Defaults Turn Junk Buyers Toward Bank Loans

With default rates in the junk market at their highest levels since 1992 and recovery rates at historical lows, investors are increasingly turning to leveraged bank loans to ward off future hits - a trend that analysts expect will continue into next year.

"The quality of new issues is declining and defaults levels are high," said Barry Allen, portfolio manager of the Altamira High Yield Fund, who plans to increase the percentage of bank loans in his portfolio from 3% to 15% within the next six months.

Indeed, compared with what the junk market has to offer right now - poor liquidity and sparse deal flow - leveraged loans present an inviting alternative.

"In an environment of greater default incidence, the loan arguably becomes a defensive asset for investors that want to stay invested in higher yielding spread product," said Mike Rushmore, managing director and head of syndicated finance research at BankAmerica.

More importantly, with defaults on the rise, investors can take comfort in the fact that loans are higher in a company's capital structure and thus get paid off before bonds.

"We think the demand for secured bank loan paper, especially on the part of the institutional market, is a reflection of that flight to quality," said Mike Rowan, managing director at Moody's Investors Service .

According to Moody's, 1999 default levels are at record highs, with 93 rated companies defaulting on $30 billion of high yield debt this year. An additional 140 unrated companies defaulted on $38 billion of debt. As a result, the rate has trended sharply higher, peaking at 5.89% last month and leveling back down to 5.79% as of Nov. 1.

Not only have default rates reached their highest level since November 1992, but recovery rates are at a historical low. While recovery rates hovered in the mid-50s for senior secured and unsecured notes and held at 34% for subordinated notes from 1977 to 1998, all three recovery rates converged at 38% in the spring of 1999.

There has been a one-month decline in the default rate from October, and at least one analyst took that as a good sign. But, for some investors, that doesn't offer much consolation. Even more worrisome is the fact that the current default rate could remain at the same high level for the next two years, said Leo Brand, an analyst at Standard & Poor's.

Positives Weigh In Favor Of Loans...

Another factor that makes loans so appealing is the present concern over interest rates. Unlike junk bonds, which have a fixed coupon, leveraged loans float over the London Interbank Offered Rate, so their yield adjusts upward when rates increase.

"We're using bank loans as part of a strategy to be defensive," Allen said. "We'd lean toward lower yield, lower risk in bank loans versus the same company's bonds. In an environment where interest rates are changing significantly, there's the issue of fixed and floating interest rates and more flexibility if you can use interest rates to your advantage."

Investors also have more deals to choose from in the bank market. While high yield bond issuance has been limited to $68 billion year-to-date, leveraged loan volume totaled over $90 billion in the third quarter alone, according to Thomson Financial Securities Data.

"On the bond side, we're seeing a light flow, several issues that have been announced, several that might not be announced depending on market conditions," Rowan said. "On the other hand, there's been a fairly steady state, an increasing state, in the syndicated bank loan side of the ratings business."

In recent weeks a number of leveraged loans have priced, including a $1 billion deal for Nextlink Communications Inc. and a $974 million refinancing for Ventas Inc., (see story, p. 1) a healthcare real estate investment trust.

....But Analysts Still Sound Warning Bell

Despite the advantages offered by loans, analysts said that both banks and institutional investors in the loan market should not ignore the rising default rate.

"The rising rate of bond defaults is of concern to all spread product investors," Rushmore said. "The rate of defaults on bonds is an indication of the general strength or weakness of other credit markets, and all underwriters are extremely sensitive to this change in market tone, in part because our investing clients have changed their own investment parameters."

Indeed, for the first time in five years, banks are showing signs of being more selective in their lending, and many have begun to tighten their underwriting standards, according to the 1999 Survey of Credit Underwriting Practices conducted by the Office of the Comptroller of the Currency.