt to make it possible. Let's use the example of a company who has $1 B face value of unsecured bonds trading at 25c, so $250 MM of market value. They have a 1st Lien secured revolver out and have 2nd lien secured capacity under ther covenants. So they talk to a few of the large holders of the unsecureds who are offered 35c to exchange into new 2nd lien debt. 40% of the lenders go ahead with it, and the rest are left in the dust. Now, you have $400 MM 2nd lien debt on a company that was previously trading at implied value of $250 MM through the unsecureds, essentially leaving the unsecureds worthless now. Pick up one of the good distressed investing books (Moyer, Marty Whitman, etc) if you want to get more in the weeds. Or look at some recent examples that have taken place (under company's PRs): MPO, HK, LTSCN.

Buybacks are a little different ballgame and usually done with highly levered companies with still good liquidity. It is typically impractical to do this in massive size before you run into guys who refuse to sell out at a big discount and given the general illiquidity of the market these days. Clearly this also uses up real cash, vs an exchange not really being as much of a use of cash.

Jul 31, 2008 - 1:37pm

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