Tuesday, June 24, 2008

Moody's: Recovery on Defaulted U.S. Corporate Debt Likely Below Historical Average

(Moodys) Holders of bank loans and bonds from US corporate issuers in default can expect to recover less of their investment than in past years, says Moody's Investors Service.

The ratings agency attributes the lower expected recovery rate to the increase in issuance of secured bank loans over the past several years, which has created top-heavy capital structures for many spec-grade issuers.

"The substantial increase in bank loans' average share of total debt will reduce average recoveries for both loans and bonds," says Moody's Director of Corporate Default Research Kenneth Emery. "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."

Moody's recovery outlook is based on its Loss Given Default (LGD) 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 US 1st lien senior secured bank loans is 68%, which compares with an actual historical average recovery rate of 87%, says Moody's.

Moody's expects recovery rates on US 2nd lien loans to be only 21%, compared to the historical average of 61%. 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 US speculative-grade issuers, Moody's expects an average ultimate recovery rate of 32%, which is below its historical average of 40%. Subordinated bonds are expected to recover 18%, which is also below their 28% historical average.

The number of speculative-grade issuers relying solely on bank loans has risen from about 10% of all speculative-grade U.S. issuers in 2004 to 34% today. Of speculative grade issuers with bank loans, nearly 60% are loan-only issuers, compared to under 30% 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 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, says Emery. 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.

The upside risk to the outlook is if creditors are able to minimize declines in issuers' enterprise values at the time of default resolution by, for example, forcing distressed issuers 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.

The full title of this Moody's Special Comment is "Strong Loan Issuance in Recent Years Signals Low Recovery Prospects for Loans and Bonds of Defaulted U.S. Corporate Issuers."

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