Debt Traders Are Losing the Junk Retail Game

Bond investors are playing a tricky game with lower-rated U.S. retailers, and they appear to be losing.

Here's how it goes: Investors buy beaten-up bonds of struggling store operators and earn big regular payments for as long as they can. The bond buyers win if the companies remain solvent for longer than expected or even improve their outlooks. They can also win if the debt is relatively high in the capital structure and they're able to recover more money than they put in if the company goes bankrupt.

On the flip side, they lose if the borrowers' condition deteriorates, even if the downturn is drawn out. That's what's happening now for store owners such as Toys "R" Us Inc. and Bon-Ton Stores Inc., which both hired advisers to help them restructure their debt, according to reports this week. More broadly, these companies are among retailers that are bumping along as their outlooks slowly worsen.

Toys "R" Us, for example, has been in a fragile financial state for years, but it appears to have taken a turn for the worse. The heavily leveraged retailer this week enlisted lawyers at Kirkland & Ellis to help restructure its $5 billion in longer-term debt, with a particular emphasis on $400 million in debt coming due next year, according to Bloomberg News.

Despite the fact that Toys "R" Us hasn't had what could be considered a long-term viable business model for several years, the move seemed to catch some bond investors by surprise. Its debt sank this week, with its $208.3 million of bonds maturing in 2018 plunging to nearly 70 cents on the dollar Friday from near par just days earlier.