Often we talk about how the various index-based, passive ETFs and mutual funds hold a number of large credits (and often multiples tranches of such credits) that have debt structures that we view as unsustainable and as potential defaults in the years to come. Apparently we are not the only ones. Today on Bloomberg, there was an article entitled “KKR’s TXU Buyout Facing 91% Odds of Default.”
Basically the gist of the story is that TXU Corp, now known as energy Future Holdings is being hit by the recent gap lower in natural gas prices and now the company’s credit default swaps are pricing in a 91% chance that the company will default over the next three years*. This company has $45 billion in debt outstanding and is one of the largest issuers in the high yield space, making it one of the largest names held by the products that mirror the various indexes.
The problem we see with many of these companies is that the big leverage buyouts of 2005-2007 lead to piling on of debt in the capital structures of the purchased companies. So, if there is any hiccup in revenues or earnings along the way, there is no ability for the company to handle it. There is no margin for error. Furthermore, many of these debt structures assumed that the companies in question would grow into them. Well, with the financial crisis of 2008 and the very weak recovery we have seen since then, that growth is looking more and more doubtful. TXU has already taken actions to extend debt maturities, last year extending more than $17.8 billion of debt*, but that is not enough. They just have too much debt to service. According to this article, along with the 91% chance of default by the market is an assumption that the bonds would recover 14.5 cents on the dollar*—indicating a tremendous potential loss in value for all.
Again, this is why we see active management as so essential in the high yield space. As active managers, we can do the research to determine the fundamental soundness of a company and analyze the sustainability of the company’s debt structure. And if for some reason we are wrong on our call on the company or a surprise comes along, we always have the ability to sell before value in our holding is further impaired. In this case, TXU/Energy Futures is a name in the index, so the index based products will continue to hold it despite the worsening outlook for TXU’s viability.
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