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Fridson: Found! The turning point for HY overweighting

Synopsis: A simple rule derived from the definition of distressed debt has consistently generated alpha for tactical asset allocators in past high-yield recoveries from market lows.

The challenge: When to pull the trigger?
The large variance in short-run returns among asset classes during major market turns produces huge payoffs for successful tactical asset allocation. Consider, for example, what a fixed-income manager could have achieved following the 2001 recession by astutely varying the relative weights of investment-grade and high-yield corporates. In the second quarter of 2002, the investment grade BofA Merrill Lynch US Corporate Index trounced the BofA Merrill Lynch US High Yield Index, 4.37% to -6.98%. One year later, the tables turned, with the HY index crushing the IG index, 10.02% to 2.47%, in the second quarter of 2003.

Given these rewards, why doesn’t every money manager grab oodles of alpha by reallocating during major market turns? The problem is that it requires calling the turn. Classically, the relatively undervalued asset may get more undervalued before the market comes to its senses. Jumping in too early can be disastrous for managers who do not have the luxury of being evaluated only on a multiyear basis. For those trying to put up good quarterly numbers, it is not good enough to say, “I am confident that in the fullness of time the market will recognize the wisdom of my positioning, even if I suffer a year or two of underperformance in the interim.”

Here is the good news: A startlingly simple timing signal has consistently paid off over a three-month horizon in recoveries from high-yield cyclical bottoms. Recognize upfront that the methodology does not guarantee capturing the cyclical rebound’s highest three-month return and the historical sample size is small. With those caveats, the trading strategy is a bona fide no-brainer and has reliably generated very substantial alpha.

Breaking through 1,000
The easy-to-remember rule for deciding when to step up high-yield exposure is to pull the trigger the day after the option-adjusted spread (OAS) on the BofAML High Yield Index falls below 1,000 bps.

High-yield cognoscenti will recognize the 1,000 bps level as the threshold for defining distressed bonds, a standard I introduced some 25 years ago. At an OAS of 1,000 bps, the market is essentially saying that the high-yield asset class as a whole is distressed. When the spread moves out of that territory, the market is signaling that financial distress is receding.

To test this trading rule, I measured three-month returns on the BofAML High Yield Index, the BofA Merrill Lynch US Non-Distressed High Yield Index, the BofA Merrill Lynch US Distressed High Yield Index, the BofA Merrill Lynch US Treasury & Agency Index, and the investment-grade BofAML Corporate Index. I started each trial on the first trading day after the spread first fell below 1,000 bps. Future users of this strategy do not have to predict anything or exercise any judgment, but can instead wait to act until the decisive piece of information has arrived.

For the period preceding OAS availability on the BofAML High Yield Index, that is, prior to Dec. 31, 1996, I used the yield-to-maturity (YTM) difference between the BofAML High Yield Index and the BofA Treasury & Agency Index. (Yield-to-worst figures are also unavailable prior to Dec. 31, 1996.) This substitution is justified by a comparison of the YTM spread and OAS during the period in which both are available. From Dec. 31, 1996 to Dec. 31, 2014, the median monthly difference between the two versions of the spread, when OAS was in a range of 900-1,000 bps, was – remarkably enough – one basis point. (The YTM version was higher by that amount.) As a point of interest, the gap increased as OAS declined.

Note, in addition, that the inception date of the BofAML Non-Distressed High Yield Index and the BofAML Distressed High Yield Index is, you guessed it, Dec. 31, 1996, so returns are not available on those indexes for the first two trials depicted in the table. Finally, the high-yield market had just one cyclical low in the early 1990s, but the high-yield spread exited the distressed zone twice. After falling below 1,000 bps on Dec. 24, 1990, the spread later rose above that threshold before definitively dropping below it on Feb. 12, 1991. (The first trial in the table commences after the market’s closure for Christmas on Dec. 25, 1990.)

First table Fridson Sept 2015

Results
In all five trials high-yield outperformed governments by at least 5.10 percentage points and in the most extreme case, by 13.28 percentage points. Note that these are non-annualized, three-month returns. On an annualized basis, the high-yield returns during the five episodes documented here ranged from 30.32-78.99%. High-yield similarly outperformed IG corporates every single time, by margins ranging from 2.75-12.13 percentage points.

