Not Too Soon to Think About Defaults and Recovery Rates

The current low-default environment supports near-term value in high-yield corporate bonds and bank loans. This is especially true for bank loans, which outperformed high-yield corporate bonds year to date with higher London interbank offered rates (Libor) translating into more attractive floating coupons. However, investors should not assume that the benign credit backdrop will exist indefinitely. Our research suggests that at around 3 percent, short-term rates will pressure corporate borrowers’ ability to pay debt service on existing liabilities. It would not take many corporate defaults to push the trailing default rate higher, evidenced by the impact of iHeartMedia’s skipped interest payment on the leveraged loan default rate this quarter.

Unlike the last recession, which featured unsustainable levels of household debt, we believe that the next downturn will be traced back to the corporate debt market. U.S. corporate liabilities stand at an all-time high of 100 percent of gross domestic product (GDP), exposing the economy to a rise in corporate borrowing costs and/or a decline in corporate earnings. Given that credit investors cannot avoid defaults with 100 percent certainty, a prudent next step is to focus on minimizing loss-given defaults, and maximizing recovery rates. In this report, we discuss why investors should insulate portfolios from credit losses by investing in secured debt and by avoiding companies that have defaulted in the past.

Report Highlights

  • As the Federal Reserve (Fed) tightens monetary policy further, we expect to see default rates higher next year.
  • Loan recovery rates averaged 70 percent between 1990 and 2017 as a result of their secured status and seniority in the capital structure. Senior secured bond recovery rates averaged 58 percent over the same period, while senior unsecured bond recovery rates averaged 43 percent.
  • We are concerned about distressed exchanges as the risk of re-default is high. About 7 percent of high-yield corporate bond issuers have defaulted in the past.

Leveraged Credit Scorecard

As of 3.31.2018

High-Yield Bonds

Bank Loans

Source: ICE Bank of America Merrill Lynch, Credit Suisse. *Discount Margin to Maturity assumes three-year average life. Past performance does not guarantee future results.