Tuesday, June 24, 2008

Junk Investors, Look Out if Defaults Rise

Investors in loans made to junk-rated U.S. companies could be surprised by how little they get back if borrowers start defaulting. A report to be published Tuesday by Moody's Investors Service argues that the explosion of loans issued by junk-rated companies in the past few years means that if they default, the recoveries on these loans might be less than in the past. The highest-priority loans, called first-lien senior secured bank loans, will likely recover on average 68 cents on the dollar upon default in this downturn, compared with a historical average of 87 cents, Moody's said. Typically, loan holders are considered the senior creditors when a company defaults, so they are the first lenders in line for a company's assets. But because companies issued so much of this debt, the loan holders will likely get back less than they have in the past, according to the report. Companies issued so much of this debt because it was popular with investors after the tech bubble burst, and the loans held up well during the previous downturn. Now, Moody's expects loan investors to fare almost as badly as investors in riskier junk bonds have done in previous busts. "It doesn't matter what you call something," says Kenneth Emery, author of the report. "What matters is where you sit in the liability structure." Since 2004, the number of junk-rated companies that borrowed money only in the loan market has doubled, according to the report. Now, these loan-only issuers amount to a third of all U.S. junk companies. Wall Street packaged these loans into popular structured-investment vehicles called collateralized loan obligations, which were among the biggest buyers of leveraged loans. Since the credit markets faltered last summer, loans have already logged unprecedented declines in their value as the M&A boom left a hefty pile of unsold loans hanging over the market. About $173 billion of that has been sold off since July, leaving $64 billion, according to Standard & Poor's Leveraged Commentary & Data. Valuations have improved, putting the average loan price back to 93 cents on the dollar from a low point earlier this year of 86 cents. But corporate defaults are expected to rise amid the economic slowdown and tighter lending standards by banks and other creditors. Weak recoveries don't help prospects for investors or for managers of collateralized loan obligations, which bought about 60% of the loans issues in the past few years. The credit-ratings agencies expect corporate defaults to rise to at least 5% by year end. "It's going to be 18 to 24 months before we slog through these pending defaults and get back to a more normal market," says Michael Bacevich, co-head of leveraged credit at Hartford Investment Management, which manages loan funds and collateralized loan obligations. Moody's also says second-lien, or low priority, loan holders are expected to recover just 21 cents on the dollar in this cycle, compared with 61 cents historically. Senior unsecured junk bonds are likely to recover 32 cents on the dollar compared with a 40-cent historical average. According to Standard & Poor's, the market is already showing investors expectations for weak recoveries on recent bankruptcies. California real-estate development entity LandSource Communities Development filed for Chapter 11 bankruptcy protection earlier this month, and its loans are trading at about 75 cents on the dollar. Its second-lien debt was most recently priced in the high teens, says S&P. For the 19 loans that have defaulted this year, the average price immediately after the default was 70 cents on the dollar, much lower than the average 91 cents during pre-2007 boom times.

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