Bank of America: 40% of Junk Bonds to Default by 2013

[Joanne98]

During the tense months of the crisis, every so often there would be a story on the looming threat of mounting corporate debt defaults. With more than half the corporate bonds rated junk, thanks to highly-levered takeovers, it wasn’t hard to imagine that a protracted economic bad spell could lead to a lot of defaults.

A related issue that has not gotten the press it deserves is that the novel feature of the binge of late-cycle merger loans, “cov lite” deals, will make the damage worse. Normally. companies that borrow heavily have to agree to meet certain requirements (covenants) like maintaining a minimum net worth. If the debtor breaches those stipulation, the lender can accelerate the debt, meaning demand it be repaid immediately. That does not necessarily happen, but the acceleration clause allows the creditor to renegotiate the obligation in light of the borrower’s deteriorating financial condition, and that can include tough measures like asset sales or a restructuring, or forcing the company into Chapter 11.

What happens in the new world of cov-lite? Well, the company goes to hell and the borrowers can’t do much to intervene. The result is if the company continues to decay, it will wind up in bankruptcy, but later and therefore in a weaker state than if the creditors had forced it into bankruptcy sooner. That means the odds of a successful structuring are lower, and more companies will wind up liquidating. Thus not only will defaults reach new post-war highs, but recoveries are likely to be lowere.

From Reuters (hat tip reader John D):

About 40 percent of all U.S. junk bonds outstanding in late 2008 will likely default by 2013….By contrast, the cumulative five-year default rate was about 30 percent in the last two default cycles…

The worst recession since the 1930s has already pushed defaults to double-digit rates. According to Standard & Poor’s, the default rate rose to 10.4 percent in August from less than 1 percent in 2007 as the recession and credit crunch left companies unable to pay off debt.

Deleveraging by consumers and financial institutions and fiscal problems at federal and state governments will slow the economic recovery, keeping defaults high, Bank of America said. Failure of the “shadow banking system” to reinvent itself will also contribute to high defaults, it said, referring to hedge funds and other non-bank institutions that fueled the last credit boom.

Defaults will also be triggered by hundreds of billions of dollars of debt coming due, especially in 2013 and 2014, Bank of America said. About $361 billion of high-yield loans come due in those two years alone, or 72 percent of the total outstanding, the bank estimated in an earlier report.

Bank of America in December had forecast that the junk bond default rate could peak at 17 percent in the second quarter of 2010, the worst since the Great Depression. Thanks to numerous government lifelines, including near-zero interest rates, it now expects the default rate to peak at 12.8 percent in the fourth quarter this year.

However, defaults will remain higher than normal and peak again at 8.5 percent in late 2012, the bank estimated. Even by 2013, the default rate will still be around 6 percent, much higher than the sub-4-percent levels usually seen at the end of a default cycle, Bank of America said…..

Many so-called distressed debt exchanges are only postponing defaults and will also contribute to the second wave, the bank said. In a distressed debt exchange, companies buy back debt at steep discounts, usually replacing it with longer-maturity debt. About 40 percent of distressed debt exchanges typically default anyway within three years, the bank said.

http://www.nakedcapitalism.com/2009/09/bank-of-america-40-of-junk-bonds-to-default-by-2013.html

[HamdenRice]

1. This doesn't make sense: "the worst since the Great Depression"

because junk bonds weren't around during the Depression. They were invented by Michael Milken in the 80s.

Junk bonds are designed to be of low credit quality, so it's not surprising that they default, and they are also easily convertible into equity.

The actual term for a junk bond in a junk bond's indenture is "convertible subordinated debenture."

[A HERETIC I AM]

3. Sorry Hamden, but your post is inaccurate.

because junk bonds weren't around during the Depression. They were invented by Michael Milken in the 80s.

Sure they were. Michael Milkin did not invent them by any means. He became famous because of insider trading and the fact that he aggressively pushed or marketed low rated, high yield debt securities, but he didn't invent them. So-called "Junk" or High yield bonds have been around for a very long time.


From the Library of Economics and Liberty website;

The history of high-yield bonds is nearly as long as the history of public capital markets, with early issuers including General Motors, IBM, J. P. Morgan’s U.S. Steel in the first few decades of the twentieth century, and the United States of America soon after the nation’s founding in the 1780s. The public market for new-issue junk bonds gradually atrophied, and for most of the twentieth century—up to the 1970s—all new publicly issued bonds were investment grade. The only publicly traded junk bonds were ones that had once been investment grade but had become “fallen angels,” having been downgraded to junk as the financial condition of the issuer deteriorated. The interest payments on these bonds were not high, but with the bonds selling at pennies on the dollar, their yields were quite high.

Junk bonds are designed to be of low credit quality

Not necessarily. The fact that a bond has a credit rating low enough to be considered a junk issue is not always by design at all. Often it is a by-product of the issuer's overall financial strength and can reflect a dramatic deteriorating change over time (GM is a perfect example). A given issuer would most assuredly prefer to have a higher rating on any bonds it issues because they can pay a lower interest rate. Damned few companies would intentionally market debt instruments at a high yield if it could be avoided.

so it's not surprising that they default,

Some do. Most don't, as the article clearly indicates. "40 per cent of all U.S. junk bonds outstanding in late 2008 will likely default by 2013" meaning 60% will NOT.

and they are also easily convertible into equity.

Wrong. Only a specific class of debt instrument is "easily convertible into equity". Not all junk or high yield bonds fall into this class.

The actual term for a junk bond in a junk bond's indenture is "convertible subordinated debenture."