In the three trials in which returns are broken out by distressed and non-distressed, dynamic asset allocators following the 1,000 bps rule and achieving average results would have beaten governments by 2.51 to 4.90 percentage points without needing to own a single distressed issue. The non-distressed high-yield performance edge over IG corporates was likewise substantial in both 2001 and 2009. Naturally, coming off the bottom, the distressed component of the high-yield market turned in exceptionally high returns, ranging from 63.29-174.40% in annualized terms.

Not engineered to catch the absolute bottom
Based on an admittedly limited historical record, the simple 1,000 bps rule generates a substantial three-month performance bonus for tactical asset allocators. Adopters of the trading rule should be forewarned, however, that I have not solved the problem of precisely calling the bottom. Indeed, the high-yield OAS may narrow by hundreds of basis points, producing sizzling high-yield returns, before it finally cracks the 1,000 bps barrier.

The table below compares the high-yield returns captured by the 1,000 bps rule during the high-yield market’s four cyclical recoveries with the peak quarterly returns observed in those cycles. In 2001 the 1,000 bps rule actually produced a return slightly higher than that of the best quarter of the cyclical rebound. In the others, an asset allocator astute enough to have entered at the start of the peak quarter did materially better than followers of the 1,000 bps rule. For mere mortals, however, adding hundreds of basis points over comparable-period returns on high-quality bonds is an outstanding achievement.

Second table Fridson Sept 2015

Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors LLC, is a contributing analyst to S&P Capital IQ. His weekly leveraged finance commentary appears exclusively on S&P Capital IQ LCD. Marty can be reached at [email protected]

Research assistance by Yueying Tang and Zizhen Wang.

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Fridson: When to pull the trigger during major market turns in high yield?

Synopsis: A simple rule derived from the definition of distressed debt has consistently generated alpha for tactical asset allocators in past high-yield recoveries from market lows.

The challenge: When to pull the trigger?

The large variance in short-run returns among asset classes during major market turns produces huge payoffs for successful tactical asset allocation. Consider, for example, what a fixed-income manager could have achieved following the 2001 recession by astutely varying the relative weights of investment-grade and high-yield corporates. In the second quarter of 2002, the investment grade BofA Merrill Lynch US Corporate Index trounced the BofA Merrill Lynch US High Yield Index, 4.37% to -6.98%. One year later, the tables turned, with the HY index crushing the IG index, 10.02% to 2.47%, in the second quarter of 2003.

Given these rewards, why doesn’t every money manager grab oodles of alpha by reallocating during major market turns? The problem is that it requires calling the turn. Classically, the relatively undervalued asset may get more undervalued before the market comes to its senses. Jumping in too early can be disastrous for managers who do not have the luxury of being evaluated only on a multiyear basis. For those trying to put up good quarterly numbers, it is not good enough to say, “I am confident that in the fullness of time the market will recognize the wisdom of my positioning, even if I suffer a year or two of underperformance in the interim.”

Here is the good news: A startlingly simple timing signal has consistently paid off over a three-month horizon in recoveries from high-yield cyclical bottoms. Recognize upfront that the methodology does not guarantee capturing the cyclical rebound’s highest three-month return and the historical sample size is small. With those caveats, the trading strategy is a bona fide no-brainer and has reliably generated very substantial alpha.

Breaking through 1,000

The easy-to-remember rule for deciding when to step up high-yield exposure is to pull the trigger the day after the option-adjusted spread (OAS) on the BofAML High Yield Index falls below 1,000 bps.

High-yield cognoscenti will recognize the 1,000 bps level as the threshold for defining distressed bonds, a standard I introduced some 25 years ago. At an OAS of 1,000 bps, the market is essentially saying that the high-yield asset class as a whole is distressed. When the spread moves out of that territory, the market is signaling that financial distress is receding.

To test this trading rule, I measured three-month returns on the BofAML High Yield Index, the BofA Merrill Lynch US Non-Distressed High Yield Index, the BofA Merrill Lynch US Distressed High Yield Index, the BofA Merrill Lynch US Treasury & Agency Index, and the investment-grade BofAML Corporate Index. I started each trial on the first trading day after the spread first fell below 1,000 bps. Future users of this strategy do not have to predict anything or exercise any judgment, but can instead wait to act until the decisive piece of information has arrived.

