America’s high-yield debt is on ever-shakier foundations

ICompany NVE STORS The issuance of high yield or “junk” bonds has caused a relatively benign pandemic. Usually, such highly leveraged borrowers suffer from financial difficulties. During the global financial crisis more than a decade ago, about one-seventh of such companies in the United States defaulted in a year. However, according to rating agency Moody’s, less than 9% defaulted in the year to August 2020, and ratings have continued to decline since then. By the end of 2021, a fast-growing recovery should be below the long-term average of 4.7%.

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However, it may be premature for high yield investors to congratulate. A low default rate obscures a much more risky market than it was before covid-19 occurred. The market takes high yield bonds worth $ 1.7 trillion. Issuers have record levels of debt compared to earnings, making them more vulnerable to high interest rates and disappointing economic recovery. Borrowers struggling to raise money are trolling creditors with less restrictive loan contracts. And for defaulting companies, loans that were previously associated with a high level of protection and security have proven to offer nothing to lenders.

Let’s start with a huge amount of debt. Last year, $ 435 billion worth of junk bonds were issued. As a result, the average high yield bond borrower has an unprecedented 6.5 times debt in total operating profit over the last 12 months. EBITDA (See chart). Bank of America’s Oleg Melentyev warns that low default rates may simply have postponed pain. “Companies are carrying baggage with a capital structure that should have been restructured, but not,” he says. “We will pay the price of the default rise later in the cycle.”

On the other hand, liquidity-problematic borrowers have an advantage over lenders. Moody’s Evan Friedman and Enam Hawk explain how low-interest investors’ thirst for returns over a decade has eased loan deals. There are currently few maintenance contracts, or restrictions that allow lenders to hold reins in the event of a borrower’s financial condition. To make matters worse, the accrual rules that limit a borrower’s ability to issue new debt and pay dividends have become ineffective over time. “When you move to covenant lights and make the outbreak covenants toothless, you give the borrower all the flexibility to perform the show,” says Friedman.

When you do that, there are some of them. Mattress maker Serta Simmons Bedding was notorious last year for raising $ 200 million by exchanging debt with new, more secure lenders and some lenders. Without their consent, non-participating creditors were exposed to higher losses in the event of default. The proceedings seeking rewinding of the transaction were dismissed by the court, paving the way for similar transactions in the future.

What happens to a sour loan? Lenders are accustomed to the idea of ​​giving priority over the borrower’s assets in the event of a so-called “first lien” debt bankruptcy. However, according to Moody’s default analysis during the pandemic, Fast Lien lenders have lost nearly twice as much capital as before. The average recovery rate in 2020 was 55%, while the long-term average was 77%.

This is the result of worsening debt structure and another decade of trend. In the past, second lien loan paybacks were high because a significant portion of the remaining debt was subordinated, that is, behind the queue in the event of a default. However, in 2020, more than one-third of second lien loans lacked subordinated debt to absorb losses. If all the borrower’s debt has an initial claim on the asset, the claim is less valuable and the lender loses more protection.

This does not necessarily mean that the US high yield market is heading for a catastrophe. Interest rates remain low and a rapid recovery should restore earnings. However, annoying surprises on either side can quickly cause problems. With the default cycle of covid-19, you may still have a puncture wound on your tail. ■■

This article was published in the print version of the Treasury and Economy section under the heading “Junk Heap”.

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