Spectre Of Defaults Haunts Markets

Spectre Of Defaults Rises Amid Tight Lending

By David Oakley, Capitalmarkets | 3 February 2008

Heavily indebted European and US companies are facing growing financial difficulties because they cannot refinance their borrowings due to the continuing closure of the credit markets. Companies’ inability to borrow is raising the spectre of defaults, particularly among the most highly leveraged companies in sectors such as property that have been hardest hit by economic uncertainty. A big source for refinancing in Europe was the high-yield bond market, which has been closed since July, the longest closure since 2003. The European leveraged loan market is also at a standstill, with only a handful of deals priced in the past month and $64bn in loans still awaiting syndication according to Dealogic (Fitch: $250bn of bonds and loans). The US high-yield and leveraged loan markets have also slowed to a trickle as fears of recession threaten to exacerbate problems for companies in need of capital. Loans awaiting syndication in the US stand at $74bn, according to Dealogic, while the US high-yield market in January saw the lowest amount of issuance since 1990.

Willem Sels, head of credit strategy at Dresdner Kleinwort, said:

"The closure of the high-yield bond market is approaching a point where it will become a problem for some companies. There does come a time when a company can no longer postpone the need for refunding."

Ken Emery, director of corporate research at Moody’s, the ratings agency, said:

"We have started to see some defaults in the consumer and real estate sectors and that will certainly pick up, although we are coming from a very low base as default rates are very low."

Moody’s reckons the global speculative-grade or junk-grade default rate will jump 10-fold to 10 per cent by the end of the year in the event of a US recession— well above the historic average default rate of 5 per cent. The rise would come off a low of just under 1 per cent recorded in December.

Many analysts believe there is a strong likelihood of a US recession, in spite of the US Federal Reserve’s aggressive interest rate cuts over the past two weeks. Moody’s says companies may survive longer in a recession this time round because easy credit conditions in the first half of last year encouraged many to refinance before the market turmoil. The use of covenant-lite loans, which have relaxed default criteria, may also allow companies to remain in business longer.

Even if companies were able to attract investors, who have remained on the sidelines in the junk-grade arena, they would face annual borrowing charges around 3 percentage points higher as spreads between high-yield bonds and government bonds have widened sharply in both Europe and the US since July last year.


Traders Believe Debt Markets Will Get Worse

By Henny Sender | 24 January 2008

So far, most of the rout in the debt markets has been linked to the US subprime mortgage debacle. Increasingly, however, many hedge funds are betting there is far worse to come for the corporate debt market as well. Hedge fund managers and the trading desks of some of the savviest firms on Wall Street are expecting a severe downturn in the corporate debt market. A big part of their bet is that bonds will perform far worse than in previous meltdowns, because financial engineering has created so many layers of debt on top of unsecured bonds, which are the last debt to get paid in the event of a default.

A number of trades have been made on the assumption that, when things go wrong, corporate creditors will receive far less than 100 cents on the dollar, and the more junior their debt, the less they will get back. One popular trade involves a host of corporate issuers that include retailers such as Linens ’n Things or Michaels Stores, property-related firms such as Realogy, newspapers such as Tribune Group and the newly-minted leveraged buy-outs of companies such as First Data.

The hedge funds hold "long", or bullish, positions in the loans and other debt which is the first to be paid back, while taking bearish or "short" positions on debt that is further down the pecking order and will be the first hit if a company has trouble meeting obligations. Such bets do not require the company to hit a financial wall for the trade to be lucrative. If the senior debt trades up and the junior trades down, hedge funds will make money. And as the macroeconomic backdrop worsens, such trades look ever more attractive.

Their pessimistic views are not yet borne out by traditional benchmarks of corporate health. Historically, the markets tend to focus on corporate debt default rates but this measure is under scrutiny. In December, the average default rate reached a record low of 0.26 per cent. S&P’s Leveraged Commentary & Data analysts think the data is so misleading that it has created a shadow default rate measure by including companies that are not able to pay interest and have taken advantage of clauses in their documents that allow them to issue more debt when they have no cash to pay out interest.

