Bondholders Face Bruising From Lehman Bankruptcy

When Lehman Brothers (LEH) made Sept. 15 a day that will live in financial infamy, stockholders were all but wiped out. As Comic Book Guy from "The Simpsons" would say: "Worst bankruptcy ever." (And he'd be right; see chart below.) But what is to become of the firm's bondholders, those who thought they had taken the less-risky route to investing in what was Wall Street's fourth-largest investment bank?

The outlook isn't good.

Right up front, a fixed-income investor needs to understand that during bankruptcy bondholders stop receiving interest and principal payments. So that steady stream of income evaporates. Since misery loves company, we should add that stockholders stop receiving dividends, too.

Once that sobering point sinks in, it's time to identify the exact type of bond that you hold because there's a pecking order as to who gets paid first. Bondholders, as a class, are in the middle of the pack as the company works its way through bankruptcy. (See chart below.)

It gets even more convoluted. The price at which your bond trades (as well as anything you can expect to get out of the bankruptcy) depends on its seniority and whether it is secured or unsecured. (A secured bond has a higher claim on a company's assets than an unsecured one.) Research firm CreditSights has estimated that senior bondholders might get 60 cents on the dollar.

Don't be surprised if you pocket much less. As of Monday Lehman's unsecured debt was trading at 35 cents on the dollar. Subordinated debt, which has a lesser claim on assets, was fetching just a nickel on the dollar.

Bondholders face an unpalatable decision: Sell now at a deep discount or hold on with white knuckles and see how things play out. It's a bitter fact to accept, but at this point the best thing a Lehman fixed-income investor can do is probably nothing.

According to Mark Riepe, head of Charles Schwab's (SCHW) Schwab Center for Financial Research, only those bondholders who desperately need the money should even bother trying to sell, since bid-offer spreads are so wide. Otherwise, he says, wait until Lehman's fate gets clarified a bit before making any move.

"The silver lining for bondholders is that the healthier Wall Street firms are considering setting up a special fund to help finance the orderly liquidation of Lehman's assets," he wrote. "If this comes to pass, it should help bondholders by providing a form of price support to those assets. The more Lehman can get for those assets as it winds down its operation, the bigger the pie for creditors to divide up among themselves."

The ugly reality is that when a company goes bankrupt, a soup line forms. Bondholders might stand ahead of stockholders, but they can expect to wait a long time before getting into the kitchen -- and even then they may not end up with much in their bowls.