Monday, January 12, 2009
Bond Recovery in Bankruptcies Likely to Be Far Lower Than in Past Downturns
Junk bond yields were recently as high as 20% (they've improved a bit recently). Some commentators considered the record spreads to be overdone. I don't have a point of view as to whether a particular junk bond interest level is cheap or dear, but I have commented from time to time that there was good reason for distressed debt to be a lot more distressed than in past down cycles. A few of the reasons: 1. Record proportion of junk issuers (more than half of the rated companies) means more companies will hit the wall (simply by virtue of more being levered). That in turn means more divisions/companies looking for suitors at the same time, more competition for workout funding, which means even worse terms for them than in the past. And that is before we get into the fact that this credit crisis is more acute that its post WWII predecessors, and the usual bottom fishers (private equity funds, wealthy families, "raiders" like Ron Perlman) all seem to have their hands full. 2. Prevalence of cov-lite means companies are likely to be in worse shape when they finally succumb. Why? With covenants, creditors can impose restrictions on company operations and force a debt restructuring/renegotiation when serious trouble first develops. If push comes to shove, the creditors can force it to file for Chapter 11 (they have the right to "accelerate" the debt, meaning demand repayment, if the covenants are breached). That means that the creditors can take steps to try to preserve value before the train goes completely off the rails. The alternative when bondholders are neutered, is that the company keeps going until it runs completely out of gas. And in that scenario. there is usually less recovery value. The Financial Times today provides some confirmation of the notion that recovery value this time around are going to be considerably lower than in past recessions: The combination of the severity of the downturn and the complex way corporate debts were structured in the credit boom is reducing rates of recovery of funds invested in companies that default. The settling of credit derivatives linked to Tribune, the now bankrupt newspaper group, last week provided evidence of the potential downside. The price of the bonds was set at only 1.5 cents on the dollar. For loans, the price was set at 23.75 cents. What creditors recover will be worked out over the ensuing months in bankruptcy court and it could be higher (or lower).... David Bullock, managing director at Advent Capital, said: “You have leverage at historically high levels in an economy that is in historically dire straits”. Kenneth Emery, director of corporate default research at Moody’s Investors Service, said that given the likely severity of the recession, his agency “wouldn’t be surprised” to see average recoveries on senior unsecured debt fall to as low as 15 cents on the dollar... Recoveries on loans, which traditionally have been around 87 cents on the dollar, could be as low as 52, on average, he said. This reflects not only a rising tide of defaults but also the way balance sheets were structured in the boom years. Leveraged loans total nearly $600bn, up from $117bn in 2000, according to Standard & Poor’s LCD. The top-heavy capital structures – loans get repaid before holders of bonds – means more loan investors will have to divide up the assets of a bankrupt company, accepting greater losses. It also leaves little for any bondholders beneath them... The loose lending conditions also produced debt structures with fewer triggers which could force a financial restructuring. This lets a struggling company continue operating longer before defaulting, sapping the value of assets. Liquidations, which result in lower recoveries, also are expected to increase as tight credit conditions are preventing companies from obtaining financing to reorganise in bankruptcy. Note that these cov-lite structures will have nasty real world effects beyond greater losses to investors. Liquidations (as opposed to restructurings) means greater job losses.