How This Default Cycle Is Different: Record Low Recovery Rates

At the end of January, when looking at some recent liquidating energy companies selling off their assets in "stalking horse" bankruptcy auctions, we found something disturbing: total recovery rates under liquidation of oil and gas companies were paltry, ranging anywhere between 5 and 20 cents on the dollar, and averaging a little under 15 cents.


While we had a rather limited universe of cases we made the following observation: "these bankruptcy auctions confirm recoveries on existing debt will be paltry, and based on our limited dataset, average to roughly 15 cents on total debt exposure, which includes both secured and unsecured debt."

A few months later we have a more complete data set and we can confirm that it is indeed the case that one novel feature about this particular default cycle are the record low recovery rates on bankrupt bonds.

First, here are some thoughts from JPM's Peter Acciavatti, who first notes the dramatic surge in default volume which in February soared to a four-year high:

Default activity increased notably in February, as eight companies defaulted totaling $9.3bn in high-yield bonds ($8.5bn) and leveraged loans ($766mn). This month’s activity marked the highest number of defaults since nine companies defaulted in August 2009 and the highest monthly volume since November 2011’s $9.5bn (excluding 2014’s defaults of TXU and CZR in April and December, respectively). By comparison, five companies defaulted totaling $5.25bn in January, which followed five defaults totaling a 2015-high $8.2bn in December and three defaults totaling $5.26bn in November. Default activity has picked up over the last several months, as February marked the fourth consecutive month of greater than $5bn in default volume, and the sixth $5bn month over the past nine. Further evidencing the recent pick up in activity, an average of $5.4bn has defaulted per month over the last seven months, compared with a $2.1bn average over the prior seven months and a modest $1.6bn monthly average from 2010 through 2014 (ex-TXU and CZR). Year to date, 13 companies have defaulted totaling $14.6bn in bonds and loans, compared with five defaults and $4.4bn during the first two months last year. As a reminder, 37 companies defaulted totaling $37.7bn in bonds ($23.6bn) and loans ($14.1bn) in full-year 2015, the sixth highest total on record and the second highest total since the credit crisis, behind FY14’s 27 defaults and $69.9bn

None of this is surprising: the default onslaught is by now well known, and the fact that it has so far remained isolated to the energy sector is the reason for the recent junk bond euphoria across other industries. Just yesterday, Credit Suisse wrote that "speculative bonds default rate reached a 6yr high of 3.3% in February. However, if you exclude energy, the US HY default rate actually went to 2.2% in Feb from 2.4% in January. This tells us that the market contagion is not translating (yet) into default contagion. Our high yield group compared it to the 2002 TMT blow-up (WCOM) , when everything sold off very hard but the defaults were confined to TMT."

Others, however, such as UBS' Matthew Mish have disagreed:

... while there may not be another 'energy' sector this cycle, our proverbial list of candidates includes lower quality high yield (ex-commodities) and commercial real estate (CRE). More broadly, the OCC's own examiners would also likely add asset-backed and auto loans to the list. The stark conclusions these credit officers draw with respect to the massive easing of credit standards due to competitive pressures seems clear enough – but unfortunately they seem to largely fall on deaf ears.

Whether or not Credit Suisse, and the recent influx of record retail fund flows into junk is right...


... or just a momentary bout of euphoria, remains to be seen and is largely irrelevant for the time being. What matters far more is what else Acciavatti writes further on in his latest weekly default report: it confirms what we first observed over a month ago.

Recovery rates in 2016 are extremely low... for high-yield bonds, the recovery rate YTD is 10.3% (10.5% senior secured and 0.5% senior subordinate), which is well below the 25-year annual average of 41.4%. Final recovery rates in 2015 for high-yield bonds were 25.2%, compared with recoveries of 48.1%, 52.7%, 53.2%, 48.6%, and 41.0% in full-years 2014, 2013, 2012, 2011, and 2010, respectively. Notably, average recoveries for Energy and Metals/Mining bonds were 18.3% and 20.0%, respectively, which weighed down overall high-yield recovery rates. Excluding the troubled commodity sectors, high-yield recoveries were a more respectable 46.1% (32.1% Ex-Energy only). As for loans, recovery rates for first-lien loans thus far in 2016 are 24.5%, compared with their 18-year annual average of 67.2%. Final 2015 1st lien recoveries were 48.2%, while average recoveries for Energy and Metals/Mining 1st lien loans were 44.1% and 38.4%, respectively.

