The Coming Default Wave Is Shaping Up to Be Among Most Painful

KKR's $3.35 Billion Call on U.S. Distressed Assets
  • Losses on defaults are growing higher as leverage rises
  • Bond prices may not reflect the trouble that's brewing

When the next corporate default wave comes, it could hurt investors more than they expect.

Losses on bonds from defaulted companies are likely to be higher than in previous cycles, because U.S. issuers have more debt relative to their assets, according to Bank of America Corp. strategists. Those high levels of borrowings mean that if a company liquidates, the proceeds have to cover more liabilities. 

"We’ve had more corporate debt than ever, and more leverage than ever, which increases the potential for greater pain," said Edwin Tai, a senior portfolio manager for distressed investments at Newfleet Asset Management.

Loss rates have already been rising. The potential for them to climb further may mean that in general junk bonds are not compensating investors enough for the risk they are taking, said Michael Contopoulos, high yield credit strategist at Bank of America Merrill Lynch. The average yield on a U.S. junk bond is now around 8.45 percent, according to Bank of America Merrill Lynch indexes, about the mean of the last 10 years.

In bad times, corporate bond investors on average lose about 70 cents on the dollar when a borrower goes bust. In this cycle, that figure could be closer to the mid-80s, Bank of America strategists said. Those losses would be the worst in decades, according to UBS Group AG’s analysis of data from Moody’s Investors Service.

At least part of the pain that investors will experience in this downturn was deferred from the last credit crunch, which for corporate issuers was relatively short-lived. During the financial crisis, the Federal Reserve was quick to cut rates, and investors began diving back into junk bonds quickly, said Alan Holtz, a managing director in the turnaround and restructuring practice at AlixPartners, a consulting firm that focuses on companies in distress. Many companies were able to refinance debt instead of defaulting.

"A lot of the troubled companies that had become overleveraged were able to find more temporary solutions in the last credit cycle," Holtz said. "Those Band-Aids are no longer available now, and a lot of companies are going to have to face distress," he said.

Leverage levels have been rising as more companies use borrowings to refinance existing liabilities, buy back shares and take other steps that do not increase asset values, Holtz said. Capital expenditure, which does boost assets, has been relatively low during this cycle.

Junk-rated companies have debt equal to about 48 percent of their assets now, up 7.5 percentage points in the last 7 years, according to Bank of America Merrill Lynch data. The ratio of debt to assets is one of the main factors in how big losses will be when a borrower defaults, and it could be headed higher than in previous cycles. 

Another factor is the rate of default, because when more companies are defaulting, more are looking to sell assets or otherwise restructure, leaving investors with lower recoveries. Default rates currently stand around 4 percent, according to Moody’s. The ratings company forecasts that the measure will rise to 5.05 percent by the end of the year in the best-case scenario, and could jump as high as 14.9 percent under the most pessimistic projection.

Default rates and debt-to-asset ratios explain 75 percent of the variation in observed recoveries, Bank of America strategists said.

Shrinking Recoveries

As debt-to-asset ratios and default rates have risen, recovery rates, or the percentage of principal that investors get back when a credit defaults, have already started falling. They stand at around 29 cents on the dollar, according to Bank of America Merrill Lynch data. Two years ago, that figure was closer to 44 cents. In other words, loss rates are already starting to rise.

The long-term average recovery rate for senior unsecured debt across the entire credit cycle is around 40 cents on the dollar, a level that falls to around 30 cents when times get bad. In downturns going back to the 1980’s, the lowest recovery rate was around 22 cents in 2001, according to UBS strategists’ analysis of Moody’s data.

Bank of America strategists see possible recovery rates in the mid-teens in this cycle. While holding a portfolio of speculative-grade bonds to maturity at current yields may still result in a positive return for investors, higher defaults and losses on the securities will likely weigh on prices in the coming months, Contopoulos said.

Taking steps including buying secured debt can help mitigate investors’ trouble, Newfleet’s Tai said. Newfleet had $11 billion under management as of December 31.

The low price of oil is another factor that will likely hamper recoveries. Crude now trades at around $36 a barrel, down about 65 percent from its level in mid-2014, a decline severe enough that a few drillers have started missing payments on their debt.

Some energy companies will be able to negotiate with their lenders to cut their debt loads. But a chunk of them have production costs that are too high even ignoring borrowing costs, giving their creditors few options apart from liquidating the company.

For many liquidated energy companies, "there’s not a whole lot to recover in terms of cash," said Leonard Klingbaum, a partner at law firm Willkie Farr & Gallagher.

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