For the period preceding OAS availability on the BofAML High Yield Index, that is, prior to Dec. 31, 1996, I used the yield-to-maturity (YTM) difference between the BofAML High Yield Index and the BofA Treasury & Agency Index. (Yield-to-worst figures are also unavailable prior to Dec. 31, 1996.) This substitution is justified by a comparison of the YTM spread and OAS during the period in which both are available. From Dec. 31, 1996 to Dec. 31, 2014, the median monthly difference between the two versions of the spread, when OAS was in a range of 900-1,000 bps, was – remarkably enough – one basis point. (The YTM version was higher by that amount.) As a point of interest, the gap increased as OAS declined.

Note, in addition, that the inception date of the BofAML Non-Distressed High Yield Index and the BofAML Distressed High Yield Index is, you guessed it, Dec. 31, 1996, so returns are not available on those indexes for the first two trials depicted in the table. Finally, the high-yield market had just one cyclical low in the early 1990s, but the high-yield spread exited the distressed zone twice. After falling below 1,000 bps on Dec. 24, 1990, the spread later rose above that threshold before definitively dropping below it on Feb. 12, 1991. (The first trial in the table commences after the market’s closure for Christmas on Dec. 25, 1990.)

Results

In all five trials high-yield outperformed governments by at least 5.10 percentage points and in the most extreme case, by 13.28 percentage points. Note that these are non-annualized, three-month returns. On an annualized basis, the high-yield returns during the five episodes documented here ranged from 30.32-78.99%. High-yield similarly outperformed IG corporates every single time, by margins ranging from 2.75-12.13 percentage points.

In the three trials in which returns are broken out by distressed and non-distressed, dynamic asset allocators following the 1,000 bps rule and achieving average results would have beaten governments by 2.51 to 4.90 percentage points without needing to own a single distressed issue. The non-distressed high-yield performance edge over IG corporates was likewise substantial in both 2001 and 2009. Naturally, coming off the bottom, the distressed component of the high-yield market turned in exceptionally high returns, ranging from 63.29-174.40% in annualized terms.

Not engineered to catch the absolute bottom

Based on an admittedly limited historical record, the simple 1,000 bps rule generates a substantial three-month performance bonus for tactical asset allocators. Adopters of the trading rule should be forewarned, however, that I have not solved the problem of precisely calling the bottom. Indeed, the high-yield OAS may narrow by hundreds of basis points, producing sizzling high-yield returns, before it finally cracks the 1,000 bps barrier.

The table below compares the high-yield returns captured by the 1,000 bps rule during the high-yield market’s four cyclical recoveries with the peak quarterly returns observed in those cycles. In 2001 the 1,000 bps rule actually produced a return slightly higher than that of the best quarter of the cyclical rebound. In the others, an asset allocator astute enough to have entered at the start of the peak quarter did materially better than followers of the 1,000 bps rule. For mere mortals, however, adding hundreds of basis points over comparable-period returns on high-quality bonds is an outstanding achievement.

Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors LLC, is a contributing analyst to S&P Capital IQ. His weekly leveraged finance commentary appears exclusively on S&P Capital IQ LCD. Marty can be reached at [email protected].

Follow Marty on Twitter

Research assistance by Yueying Tang and Zizhen Wang.

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Dex Media fails to make Sept. 30 interest payment on PIK high yield bonds

Directory publisher Dex Media today announced that it will not make the Sept. 30 interest payment due on its subordinated high yield bonds, and will now enter into a customary 30-day grace period.

The directory publisher filed for Chapter 11 bankruptcy protection in 2013 as part of the merger of Dex One with SuperMedia.

The CCC-/Caa3 notes were pegged at 5.75 according to S&P Capital IQ, and have been trading right around there in odd lots of late, including a small block at 5 this morning.

Over in the loan market, the company’s loans have recently been quoted at distressed levels. Earlier this week, both the Dex East term loan (L+300, 3% LIBOR floor) and the Dex West (L+500, 3% floor) were marked at 59/61, while the SuperMedia term loan (L+860, 3% floor) was quoted at 52.5/54.5, and the R.H. Donnelly term loan (L+675, 3% floor) was quoted at 47/49. All four of the company’s loans mature on Dec. 31, 2016.

