US high yield debt rests on increasingly fragile foundations
IBUSINESS INVESTORS the issue of high yield or “junk” debt has experienced a relatively mild pandemic. Usually, these heavily indebted borrowers are stung by economic hardship. During the global financial crisis more than a decade ago, about one-seventh of these American companies defaulted on their debt in one year. Yet, according to Moody’s, a rating agency, less than 9% of them defaulted until August 2020, and the rate has been dropping steadily since. By the end of 2021, a meteoric recovery is expected to drop it below its long-run average of 4.7%
However, it may be too early for high yield investors to congratulate themselves. The low default rate masks a much riskier market than it was before Covid-19. Take high yield bonds, whose market is worth $ 1.7 billion. Issuers have record levels of leverage relative to their earnings, which increases their vulnerability to higher interest rates or a disappointing economic recovery. Cash-strapped borrowers take advantage of less stringent loan contracts to abuse their creditors. And for businesses that default, loans that were previously associated with high levels of protection and security are proving to offer lenders anything but.
Start with the amount of debt. Last year, $ 435 billion worth of junk bonds were issued. As a result, the average high yield borrower now has debt equivalent to an unprecedented six and a half times their gross operating profit of the past 12 months, or EBITDA (see table). Oleg Melentyev, of Bank of America, warns that the low default rate may have simply delayed the pain. “Companies carry the baggage of capital structures that should have been restructured, but were not,” he says. “We will pay the price for high defaults later in the cycle.”
Meanwhile, borrowers with liquidity issues get the better of their lenders. Moody’s Evan Friedman and Enam Hoque describe how investors’ thirst for yield over more than a decade of low interest rates eased loan agreements. Maintenance covenants, or restrictive covenants that allow lenders to take the reins if the borrower’s financial situation deteriorates, are now mostly absent. Worse yet, covenants, which limit the ability of borrowers to issue new debt and pay dividends, have lost their strength over time. “When you go into covenants and reduce your insurance liabilities, you give the borrower all the flexibility to run the show,” says Friedman.
The run some of them are. Serta Simmons Bedding, a mattress maker, gained notoriety last year for raising $ 200 million by swapping debts with some lenders for new ones with a higher level of security. Without their consent, non-participating creditors were exposed to higher losses in the event of default. A lawsuit to unwind the transaction has been dismissed by the courts, paving the way for similar settlements in the future.
What happens to loans that go wrong? Lenders are used to the idea that so-called “senior” debt gives them priority over the borrower’s assets in the event of bankruptcy. But Moody’s analysis of defaults during the pandemic shows senior lenders are losing nearly twice as much of their principal as before: the average collection rate in 2020 was 55%, compared to a long average. 77% term.
This is the result of the deterioration of debt structures, another trend that has lasted for a decade. In the past, senior loans had high recovery rates because a significant portion of the remaining debt was subordinated, i.e. behind them in the default queue. But in 2020, more than a third of senior loans had no underlying junior debt to absorb losses. If all of a borrower’s debt has a primary claim on its assets, the value of that claim is lower and lenders lose more protection.
None of this necessarily means the US high yield market is heading for disaster. Interest rates remain low and a rapid recovery should restore profits. But a nasty surprise on either front could quickly cause problems. The default cycle of covid-19 may still have a sting in the tail. ■
This article appeared in the Finance and Economics section of the print edition under the title “The Scrap Heap”