During the tense months of the crisis, every so often there would be a story on the looming threat of mounting corporate debt defaults. With more than half the corporate bonds rated junk, thanks to highly-levered takeovers, it wasn’t hard to imagine that a protracted economic bad spell could lead to a lot of defaults.
A related issue that has not gotten the press it deserves is that the novel feature of the binge of late-cycle merger loans, “cov lite” deals, will make the damage worse. Normally. companies that borrow heavily have to agree to meet certain requirements (covenants) like maintaining a minimum net worth. If the debtor breaches those stipulation, the lender can accelerate the debt, meaning demand it be repaid immediately. That does not necessarily happen, but the acceleration clause allows the creditor to renegotiate the obligation in light of the borrower’s deteriorating financial condition, and that can include tough measures like asset sales or a restructuring, or forcing the company into Chapter 11.
What happens in the new world of cov-lite? Well, the company goes to hell and the borrowers can’t do much to intervene. The result is if the company continues to decay, it will wind up in bankruptcy, but later and therefore in a weaker state than if the creditors had forced it into bankruptcy sooner. That means the odds of a successful structuring are lower, and more companies will wind up liquidating. Thus not only will defaults reach new post-war highs, but recoveries are likely to be lowere.
From Reuters (hat tip reader John D):
About 40 percent of all U.S. junk bonds outstanding in late 2008 will likely default by 2013….By contrast, the cumulative five-year default rate was about 30 percent in the last two default cycles…
The worst recession since the 1930s has already pushed defaults to double-digit rates. According to Standard & Poor’s, the default rate rose to 10.4 percent in August from less than 1 percent in 2007 as the recession and credit crunch left companies unable to pay off debt.
Deleveraging by consumers and financial institutions and fiscal problems at federal and state governments will slow the economic recovery, keeping defaults high, Bank of America said. Failure of the “shadow banking system” to reinvent itself will also contribute to high defaults, it said, referring to hedge funds and other non-bank institutions that fueled the last credit boom.
Defaults will also be triggered by hundreds of billions of dollars of debt coming due, especially in 2013 and 2014, Bank of America said. About $361 billion of high-yield loans come due in those two years alone, or 72 percent of the total outstanding, the bank estimated in an earlier report.
Bank of America in December had forecast that the junk bond default rate could peak at 17 percent in the second quarter of 2010, the worst since the Great Depression. Thanks to numerous government lifelines, including near-zero interest rates, it now expects the default rate to peak at 12.8 percent in the fourth quarter this year.
However, defaults will remain higher than normal and peak again at 8.5 percent in late 2012, the bank estimated. Even by 2013, the default rate will still be around 6 percent, much higher than the sub-4-percent levels usually seen at the end of a default cycle, Bank of America said…..
Many so-called distressed debt exchanges are only postponing defaults and will also contribute to the second wave, the bank said. In a distressed debt exchange, companies buy back debt at steep discounts, usually replacing it with longer-maturity debt. About 40 percent of distressed debt exchanges typically default anyway within three years, the bank said.