Moody's has forecasted 300 speculative-grade borrowers will default this year. Given the well-established fact that recession leads to lower recoveries, investors could get a double hit: more defaults and higher losses in each case. Recovery rates could prove to be just as important as defaults in determining the fate of creditors in the loan and bond markets alike. Duncan Wood reports.
Default rates are expected to soar this year to levels not seen since the bursting of the dot-com bubble. When more companies default, investors recover less on their loans and bonds. That’s reason enough for investors to be nervous – but it gets worse: analysts warn that changes in the debt market prior to the crisis, in particular the shift to complicated, loan-heavy capital structures, will make it difficult to forecast recoveries. It could also mean that more value than unusual is destroyed in default, especially for high yield bonds which now have more senior debt above them and will therefore absorb greater losses.
The early signs – while patchy – are not promising. In the most alarming case to date, holders of high-yield bonds issued by Dutch petrochemicals company LyondellBasell saw the April 16 settlement of default swaps on the company’s loans imply a recovery of just 2 cents on the dollar. A number of other recent defaults are expected to see disappointing recoveries on loans and bonds alike.
The trend started last year. According to an analysis of post-default trading prices by Moody’s Investors Service, senior unsecured bonds that defaulted in 2008 will recover 23.9% on average in Europe and 36% in the US, compared to historical averages of 28.6% and 37.2% respectively. In the US, loans have tended to recover close to 70% of their value – last year it was 62%, the agency said. As the default rate surges in 2009 and 2010, the fear is that recoveries will fall further.
The times they are a changin’?
“The market has changed so much that we really can’t forecast what is going to happen, but if you look at where loans and bonds are trading, it suggests that not only will defaults increase but recovery rates may not be what we have seen in the past,” said Luisa Michel, a senior research analyst with Hammond Associates, investment consulting firm in St Louis.
The rating agencies broadly agree that around 14% of speculative-grade debt will default this year, said William Porter, head of credit strategy with Credit Suisse in London – a figure he also concurs with. But he warned that one indicator is currently painting a more pessimistic picture: earnings. Having looked at profitability for speculative grade issuers, a large number of companies experienced a fall in earnings of around 80% in the first quarter of 2009 compared with the same period in 2008, he said.
“I’ve been getting numbers that don’t make sense because they are so high,” he added. “If profits don’t bounce back right away then the second quarter will see a slug of companies running at a loss. The numbers I’m seeing imply a default rate of 16% or 17%. That’s not a forecast, but it does show why I’m entirely comfortable with the default rates coming out of the agencies.”
While there is broad consensus around default rates, recoveries are more contentious – in part because individual cases vary so much. Last year, for example, unsecured bonds issued by GMAC International recovered 85.5%, while those belonging to three defaulted Icelandic banks all recovered less than 5%. This year, the recoveries implied by settlements in the credit default swap market have ranged from the rock-bottom Lyondell rate to a more generous 28% for US mall developer The Rouse Company. Part of this variation is due to the sector: services companies, for example, don’t have a lot of valuable machinery.
The jurisdiction in which an issuer files for bankruptcy introduces another important variable, said Marc Lewis, an analyst with Standard & Poor’s in London: “Insolvency regimes matter. Two equivalent companies that were based in the UK and France could produce very different recoveries simply because the jurisdiction for creditors is much more favourable in the UK. You should get your money back quicker and in a more predictable way.”
Some general themes could also depress recoveries. Before the crisis took hold, collateralised loan obligations and non-bank investors had replaced banks as the ultimate risk takers, said Ed Eyerman, head of European leveraged finance with Fitch Ratings in London. These new creditors had deep pockets and brought asset management savvy to the loan market – but their belief in the power of diversification made them less sensitive to the credit risk of individual companies. The result was that credit became easier to get, the terms became looser and the average credit risk of borrowers increased. Today, a third of the 288 loans rated by Eyerman’s team are either in the severely distressed CCC rating bucket, or are B- with a negative outlook. Things were very different five years ago: “If you were to look at our ratings in 2004, most of the portfolio would have been rated single B or B+ even. By 2006 we were decidedly in B and B- territory and then by 2007 we were solidly B-.”
“In the refinancing boom from 2004 to 2007, loans became very popular,” said Ken Emery, director of corporate default research with Moody’s in New York “A lot of companies in our rated universe were only issuing loans – no bonds at all – and even for companies that had both loans and bonds, loans were becoming a larger share of total debt. That alone, even with no changes in the macro-economic environment, implies less debt below the loans in a bankruptcy situation – so lower expected loan recoveries. It should also mean lower expected bond recoveries as well because they now have more senior debt in front of them in the capital structure.”
Loans were gaining popularity partly because they came with fewer strings than in the past. Lenders removed or weakened covenants, giving them a chance to restructure the credit when companies got into trouble. Investors are now being forced to sit by and watch as company profits turn to losses and cash reserves go up in smoke. By the time they can re-engage with the borrower, missing interest payments and the value of the entity – along with recovery prospects – may have dwindled.
But there’s a flipside to this argument: “If we do now see a reasonably strong economic recovery here, those deal structures may have allowed companies to escape default altogether. So, both default rates and recovery rates really hinge on where the macro-economy is going to be heading over the next six to 18 months,” said Emery.
In some cases, creditors are deciding that propping a company up for a while longer is a better bet than allowing it to go under now, said Fitch’s Eyerman: “We are seeing a lot of restructurings that are not real restructurings. They are not designed to make the company competitive within its industry over the long term, they are designed to just buy the creditors a bit more time to avoid taking a greater loss than they expected to realise.” Mobile phone distributor 20:20 Mobile and German auto supplier TMD Friction both had debt written off more than once, he said.
The explosive growth of the credit default swap market prior to the crisis has also contributed to the situation. Creditors that are holding protection may not have any economic interest in seeing a company’s debts reorganised, said S&P’s Lewis: “If you’re protected and you can have a default declared, then you can potentially get paid out in full quickly. So CDS holders are less likely to be concerned with the outcome of potentially drawn-out restructurings, because the recovery risk is transferred to the credit protection seller.”
Credit Suisse’s Porter said the impact of CDS buyers’ motivations is one of the big unknowns in the current cycle: “In bankruptcy discussions, you will have people in the room with a set of interests that can be diametrically opposed to the remainder of the bondholders. So, for example, you could in theory be sitting in a meeting where the company needs your consent to a unanimous restructuring to avoid a default, but because you are long protection you simply withhold your consent. In fairness, we have seen 28 auctions this year with no such action and the market would punish it, but it is a clear risk.”
The bottom line, for Porter, is that recoveries could prove to be just as significant in determining total losses as the actual rate of default. In the high yield market at least, secondary market prices currently appear to have factored in expectations for a strong economic recovery, he said, with the Credit Suisse index rallying from 1400 in March to around 800 in the first week of June. If recoveries fall to around 20% and default rates hit 15%, the market as a whole will see a 12% credit loss, he said. That is roughly what investors might expect to write off across an entire credit cycle.
“My challenge to the market is ‘how are you going to feel about defaults and recoveries at these sorts of levels later in the year?’ And I think the answer has to be that it wouldn't feel too good at these pricing levels,” said Porter.