The company is required to make payments of 50% in cash, and 50% in PIK interest on the 12%/14% subordinated PIK toggle notes due 1/29/2017 until maturity of the senior secured credit facilities on December 31, 2016, filings show.

If the company fails to make the required interest payment on or before Oct. 30, 2015 and subsequently falls into default, holders of the notes can declare the notes immediately payable.

The subordinated notes have approximately $270.1 million outstanding, according to Bloomberg. Dex said in today’s filing that it had a cash bank balance of approximately $251.6 million as of Sept 25, 2015.

Upon the company’s 2013 emergence from Chapter 11, the capital structure split into four parts: the R.H. Donnelley TLB, the Dex Media East term loan, the Dex Media West term loan and the senior subordinated notes due January 2017.

J.P. Morgan is administrative agent under the SuperMedia, Dex Media East, and Dex Media West credit facilities. Deutsche Bank is administrative agent under the R.H. Donnelley credit agreement. – Staff reports

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LCD Daily High Yield Bond Index Report: Data for September 28, 2015

The S&P U.S. Issued High Yield Corporate Bond Index tracks U.S.-dollar-denominated high-yield bonds issued by U.S.-domiciled companies and includes ratings-based sub-indices. Observations below are as of the most recent close, the prior close, a week ago, and a year ago. The data is courtesy of S&P Dow Jones Indices. Further details can be found online at http://bit.ly/1jm5vGs.

HY Corporate Bond Index Sept 28 2015

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High yield bond bids take biggest plunge of 2015, to 4-year low

The average bid of LCD’s flow-name high-yield bonds fell 246 bps in today’s reading, to 91.98% of par, yielding 8.62%, from 94.44% of par on Sept. 24. Performance within the sample was deeply negative, with 13 constituents in the red and 11 by greater than one full point.

Today’s drop takes the average down to a four-year low, or a context not visited since 91.25 on Oct. 6, 2011. It’s also the single largest downside move in the average bid price since that date, when it fell 265 bps amid a squall in the European debt crisis, before rebounding the same amount the next reading.

This time around, declines are linked to ongoing concerns about global economic growth and the commodities crunch, with the latter, in particular, forever defining the state of play for late 2015. The decrease builds on a 186 bps retreat on Thursday, for a net-432 bps decline week over week, and it follows negative observations more mildly in the prior three readings, for a decline of 578 bps dating back four weeks.

Today’s fresh 2015 low now surpasses the depths of December’s oil-related sell-off that put the average at a 2014 low of 93.33 on Dec. 16. Although it had since rallied back for the New Year, the summer sell-off and September slough now have the average 135 bps below that prior low and down 371 bps in the year to date.

Likewise in the broad market, averages have this month turned into the red. To wit, the S&P U.S. Issued High-Yield Corporate Bond Index moved to negative 0.24% at market close on Sept. 22, from positive 0.27% a day earlier, and now sits at negative 1.94% as of market close Sept. 28. One year ago at this point, the index was putting forth a 3.38% year-to-date return.

With the fresh decrease in the average bid price, the average yield to worst jumped 69 bps, to 8.62%, and the average option-adjusted spread to worst gapped out 66 bps, to T+708. Those levels are 2015 wides for both yield and spread. (Note: reconciliation to last week’s yields will be erroneous due to a prior miscalculation on yield to worst.)

Given the small size and more high-beta nature of the flow-name sample, the yield and spread in today’s reading remain a bit wider than the broad index. The S&P U.S. Issued High Yield Corporate Bond Index closed the last reading, Monday, Sept. 28, with a yield to worst of 7.78% and an option-adjusted spread to worst of T+639. – Staff reports

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Unisys withdraws $350M high yield bond offering, citing unattractive market

Unisys on Friday withdrew its $350 million offering of five-year (non-call two) secured notes via joint bookrunners Wells Fargo and Bank of America. Unisys said in a statement that the “current terms and conditions available in the market were not attractive for the company to move forward.”

