Recovery Rates Sink for Loans Tied to Defaults

By KATE HAYWOOD Loan investors are waking up to the harsh reality that they could end up with much less than they had bargained for. Recovery rates on leveraged loans, a type of debt used by many companies during the credit boom to fund buyouts, indicated in recent bankruptcies have been less than 25%, well below the historical average of more than 80%. The reason: The expected rapid-fire failure of companies with high debt loads and shrinking revenues, and a significant shift in borrowing behavior during the credit boom this decade. When a company defaults, creditors that hold loans secured with assets are at the front of the line of those clamoring to be paid back. Their claims on assets are stronger than those of unsecured bondholders and equity investors, who often are wiped out. During the past 20 years, this top-ranking position has enabled loan investors to recover an average of 81%, or 81 cents on the dollar, in default situations, compared with 29% for the lowest tiers of debt, according to Moody's Investors Service. But accelerating ratings downgrades and corporate defaults spell much lower recovery rates for what had been considered the safer debt in this $2.4 trillion market. "There is a growing awareness that the default rate will go up much quicker than expected," said Mark Pibl, managing director at NewOak Capital in New York. Rather than defaults rising progressively over a two- or three-year period, Mr. Pibl said, many market participants now believe the increase will be "front loaded." "We are now in a tail-risk scenario looking at a cluster of defaults occurring at the same time," Mr. Pibl said. The problem is that the majority of leveraged financings relied disproportionately on loans, rather than unsecured bonds, to fund acquisitions. This has reduced (and in some cases eliminated) the traditional cushion of subordinated debt such as junk bonds that would absorb losses first. Indeed, according to Moody's, about 60% of all U.S. issuers that have rated loans, and one-third of all U.S. speculative-grade issuers, have a loan-only capital structure. Things could be far worse for holders of some second-lien loans, which are junior to senior secured first-lien loans. As such, holders of these securities stand behind more-senior lenders in terms of their rights to collect proceeds from the debt's underlying collateral.