This time, the amount of debt and the number of companies whose debt trades below par— or at less than 100 cents on the dollar— may be a better indicator of things to come. Virtually every loan in the market now trades below par, a far cry from six months ago when virtually every leveraged loan traded above par. For a sobering indication of a possible future, consider the fate of lenders to Movie Gallery, one of the few firms to default in this cycle. Lenders were paid 91 cents on the dollar while bondholders received only 30 cents, according to data from Deutsche Bank.

As long as corporate cash flows hold up, distress isn’t likely to be widespread. Thanks to the 'inventiveness' of bankers, Wall Street and the private equity owners of companies in trouble can buy time because lenders sometimes allow them to issue more debt if they cannot pay their interest in cash— the so-called payment-in-kind debt.<

Such terms are great for owners and the borrowers, because companies can stay afloat without creditors pulling the plug. However, in some cases, companies that are no longer truly viable stay afloat longer than they should, destroying more value and eating up more capital than they should, and lowering recoveries for creditors when they finally do hit the financial wall. In the past, there were lots of early warning signs of looming stress when cash-strapped companies could not meet the terms of their loans. But after years of easy credit, there are fortunate borrowers who are tied to virtually no terms.

David Rubenstein, co-founder of Carlyle Group, has observed that even if many of the companies he owns wanted to default, they could not because they have no obligations at all. Today, the gap between where loans trade and where bonds trade is the highest since May 2005 when the rating agencies considered lowering their ratings on the American car companies, which caused a short-term swoon in the credit markets. This gap highlights the poor outlook for corporate bonds. This is the result of "a lethal cocktail of falling equity and bond prices and poor economic news", says S&P, the rating agency, adding that defaults are already higher than official numbers.

The poor performance is especially marked for companies that are particularly sensitive to a downturn and had aggressive terms. That first category embraces a growing swath of the economy and extends to everything remotely related to housing including retail, building materials, real estate and big-ticket consumption items such as cars.

Now the contagion is reaching companies thought to have been relatively recession-proof.

[ Normxxx Here:  Oh, what a tangled web we weave, when first we practice to deceive.  ]

FT: Lower interest rates by Fed lower the yields on floating rate leveraged loans and do not completely compensate for the increased risk premia in high-yield bond market => increased refinancing costs.

Fitch: $250bn of bonds and loans are in the pipeline waiting to be syndicated by underwriters ('hung loans'). New investors demand better conditions/covenants. Riskier debt structures, including covenant-light, second-lien and payment-in-kind (PIK) loans, have all but disappeared from the market. Issuance of CLOs fell 40% to $23.7bn in Q3, shut for business in Q4.

Fitch: Leveraged loan issuance fell from approximately $427.8bn during the first half of 2007 to just $260.7bn during the second half (-39%). High yield bond issuance declined even more sharply from $89.8bn in the first half of 2007 to $45.7bn during H2 (-49%) with just $11.2bn in Q3.

S&P (via Blbg): Speculative-grade borrowers made up the majority of U.S. corporate debtors for the first time in 2007 (i.e. 51% of all corporate bonds).

UBS: the default rate will soar to more than 8% in 2008.

Prudential: High yield bonds succumbed to the market’s turmoil, delivering -1.30% in 4Q and +1.87% for all of 2007, with an excess return to US Treasuries of -770 bps. Bank loan prices fell in sympathy with high yield bonds upon lower demand from CLOs, which represented 60-70% of leveraged loan buyers.

InvestorsInsight: The amount of outstanding corporate credit and the leverage applied to it dwarfs the market for subprime mortgages [leveraged loans plus junk bond notional $850bn YTD] => Counterparty risk on credit protection written is substantial [[read: OUT OF SIGHT! : normxxx]]

Hu/Black, FT: Distress renegotiations less likely with HF than with PE due to short-term focus. Also: Investors high on seniority scale (e.g. investors in CLO senior tranche) prefer early default to preserve their full nominal investment.

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Normxxx    
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