The record collapse in recovery rates is shown below.

It is not just JPM who points out what we first noticed in January: in an interview with Goldman's Allison Nathan, credit guru Edward Altman reiterates that same warning, although he focuses on the 2015 recovery rate which already is more than two times higher than that seen in 2016 defaults:

Allison Nathan: What is your view on recovery rates?


Edward Altman: Our approach to recovery rates is not centered on sectors. What we’ve looked at carefully over 25 years is the correlation between default rates and recovery rates. As you would expect, when the former rise to high or above-average levels, you always observe the latter dropping to below-average levels. This strong inverse relationship is as much a function of supply and demand as it is of company fundamentals. So if we are expecting a higher default rate in 2016 and even 2017, then we would expect a lower recovery rate. Already in 2015, the recovery rate dropped dramatically relative to 2014 even though the default rate was below average; we saw a 33-34% recovery rate versus the historical average of 45%, measured as the price just after default. This is primarily due to the heavy concentration of energy companies whose recovery rates depend on their ability to liquidate their assets at reasonable prices, which in turn depends on the price of oil. Low oil prices have pushed recovery rates in the energy sector below 25% and even into the single digits for some companies. And that’s going to continue. So this year I expect recovery rates much below average, producing a double-whammy of high default rates and low recovery rates for credit investors.

So why do recovery rates matter? Simple: they determine the exit IRR calculation for distressed investors in the case of a bankruptcy.

A simple analysis on the importance of how recovery rates play into purchase assumptions was made once again by UBS' Matt Mish three weeks ago, when he calculated at what yield bond investors should start to buy the numerous distressed opportunities. This is what he said:

In our 2016 US high yield outlook we posited there is one central question that will dictate the outlook for high yield: will credit markets be able to absorb refinancing needs of almost $1tn stressed and distressed credit. And we continue to believe this should be THE debate in the market. In our view, if the lower quality rung of the market cannot stabilize the balance of risks is for contagion to spread further. So what is the clearing level for what we believe is upwards of $750 - 1tn in stressed credit? First, investors will require compensation for loss risks; cohorts of triple Cs typically experience 5yr cumulative default rates of 55 - 65% near the end of the cycle, implying half of the universe defaults before the end of year 5 and no longer pay coupons. Assuming recovery rates of 35% an investor should require roughly 12% yield to compensate for loss risks alone... 


Further, although our prior analysis assumes hold-to-maturity, investors will need to be compensated for the fact that illiquidity may prevent them from selling when needed. Bottom line, our conversations with investors suggest yields in the 20 – 25% context could be attractive enough to draw in marginal capital – although several investors noted that is reasonable for triple C risk excluding commodities. In short, we're not there yet.

Keeping everything constant, and assuming these new, if not improved, record low recovery rates, what it means is that for Mish' analysis to hold, the yield required to compensate for loss risks doubles to over 20%, while the all-in liquidity risk analysis moves the 20-25% yield threshold to over 30%, if not 40% if one indeed is expected to recover 10 cents on the dollar in the upcoming default wave.

That record lower recovery rate also explains what we discussed earlier, namely the desire of banks to force an equity short squeeze in energy stocks, so these distressed names are able to issue equity with which to repay secured loans to banks who are scrambling to get out of the capital structure of distressed E&P names. Or as MatlinPatterson's Michael Lipsky put it: "we always assume that secured lenders would roll into the bankruptcy become the DIP lenders, emerge from bankruptcy as the new secured debt of the company. But they don't want to be there, so you are buying the debt behind them and you could find yourself in a situation where you could lose 100% of your money."

And so, one by one the pieces of the puzzle fall into place: banks, well aware that they are facing paltry recoveries in bankruptcy on their secured exposure (and unsecured creditors looking at 10 cents on the dollar), have engineered an oil short squeeze via oil ETFs...


... to push oil prices higher, to unleash the current record equity follow-on offering spree...

... to take advantage of panicked investors who are desperate to buy the new equity issued. Those proceeds, however, will not go to organic growth or even to shore liquidity but straight to the bank to refi loan facilities and let banks, currently on the hook, leave silently by the back door. Meanwhile, the new investors have no security claims and zero liens, and are in fact at the very bottom of the capital structure, face near certain wipe outs.

In short, once the current short squeeze is over, expect everyone to start paying far more attention to recovery rates and the true value of "fundamentals."