The Financial Times’ Lex column today takes issue with those who take comfort in the oft-quoted statistic that default rates are at a 25 year low. The article shows a long-term, unrelenting decline in average ratings and notes that bond defaults tend to peak two to four years after issuance. We’ve had an increase in lower rated debt thanks to a spike up in large leveraged buyout deals in the last couple of years.
What may make things different (and not necessarily better) this time is that many of the private equity deals were “cov-lite.” That means investors have much less protection. For example, borrowers were often required to keep a specified working capital ratio and level of interest coverage, and meet a net worth test. Failing those meant the creditors could accelerate the principal, as in demand repayment. That was a mechanism for forcing a restructuring.
Although I have not seen the documents on any of these deals, what I’ve heard from my buddies in private equity suggests that on some of these deals, the lenders can’t accelerate the debt even in the event of default. (Somebody, please, tell me this is wrong. It is just too deranged to be true).
Now that arrangement may seem hunky dory for the borrower, but consider: in this modern world of finance, the lenders (often banks who buy collateralized loan obligations or sometimes syndicated loans) still have to mark the assets to market. So when a borrower deteriorates, creditors reduce the value of their loan. This haircut is a balance sheet hit which damages earnings, and if enough deals come a cropper, reduces their capital. And they have no ability to remedy the situation.
I’m not sure how this all resolves, but expect things to get ugly.
From the Financial Times:
Dystopian visions of the future often portray humanity drowning in its own junk. The future is now. More than half the US issuers rated by Standard & Poor’s are currently graded as “speculative”. The proportion rated “B” or lower – well into junk territory – has jumped from one-fifth in 1997 to about one-third currently. The paradox is that the default rate for speculative grade bonds, globally, stands at a 25-year low…..
But the recent seizing-up of credit markets shows that many lenders are rediscovering the concept of risk. As refinancing becomes harder, the result is likely to be a sharp increase in defaults, particularly if the economy weakens significantly.
Easier lending terms – taken to the extreme with so-called covenant-lite agreements – strip out many of the usual default triggers. But that “see-no-evil” approach means credit can deteriorate out of the spotlight. Defaults can then occur with little warning and subsequent recovery rates are likely to be weak.
Optimists may point out that just 11 per cent of the $2,910bn of US corporate debt rated by S&P falls due by the end of 2008. But focusing on maturities misses the point. Analysis of defaults from 1971-2006 by Professor Ed Altman of New York University’s Stern School of Business shows that defaults for junk bonds tend to spike two to four years after issuance. Some 73 per cent of US paper rated “B-” or lower by S&P is less than five years old. History shows that, well before maturity, weak credits can struggle to pay interest and meet covenants.
Of the 28 speculative grade issuers that Moody’s assesses for “intrinsic liquidity” – a measure of reliance on market access for funding – 12 are described as “merely adequate” or weak….