Also wrong. Senior secured debt can also be downgraded to junk status (Again, GM is a perfect example) and a "Convertible Subordinated Debenture" can be rated AAA or it can be rated CCC or anywhere in between.

[HamdenRice]

4. OK Milken popularized them

As your own post shows, they had disappeared from the 1780s until the 1970s. That means they weren't around during the Depression.

So what's your point, if your own data confirms what I wrote?

The point is, you can't compare the rate of defaults of high quality credit in the 1930s with the default of junk bonds today. Apples and oranges.

Milken wrote his thesis on the use of low grade debt at University of Pennsylvania's Wharton School, and he brought those insights to Wall Street. Milken may not have invented junk bonds, but he certainly created (invented) the market for them from the late 70s through the 80s. Even Wiki acknowledges this:

http://en.wikipedia.org/wiki/Michael_Milken

Michael Robert Milken (born July 4, 1946) is an American financier and philanthropist noted for his role in the development of the market for high-yield bonds (also called junk bonds) during the 1970s and 1980s, for his 1990 guilty plea to multiple felony charges that he violated US securities laws,<2><3> and for his funding of medical research<4>.

<end quote>

He was famous long before his felony charges, and it was his insight and ability to build a market that led to the junk bond boom of the 80s. Junk bonds are still crucial to the financial markets despite the public's apprehension about them because of the term "junk".

As for their low credit quality -- that's the very essence of why they are called "junk." If they are not low credit quality, they are not "junk bonds." It doesn't matter whether they are junk because of the covenants or because of the overall credit quality of the company. They are designed to be of low credit quality (so they can be high yield, in the credit interest rate trade off). I don't see how anyone can seriously dispute the idea that a junk credit bond is designed to be a junk credit. A triple A bond can deteriorate to junk credit, but that doesn't mean it started out as a junk bond. People use that term as an analogy. A triple A GM bond of junk credit is not a "junk bond." You've simply got that terminology wrong.

As for "convertability" -- yes some convertible bonds are not junk, but most junk bonds are convertible. You are making a mistake of logic. I said most junk bonds are convertible, not all convertible bonds are junk bonds. The purpose of the convertability is to acquire upside benefit in return for the downside credit risk.

As for the expectation that they default, I did not say they all default; just that it's not surprising if they do default. After all their initial junk credit status is an indication of the likelihood of default. Once again, you've made an error of semantic logic. As Wiki points out:

http://en.wikipedia.org/wiki/Junk_bonds

In finance, a high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated below investment grade at the time of purchase. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors.

[A HERETIC I AM]

5. I merely took issue with the way you worded your post.

You made declarative statements that are not true. I know what a junk bond is. I also know that bonds rated in that category come in many forms and are not all "convertible subordinated debentures".

As your own post shows, they had disappeared from the 1780s until the 1970s. That means they weren't around during the Depression.

Actually, it doesn't. The article I linked does not say nor indicate "they had disappeared from the 1780's until the 1970's" The article says NEW-issue junk bonds deteriorated. It does not mean there were no junk bonds available or that none were issued.

From the article I linked;

Companies deemed speculative grade were effectively shut out of the public capital market and had to rely on more expensive and restrictive bank loans and private placements (where bonds are sold directly to investors such as insurance companies). Interestingly, even though these private placements were riskier than the public high-yield bonds of the 1980s, they were never labeled “junk.” Indeed, the label “junk” and the decision about what level of risk it applies to, though now well established, is essentially arbitrary.

Were they as commonly publicly traded back then as they are today? No, they weren't. But they didn't disappear.

So what's your point, if your own data confirms what I wrote?

My point is that you made declarative statements that are not true, but at this point we are likely talking past each other.

A triple A bond can deteriorate to junk credit, but that doesn't mean it started out as a junk bond.

That is pretty much what I said.

People use that term as an analogy. A triple A GM bond of junk credit is not a "junk bond." You've simply got that terminology wrong.

A triple A rated bond is NOT a junk bond. I never suggested it was. It's a AAA bond. The statement "A triple A GM bond of junk credit" is a non-sequiter. People who deal in bonds understand the term "junk" to mean "speculative grade" or one that is rated below "investment grade" and has a higher degree of risk of default. Full stop. I don't have the terminology wrong, but again, we may indeed be talking past each other here.

As for "convertability" -- yes some convertible bonds are not junk, but most junk bonds are convertible. You are making a mistake of logic. I said most junk bonds are convertible, not all convertible bonds are junk bonds. The purpose of the convertability is to acquire upside benefit in return for the downside credit risk.

There is no "mistake of logic" here. You did NOT say "most junk bonds are convertible"

You wrote

"Junk bonds are designed to be of low credit quality, so it's not surprising that they default, and they are also easily convertible into equity. The actual term for a junk bond in a junk bond's indenture is "convertible subordinated debenture."

I'm saying that is simply not always the case. Saying "Most junk bonds are convertible" and that they are "easily convertible into equity" are inaccurate statements. If you have data or a link that demonstrates "most" (or more than 51%) of speculative grade bonds are convertibles, then I will stand corrected and graciously admit so.

[HamdenRice]

6. Whatever

Do you have any opinion on the main point -- that you can compare bond default rates in the 30s, when junk bonds were rare and defaults were of high quality credits, with a predicted junk bond default rates today, as a measure of the economy?

That's the issue the OP and I raise. Not the minutia.

[Crewleader]

2. k&r

and from:The Market Ticker



Posted by Karl Denninger in Banking System at 10:56
CORRUPTION: Is The Lid About To Come Off?


http://market-ticker.denninger.net/archives/1452-CORRUPTION-Is-The-Lid-About-To-Come-Off.html