The Time Is Right, But Can You Pick 'Em?

As the storm that hovered over the high yield debt markets for the second half of 2008 appears to recede, some junk managers are treading default ridden waters hoping to find that oyster with the pearl.

And while any portfolio manager worth his or her salt will tell you that fundamental credit analysis is always important, one could argue that in a bull market, with easy flowing credit that can keep a company floating along for years, it’s not quite as important as in times like these. In times like these, default rates amount to more than just abstract projections the credit wonks at the rating agencies write reports about each month. Defaults, and bankruptcies, are painfully real; they’re happening every day.

The good news is that the market has priced in a default rate far above the reality, so there are many companies with debt offering fantastic returns without much risk. The trick is finding them. So if you’re fishing for deals, delving into each company’s inner workings has become more important than ever, especially for single-B credits. Or lower.

To illustrate this point, analysts at UBS recently looked at implied defaults at the issuer level. First, they identified higher quality names in a variety of sectors that have outstanding debt maturing within three to five years. Though the average recovery rate in this cycle is expected to be low, they assumed the recovery rate for these issuers will be more in line with historical norms (70% for first-lien loans, 40% for senior unsecured bonds, and 20% for subordinate bonds).

In the end, they came up with a list of issues where, in their view, the true probability of default is more optimistic than what the current market price implies.

One example: Quicksilver’s 8.25% bonds due 2015. With a trading price of 82.50 (as of Feb. 4) and a yield of 12.20%, these notes have an implied probability of default of 57% and, being senior unsecured, a historically based recovery rate of 40%. But, after some fundamental credit analysis, UBS’s analysts put the default rate on these B- bonds at 10% and the recovery rate at 100%. Quite a bit less risk than one might think.

An even more striking example is Dresser’s second-lien loan. Priced at Libor plus 575 bps, this B- loan was trading at 51 on Feb. 4 with a yield of 21%. This implies a probability of default of 83%, along with an historically based recovery rate of 40%. But UBS’s analysis puts the likelihood of default at 10% and the recovery rate at 65%. Again, much less risk than the price implies.

And to this I say, sweet. Time to start shucking.

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