US high-yield debt rests on increasingly fragile foundations


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

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However, it may be premature for high yield investors to congratulate themselves. A low default rate masks a much riskier market than it was before Covid-19. The market takes on high yield bonds worth $ 1.7 trillion. Issuers have record levels of debt to earnings, making them more vulnerable to high interest rates and a disappointing economic recovery. Borrowers who have difficulty raising funds troll creditors with less restrictive loan agreements. And for failed businesses, 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 debt. Last year, $ 435 billion in junk bonds were issued. As a result, the average high yield bond borrower has unprecedented debt of 6.5 times total operating income over the past 12 months. EBITDA (See table). Bank of America’s Oleg Melentyev warns that low default rates may simply have delayed the pain. “Companies carry baggage with a capital structure that should have been restructured, but not,” he says. “We’ll pay the price for the default hike later in the cycle.”

On the other hand, borrowers with cash flow problems have an advantage over lenders. Moody’s Evan Friedman and Enam Hawk discuss how investors’ thirst for decade-long low-interest yields facilitated loan deals. There are currently few maintenance contracts, or restrictions that allow lenders to keep the reins in the event of a borrower’s financial situation. To make matters worse, accrual accounting rules that limit a borrower’s ability to issue new debt and pay dividends have become ineffective over time. “When you step into the wedding ring light and the epidemic alliances are toothless, you give the borrower all the flexibility to put on the show,” says Friedman.

When you do that, there are some. Mattress maker Serta Simmons Bedding was known last year for raising $ 200 million by swapping debts with new, safer lenders and some lenders. Without their consent, non-participating creditors were exposed to higher losses in the event of default. The process to roll back the transaction was dismissed by the court, paving the way for similar transactions in the future.

What happens to a bitter loan? Lenders are used to the idea of ​​prioritizing the assets of the borrower in so-called “first lien” bankruptcy. However, according to Moody’s default analysis during the pandemic, Fast Lien lenders lost almost 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 the worsening debt structure and another decade of trending. In the past, repayments on second-tier loans were high because a significant portion of the remaining debt was subordinated, that is, behind the queue in the event of default. However, in 2020, more than a third of second-tier loans lacked subordinated debt to absorb losses. If all of the borrower’s debts have an initial claim on the asset, the claim has less value and the lender loses more protection.

This does not necessarily mean that the US high yield market is headed for disaster. Interest rates remain low and a rapid recovery should restore profits. However, annoying surprises on either side can quickly cause problems. With the default cycle of covid-19, you can still have a prick injury on your tail. â– â– 

This article appeared in the print version of the Treasury and Economics section under the title “Junk Heap”.


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