Conventional wisdom suggests that a fall in recovery rates should accompany a surge in defaults. However, this has not been the case in the last year, suggesting the current climate for low-quality credit could be challenging for issuers and investors alike.
Early warning: It is logical and historically demonstrable that in recessions the number of firms that default on their debt rises. In bear markets, default rates increase as lower risk-appetites among investors reduces access to finance for businesses. A less widely understood aspect of this phenomenon is that average recovery rates fall as defaults rise: the amount of capital retrieved against delinquent bonds diminishes.
Figure 1. Default and recovery rates, 1995-present
Source: JP Morgan, as at 31 March 2016
During the last 12 months, recovery rates on defaulting bonds have plunged below historical averages despite a marginal rise in default rates. It is tempting to point to low oil prices as the reason for this, as the rapid expansion of the US shale-oil industry was largely funded by the high-yield market. But recovery rates and default rates are also diverging in other parts of the credit markets, such as loans, which are not significantly exposed to the oil sector.
Figure 2. Falling recovery rates are not being driven by low oil prices
Source: Credit Suisse, as at 31 March 2016
Buyers stressed over distressed assets: Investors in distressed debt have had a testing two years. Returns have been poor, damaged by a high level of dispersion, as high-quality and senior-secured debt has outperformed low-quality and unsecured debt. The net result has been outflows from this segment of the market. Disillusioned investors have pulled their cash from the space, sometimes too quickly for funds to manage redemption obligations, leaving the overall appetite for distressed assets much lower than in previous periods.The rise in equity-friendly corporate behaviour has had a similar effect, as many businesses have preferred to use cash for share buybacks, dividend increases and even paying down more expensive high-coupon debt. Long-term investments, including distressed-asset purchases, have become rare. Meanwhile, blue chip companies – the natural buyers of distressed assets – are not acquiring their distressed peers because the commodity cycle has turned. With uncertainty in the air, their equity and credit investors are urging them to ensure their survival rather than invest.
Little upside for a lot of down: During the credit bull market after the financial crisis, bond and loan convenants gradually loosened, which we previously wrote about. This has allowed stressed and distressed companies to survive for longer than they would have in previous cycles. In practice, this has meant these companies have burnt through cash, sold their assets, drawn heavily on revolving credit facilities and issued secured notes to prolong their lives, leaving unsecured bond holders with much less to recover once the company’s luck has run out.
Low-quality credit struggling to perform: In the past, half of all companies that issued CCC-rated bonds have defaulted, with investors seeing a 40% recovery rate for failures and significant returns among the successful companies, which outweighed the losses and created a good risk-return profile for the asset class. However, in a market which lacks buyers and where loose covenants prevail, both the 40% floor and the large returns from the outperformers are in question.
The CCC market is also considered illiquid, resulting in investors requiring more default and liquidity premia than ever before to purchase bonds lower down the quality spectrum. This in turn means that companies with BB or higher ratings aim to avoid becoming CCC debt issuers, even if this means forgoing the finance needed to make acquisitions, because the cost-of-capital jump is so high. This reduces the number of attractive players in the CCC segment of the market, further discouraging investors.
Defaults are becoming more difficult: The proportion of market volatility coming from the energy and basic industry sectors is double what it has been historically. Also, the size of this market is unlikely to subside as an increasing number of “fallen angel” investment-grade issuers are descending to the high-yield market, meaning that investors need to be wary of the names in the sector at risk of permanent capital loss. From a regional perspective, Europe is a difficult place for distressed-debt investors who are negotiating defaults, with non-homogenous bankruptcy regimes and differing levels of creditor friendliness making the process uncertain, complex and lengthy. This eats into internal rates of return and risk-adjusted returns, ultimately lowering investor appetite for this segment of the market.
Pick and mix: We believe that flexibility is vital in generating strong performance in the credit markets currently. Being able to avoid the areas that experience the most pain, such as distressed energy companies and European CCC-rated credit, and exploit opportunities among higher quality instruments, is key. As the default cycle matures, the path of recovery rates is unclear. If these continue to fall, we are likely to see low-quality credit struggle regardless of the wider market backdrop.
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