This is the 15th deal withdrawn from the market in 2015, although two of those – Fortescue Metals and Presidio – returned. In all, $3.93 billion in issuance has been withdrawn this year.

Proceeds had been targeting general corporate purposes, including funding cost-reduction and savings initiatives, obligations under defined benefit plans, and investments in next-generation services and technologies, filings showed.

The notes had been rated BB/Ba2 and guided at 8% area.

Blue Bell, Pa.-based Unisys is an information-technology company that provides IT services, software, and technology solutions worldwide. The company trades publicly on the NYSE under the symbol UIS, with a market capitalization of roughly $650 million. – Staff reports

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Glencore bonds plunge as company scrambles for liquidity

Bonds backing Swiss metals-and-mining concern Glencore plunged in price today after reports late last week that the company was seeking to sell a minority stake in its agricultural business, following other recent bids to shore up its credit standing amid weak commodity-price trends.

The 2.875% bonds due Apr. 16, 2020, which were placed in April by Glencore funding vehicle Glencore Funding at T+155, traded today at a dollar price of 81, or down more than seven points on the day to change hands at T+647, or 380 bps wider week to week, trade data show. The issuer’s 4% notes due April 2025, which were placed in the same April offering at T+220, traded today at dollar prices south of 70, or roughly eight points lower on the day for spreads of roughly T+664, from T+350 a week ago.

News surfaced Friday that Glencore had hired Citigroup and Credit Suisse Group to sell a minority stake in its agricultural business to a group of sovereign wealth funds and Asian trading houses, according to S&P Capital IQ. The whole division could be valued at roughly $12 billion.

The news came hard on the heels of Glencore’s Sept. 7 announcement of plans to raise roughly $2.5 billion of equity capital as part of a broader plan to preserve capital and reduce debt valued at more than $10 billion, in the face of what the company characterized as a “weak commodity price environment.” That plan included the suspension of roughly $2.4 billion of scheduled dividends, $1.5 billion of further cuts to working capital, $2 billion of other asset sales, and cuts to loans and advances and capital spending.

“Notwithstanding our strong liquidity, positive operational free cashflow generation, lack of debt covenants, modest near-term maturities and the recent affirmation of our credit ratings, recent stakeholder engagement in response to market speculation around the sustainability of our leverage, highlights the desire to strengthen and protect our balance sheet amid the current market uncertainty,” said CEO Ivan Glasenberg and CFO Steven Kalmin in a joint statement.

S&P and Moody’s earlier this month affirmed respective BBB/Baa2 ratings after the announcement of the equity-raising plan, but both noted negative outlooks on the ratings profile.

Moody’s shift to negative reflected “the scope for a prolonged difficult market that may cause a slower recovery in Glencore’s financial profile, particularly if copper prices were to decline to below $2.2/lb on a prolonged basis from Moody’s current copper price assumption of $ 2.35/lb for 2016.”

“Given Glencore’s financial leverage, changes in EBITDA and operating cash flow have a proportionately greater impact on our debt coverage measures than changes in debt,” S&P analysts argued. – John Atkins

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European high yield bond funds see €25M cash inflow amid a fragile market

J.P. Morgan’s weekly analysis of European high-yield bond funds shows a €25 million inflow for the week ended Sept. 23. The reading includes a €12 million net outflow from ETFs, and a €73 million net inflow for short duration funds. The reading for the week ended Sept. 16 has not been revised from a €79 million inflow.

The provisional reading for August is a €1.1 billion outflow, marking the third consecutive monthly outflow, with July and June having recorded €260 million and €702 million outflows, respectively. March’s €3.1 billion influx remains the largest monthly inflow on record. January and February both registered a €1.9 billion monthly inflow, while April’s inflow was €1.4 billion, and May’s inflow was €550 million.

Inflows for 2015 through August are €7 billion, versus full-year inflows of €4.15 billion and €8.94 billion in 2014 and 2013, respectively. Inflows for 2015 peaked at €9 billion through the end of May.

Market conditions – both in primary and secondary – are currently fragile, and consequently fund flows have been anaemic over the last couple of weeks, with investors unsure whether the asset class is due for a rally or sell-off. Secondary endured two difficult days last week, during which cash bonds tumbled more than a point across the market, while there were mixed signals in primary where debut issuer Interoute got its M&A-related deal away, but Soho House was forced to withdraw its opportunistic refinancing.

