The $1 Million (Or Are We Back To $64,000?) Question
July 10, 2008
Whether you care to define it as a recession, a downturn or a pickle, the big question we all face regarding today’s economy is: When will it recover?
Predictions have come and gone over the past several months, often getting shoved aside to make way for more extended estimates. Yesterday, analysts from UBS chimed in on the issue, at the bank’s “Leveraged Finance Market Discussion—Opportunities in the Current Market Environment,” and they, unfortunately, don’t seem to think the markets will be coming out of their current doldrums anytime soon.
When looking at it from a distressed debt point of view, “We’re at the beginning of the cycle,” said Jon Emswiler, a UBS senior distressed analyst. “I don’t think we’re even in the third inning at this point. You can see that the rest of the market assumes that defaults will pick up ... but they haven’t really started yet.”
On the upside, Emswiler and others say, investors can find opportunities with specific credits. “I do believe we’re heading into a point where there will be opportunities picking up good companies on an individual credit-by-credit basis as opposed to looking statistically at a broad-based recovery scenario,” he said.
Generally, talk in the leveraged finance market has been that recoveries in this cycle will be lower than in previous ones, largely because there have been a significant number of covenant-lite deals and second liens, aggressively structured LBO deals and high leverage among benchmark credits.
Looking at 40 selected issuers from 2005 to 2007, the UBS analysts found that the range in recoveries was not only huge, but much wider for bonds. Loan recoveries ranged from 42% to 100.3%, with an average of 80.2%, while bond recoveries ranged from 0.3% to 99%, with an average at 49.5%.
But what investors might find most interesting regarding the differences between loans and bonds is: The recovery on loans actually skewed positively, while the recovery on bonds skewed negatively.
Looking at recovery percentages on defaults from 1985 to 2006, the analysts found “you had about a 45% chance of recovering 80 cents or better in the loan market; conversely, you had about a 45% chance of recovering zero to 20% in the unsecured market,” said Steve Antczak, head of leveraged finance strategy at UBS.
So their advice to investors expecting defaults to rise would be to add exposure to select names from the loan credit default swap market and to buy protection on names that may be vulnerable to a downturn via the bond credit default swap market.
In other words, even though we may not reach the end of the pickle anytime soon, one can make a nice pitcher of lemonade, from our economy of lemons, to wash it down with.
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