How much should investors expect to get back if a bond defaults?

In March last year we wrote a blog comment explaining how the trend for so called ‘covenant lite’ deals would result in marginally lower default rates, but would result in recovery rates being lower when a company did actually go bust (see article). We were talking about the leveraged loan market, although the same thing appears to be playing out in the bond market.

Moody’s rating agency recently released an interesting (if not a little belated) paper arguing that recovery rates on both defaulted loans and bonds in the US will be significantly lower than has historically been the case. In the past few years, the appetite for senior secured loans and corporate bonds has increased dramatically, due to leveraged borrowers being only too happy to fill their boots given the relatively cheap and abundant financing available. Loans, therefore, now form a greater portion of capital structures than has traditionally been the case. As a result, the recovery rate on loans, which occupy a senior position in a company’s capital structure, are likely to be lower. Holders of defaulted loans have historically got 87% of their money back, but this is forecast to drop to 68%.

There are implications for high yield bond holders too. As a result of the average bond having more loans ahead of it in the capital structure, bond holders are further back in the queue for the company’s assets if the company defaults. Moody’s believe that recovery rates on US senior unsecured high yield bonds will drop from 40% to 32%, while the recovery rate on subordinated bonds will drop from 28% to 18%. These numbers may be on the conservative side, judging by the involvement of non-traditional players (eg hedge funds) in the senior bank loan market who may well act in a more aggressive fashion to the detriment of subordinated lenders.

Moody’s specifically refer to the US bond market, where both loan issuance and covenant-lite loan issuance has been heavier than in Europe. We’d therefore expect recovery rates in Europe to be a bit higher than in the US. Nevertheless, for a given bond, the prospect of a lower recovery rate means that we should be compensated in the form of higher yields. Thorough analysis of the capital structure and covenants of every bond we invest in becomes ever more important.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Stefan Isaacs

Job Title: Deputy CIO Public Fixed Income

Specialist Subjects: Bonds

Likes: Football, travel and the prospect of retirement

Heroes: Sir David Attenborough, Bill Shankly and Theodor Herzl

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