In the U.S., cashflows for U.S. high-yield funds were positive $18 million in the week ended Sept. 23, marking the third consecutive one-week infusion, for a net $440 million inflow over the span, according to Lipper. The latest inflow was all tied to the ETF segment. The full-year reading remains in the red at negative $2.8 billion, with 29% of that ETF-related. Last year after 38 weeks there was a net outflow of $4 billion, with a whopping 47% tied to ETF redemptions.

J.P. Morgan only calculates flows for funds that publish daily or weekly updates of their net asset value and total fund assets. As a result, J.P. Morgan’s weekly analysis looks at around 55 funds, with total assets under management of €38 billion. Its monthly analysis takes in a larger universe of 100 funds, with €52 billion of assets under management. For a full analysis, please see “Europe receives HY fund flow calculation.” – Luke Millar

Follow Luke on Twitter for European leveraged finance news and insight. 

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S&P U.S. distress ratio approaches four-year high

The S&P U.S. distress ratio climbed to 15.7% in September, its highest level since December 2011, according to a report by S&P Global Fixed Income Research (S&P GFIR).

The Metals, Mining, and Steel sector had the largest increase in the proportion of distressed issues, according to the report, gaining about 1.2% to a distress ratio at 53.4%. This also represents the highest sector distress ratio and the second-most issues at 47.

The Oil and Gas sector accounted for 95 of the 270 issues in the distress ratio. The sector had 40% of total distressed debt, and the second-highest sector distress ratio, at 41.9%.

Distressed credits are speculative-grade issues with option-adjusted composite spreads of more than 1,000 basis points relative to U.S. Treasuries. The ratio indicates the level of risk the market has priced into the bonds.

A rising distress ratio reflects an increased need for capital and is typically a precursor to more defaults when accompanied by a severe and sustained market disruption. The default rate – a lagging indicator of distress – increased to 2.21% as of July 31, 2015, from 2.01% on June 30.

Today’s report, titled “Distressed Debt Monitor–Distress Ratio Nears A Four-Year High,” is available to subscribers of premium S&P GFIR content at the S&P Global Credit Portal.

For more information or data inquiries, please call S&P Client Services at (877) 772-5436. – Staff reports

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Goodrich Petroleum bonds fall as co. enters into another distressed debt swap

High yield bonds backing Goodrich Petroleum traded lower on Friday after the Texas-based exploration and production company announced yet another distressed debt exchange, the latest in a series of measures taken by the company as it tries to shore up its balance sheet.

The new transaction will leave investors receiving less than what was promised on the original securities after the company entered into an agreement with a portion of holders of its senior unsecured notes to exchange $158.2 million of the company’s 8.875% notes due 2019 for $75 million of 8.875% second-lien senior secured notes due 2018.

The targeted 8.875% due 2018 notes dropped two to three points to an 18/19 context on Friday, trade data show.

Holders who exchange into the new second-lien notes will receive warrants to acquire six million shares of the company’s common stock.

Following these transactions, approximately $116.8 million in an aggregate original principal amount of the existing notes will remain outstanding. The exchange is expected to close on October 1, 2015, the company said.

In connection with the exchange, Goodrich expects to enter into new amendments to its credit agreement and its existing 8.00% second-lien senior secured notes due 2018 to further allow for the company to incur a new third-lien debt basket to be used for additional exchanges of existing notes for up to $50 million. As a result, the company’s borrowing base is expected to be reduced from $105 million to $75 million in connection with any new amendment.

Standard and Poor’s earlier this month downgraded Goodrich Petroleum’s corporate credit rating to selective default (SD) from B- after the company reached an agreement to exchange $55 million of its original 5% convertible senior notes due 2032 for $27.5 million of 5% convertible notes due 2032.

Goodrich has taken a number of steps to prop up its balance sheet in recent months, including suspending dividend payments to shareholders in August, and divesting a portion of its Eagle Ford assets in a $116 million asset sale that closed earlier this month. – Rachelle Kakouris

Follow Rachelle on Twitter for distressed debt news and insight.