Beneath the surge in corporate defaults lies a surge in distressed exchanges.
Such exchanges — defined by Moody's Investors Service as when a troubled company offers its lenders new or restructured debt, securities, cash, or other assets, that amount to a smaller commitment than the original IOU — could have big implications for debt markets as they stretch out the current credit cycle and result in even greater losses for investors.
The trend is most apparent in the energy sector where oil and gas companies have been deploying a raft of creative measures to stay afloat amid lower crude prices that have crimped profits and threatened their survival. Such measures have included swapping unsecured debt for secured, offering discounted buybacks of existing debt, or junior-lien debt that gets paid after other creditors.
"While these [distressed exchanges] do result in some level of loss to bondholders, unlike missed payments and bankruptcy filings the bonds typically remain eligible for inclusion in the high-yield index," Kai Gilkes and Anneli Lefranc, analysts at CreditSights Inc, wrote in new research. They note that the 12-month default rate rose to 7.2 percent for U.S. junk-rated bonds in August. That's an increase of 30 basis points compared to July's default rate of 6.9 percent, spurred on by six corporate defaults last months — including a trio of U.S. energy companies.
"Distressed exchanges have contributed greatly to the rise in default rates," they add, with 38 of the 75 U.S. high-yield defaults over the last 12 months coming from such deals.
The degree to which distressed exchanges are propelling defaults higher is apparent in the below CreditSights chart, which shows the U.S. and European default rate excluding the swaps.
The question now will be whether such exchanges actually help companies improve their balance sheets and reduce their debt long enough to enjoy a recovery in oil prices or the market's appetite for energy-related assets. If they don't, then truly troubled companies will only have succeeded in putting off the inevitable and their lenders risk suffering greater losses further down the line.
It's a point made more salient by this week's news that recovery rates for investors in energy company bankruptcies already averaged a "catastrophic" 21 percent last year — or well below the historical average of 59 percent, according to Moody's data.
"When all the data is in, including 2016 bankruptcies, it may turn out that this oil and gas industry bust may be on par with, and possibly worse than the telecom industry collapse in the early 2000s, in terms of both number of recorded bankruptcies and very poor firm-wide recoveries for creditors," the rating agency's analysts, led by David Keisman, said in their report.
Moreover, the degree to which such exchanges actually help energy companies stave off bankruptcy is not entirely clear. More than half of the exchanges struck by energy companies last year failed to stop the firms from filing from bankruptcy protection in 2016, according to Moody's. In the meantime, the deals may add to pressures in the oil market by keeping 'zombie' drillers alive for longer than crude prices might suggest.
"The issuance of second-lien debt — and other secured debt variants such as third-lien debt or even 1.5-lien debt — led to significant leverage creep in the already highly levered capital structures, while funding capital expenditures and extending the financial viability of distressed companies," the analysts wrote. "It arguably sustained the U.S. oil and gas supply, while prices remained uneconomic for a significant swath of such oil and gas drilling."