Capital Markets

Corporate Bonds: a Lot to Swallow

Corporate-bond defaults may be peaking, but there could still be trouble ahead in leveraged loans.
Economist StaffOctober 2, 2009

At the start of 2009 bond investors sniffed an opportunity. The world was in recession and many companies were going to struggle to pay back their debts. But spreads (the excess interest rate paid by risky borrowers) on corporate bonds were so high that they seemed to discount catastrophe. Speculative-grade debt was paying more than 16 percentage points over Treasury bonds.

Investors who wanted income from their portfolios had few alternatives. Central banks had slashed short-term interest rates almost to zero. A flight to safety had pushed government-bond yields in many countries down to 2-3%. So investors were willing to take a chance.

The gamble paid off. In Europe speculative bonds have returned more than 50% this year. And investors are backing the trend to continue. A survey of bond managers by BofA Merrill Lynch found 80% had recently seen inflows into their funds, against just 2% suffering outflows. This increased demand has allowed the market for corporate-bond issuance to revive, taking the pressure off companies that had difficulty finding bank loans.

What could disturb this rosy picture? The obvious danger is that corporate defaults will be higher than investors expect. So far this year, 216 bond issuers have defaulted worldwide, according to Standard & Poor’s, compared with just 62 at the same stage of 2008. S&P is forecasting that the trailing 12-month default rate on American bonds (currently 10.4%) will rise to 13.9% by mid-2010.

That may turn out to be a pessimistic view. Michael Hampden-Turner, a strategist at Citigroup, thinks the American default rate will peak at 11.5% this quarter and fall to 6.5% by the autumn of next year. His model is based on factors such as changes in bank lending, the economic growth rate and the size of the speculative-grade market (a glut of issuance tends to be an indicator of loose lending practices).

Even if the more gloomy view of S&P turns out to be right, this outcome will be a lot better than investors envisaged at the start of the year. You can work out default expectations by looking at the spreads on speculative bonds and making an assumption about the amount investors will recover from companies that fail to pay up in full. CreditSights, a rating agency, says that the European implied default rate, assuming a 20% recovery rate, reached 25% at the end of last year but has since fallen to 15%. That still leaves it well ahead of the actual default rate so far. In America implied and actual default rates have now equalized at around 10%.

The biggest problems may occur not in the bond market but in leveraged loans, the debt issued by private-equity companies to finance their buy-outs of public companies. Returns on leveraged loans have lagged behind those achieved by high-yield bonds this year.

The problem is indigestion. Over the next few years, a lot of the debt issued in the buy-out boom of 2006 and 2007 will need refinancing. Daniel Lamy of JPMorgan reckons 23% of the market for European senior secured loans will mature by the end of 2012 (and 44% by end-2013).

At the moment it is hard to see where the appetite for refinancing this debt will come from. A lot of the original debt was bundled together into specialist funds called collateralized loan obligations. But their reputation was tarnished in the credit crunch and demand for new CLOs has dried up. Those that remain are reported to have little in the way of cash. Hedge funds, as Mr. Lamy points out, have an appetite for buying debt but only at distressed prices. As a consequence they may demand high returns for rolling over existing debt.

That leaves the banks. They have a potential dilemma. They have no desire to indulge in a further round of write-offs, which will weaken their balance-sheets, and thus have a temptation to extend loans and allow covenants (commitments by borrowers to meet certain financial conditions) to be renegotiated. But at the same time, under pressure from regulators, they are trying to boost their capital ratios. That makes them unwilling to underwrite larger deals as struggling borrowers seek to refinance.

So the next 12 months will prove to be a make-or-break period. If the economic recovery turns out to be robust, then business conditions will improve and buy-out companies will find it easier to service their existing debts. In such circumstances, investors’ appetite for leveraged loans will doubtless improve. But if the economy falters, then defaults may soar and the leveraged-loan market may be staring at a refinancing crisis in 2011.