The Coming Default Wave Is Shaping Up to Be Among Most Painful

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When the next corporate default wave comes, it could hurt investors more than they expect.

Losses on bonds from defaulted companies are likely to be higher than in previous cycles, because U.S. issuers have more debt relative to their assets, according to Bank of America Corp. strategists. Those high levels of borrowings mean that if a company liquidates, the proceeds have to cover more liabilities.

“We’ve had more corporate debt than ever, and more leverage than ever, which increases the potential for greater pain,” said Edwin Tai, a senior portfolio manager for distressed investments at Newfleet Asset Management.

Loss rates have already been rising. The potential for them to climb further may mean that in general junk bonds are not compensating investors enough for the risk they are taking, said Michael Contopoulos, high yield credit strategist at Bank of America Merrill Lynch. The average yield on a U.S. junk bond is now around 8.45 percent, according to Bank of America Merrill Lynch indexes, about the mean of the last 10 years.

In bad times, corporate bond investors on average lose about 70 cents on the dollar when a borrower goes bust. In this cycle, that figure could be closer to the mid-80s, Bank of America strategists said. Those losses would be the worst in decades, according to UBS Group AG’s analysis of data from Moody’s Investors Service.

At least part of the pain that investors will experience in this downturn was deferred from the last credit crunch, which for corporate issuers was relatively short-lived. During the financial crisis, the Federal Reserve was quick to cut rates, and investors began diving back into junk bonds quickly, said Alan Holtz, a managing director in the turnaround and restructuring practice at AlixPartners, a consulting firm that focuses on companies in distress. Many companies were able to refinance debt instead of defaulting.

“A lot of the troubled companies that had become overleveraged were able to find more temporary solutions in the last credit cycle,” Holtz said. “Those Band-Aids are no longer available now, and a lot of companies are going to have to face distress,” he said.

Junk-rated companies have debt equal to about 48 percent of their assets now, up 7.5 percentage points in the last 7 years, according to Bank of America Merrill Lynch data. The ratio of debt to assets is one of the main factors in how big losses will be when a borrower defaults, and it could be.

Another factor is the rate of default, because when more companies are defaulting, more are looking to sell assets or otherwise restructure, leaving investors with lower recoveries. Default rates currently stand around 4 percent, according to Moody’s. The ratings company forecasts that the measure will rise to 5.05 percent by the end of the year in the best-case scenario, and could jump as high as 14.9 percent under the most pessimistic projection.

Full article: The Coming Default Wave Is Shaping Up to Be Among Most Painful (BloombergPolitics)

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