Monday, October 26, 2020

Corporate default severity rises

Congressional and Federal Reserve actions have minimized default frequency so far during the covid crisis, but the severity of losses conditional on default has risen.

In Bond Defaults Deliver 99% Losses in New Era of U.S. Bankruptcies, Bloomberg's Jeremy Hill and Max Reyes write that
"Bankruptcy filings are surging due to the economic fallout of Covid-19, and many lenders are coming to the realization that their claims are almost worthless. Instead of recouping, say, 40 cents for every dollar owed, as has been the norm for years, unsecured creditors now face the unenviable prospect of walking away with just pennies -- if that.

"While few could have foreseen the pandemic's toll on the economy, the depth of investors' pain from corporate distress was all too predictable. Desperate to generate higher returns during a decade of rock-bottom interest rates, money managers bargained away legal protections, accepted ever-widening loopholes, and turned a blind eye to questionable earnings projections. Corporations, for their part, took full advantage and gorged on astronomical amounts of debt that many now cannot repay or refinance."

Debt issued by retailers like Men's Wearhouse, J.C. Penney, and Neiman Marcus is trading for pennies or fractions of pennies on the dollar. The chart below shows that expectations of recoveries from bond defaults are at record lows. Credit default swaps pay 100 cents on the dollar minus the auction value of the cheapest-to-deliver security.

Loan investors also expect low recoveries -- 40 to 45 cents on the dollar compared to historical averages of 30 to 35 cents. This is happening because of a similar trend towards loans with fewer safeguards, aka covenant-lite loans.

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