Capital Markets

Holders of Distressed Debt, Beware

Moody's report says recovery rates are shrinking, to 68 percent in the case of first-lien loans, compared to historic rate of 87 percent.
Stephen TaubJune 24, 2008

The credit crunch is presenting new worries in the distressed-debt market, as holders of bank loans and bonds from U.S. corporate issuers in default are being told to smaller recovery rates on their investments than in past years.

A report by Moody’s Investors Service attributes lower expected recovery rates to the increase in issuance of secured bank loans over the past several years, which has created top-heavy capital structures for many speculative-grade issuers.

“The substantial increase in bank loans’ average share of total debt will reduce average recoveries for both loans and bonds,” says Kenneth Emery, Moody’s director of corporate default research. “Loans have less junior debt below them which will serve as a drag on recovery rates, while bond recovery rates will suffer from being in a more subordinated position relative to loans.”

Typically, of course, many of the holders of the defaulted debt wind up being opportunistic hedge funds and private equity funds that bought the paper from the original holders in the secondary market or through a private transaction.

Moody’s explains that its recovery outlook is based on its “loss given default” assessments, which it has published for non-financial speculative-grade corporate issues since 2006. The LGD assessments signal that the average expected ultimate recovery rate on U.S. first lien senior secured bank loans is 68 percent. This compares with a historical average recovery rate of 87 percent, according to Moody’s.

The ratings service expects recovery rates on second lien loans to be only 21 percent, about one-third the historical average of 61 percent. Moody’s points out that most of these loans have been made to ‘loan only’ issuers with only bank debt — no bonds — so that they sit at the bottom of the capital structure.

For senior unsecured bonds of U.S. spec-grade issuers, Moody’s expects an average ultimate recovery rate of 32 percent versus the historical average of 40 percent. Subordinated bonds are expected to recover 18 percent, below their 28 percent historical average.

Moody’s notes that the number of spec-grade issuers relying solely on bank loans has risen to 34 percent of all speculative-grade U.S. issuers, from about 10 percent in 2004. Of speculative grade issuers with bank loans, nearly 60 percent are loan-only issuers, compared to less than 30 percent in 2004.

“The rapid growth of issuers having only rated loans, without any bonds outstanding, has played a substantial role in increasing loans’ share of total debt across rated issuers,” says Emery. “It will reduce recovery rates on both bank loans and bonds.”

Moody’s explains that its LGD assessments are calibrated to a large extent on the experience of the 1990-91 and 2001-02 recessions, and therefore already largely incorporate downturn economic conditions. However, if the US economy were to experience a recession that was more severe than the past two US recessions, debt recovery rates could be even lower than currently given by Moody’s LGD assessments.

Moody’s could be too pessimistic, of course. It notes that recoveries could wind up larger than forecast if, for example, distressed issuers are forced into bankruptcy at a relatively early stage of distress. “While large loan shares imply that loan holders have an incentive to be more vigilant in maintaining issuers’ enterprise values, weak or no loan maintenance covenants will likely prevent such an outcome,” says Moody’s.

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