State of Distressed: Bloomberg’s Diaz-Matos on LME Whack-a-Mole

September’s credit selloff was broad: the ICE US high-yield index fell 2.5% as Treasury yields rose 55 basis points and spreads widened 48 basis points, while distressed debt fell 5.1%. The speaker also relayed the view that covenants can signal weaker credit quality, and speculated that stronger covenant protection might lift some debt trading in the 60s into the 80s.

Diaz-Matos said covenant quality has deteriorated through changes to voting provisions and EBITDA definitions and the removal of covenants, helping create conditions for modern liability-management transactions. He also questioned whether today’s much longer agreements are more protective, while noting that AI can review a corpus of loan documents for concerns and could make drafting faster and more efficient.

Several liability-management disputes turned on routes around document restrictions: Realogy was blocked by a collateral-document restriction, J. Crew moved IP through a non-guarantor restricted subsidiary before transferring it to an unrestricted subsidiary, and Aston Martin’s blocker did not prevent an IP transfer to a non-guarantor restricted subsidiary. Diaz-Matos also cited Xerox’s joint-venture transfer of its brand and other IP as an example of how typical covenants may not reach a new transaction structure.

Serta’s use of a non-pro-rata exchange under an open-market-purchase exception left excluded lenders behind; the Fifth Circuit rejected the transaction as an open-market purchase, and the bankruptcy court later awarded those lenders about $261 million plus prejudgment interest. Diaz-Matos linked the dispute to covenant drift and seemingly small drafting distinctions, and said significant damages in non-pro-rata deals could push lender groups toward pro-rata solutions.

Diaz-Matos said borrowers increasingly may execute a transaction and leave lenders to challenge it, rather than having lenders self-police against agreement language; he illustrated how a 79.5%-of-EBITDA transfer threshold could leave a route around a restriction. Sacred rights can provide more durable protection because ordinary covenants can be changed, but examples such as Ankora and Wesco show issuers finding ways to meet heightened consent thresholds, while after-the-fact Serta blockers may not prevent future transactions.

EA bondholders are seeking a par takeout on bonds that traded in the low 80s, illustrating how covenants can offer investors upside as well as downside protection. That potential benefit sits alongside Diaz-Matos’s warning that covenant quality has deteriorated over time and his view that sacred rights can preserve protections that ordinary covenants cannot.