Market: No Recovery On Recovery Rates

Those who believe in karma think that you get back what you give out. Unfortunately, in leveraged finance, what you get back may be just a sliver of what you gave, especially right now.

Case in point, the recent credit default swap auction for now bankrupt Tribune left investors with a recovery rate of 23.75%. This illustrates what many market participants are saying: Recovery rates will be far below what they have historically been in past downturns.

"We're looking at recovery values around 25% [for bonds]," said Gary Sullivan, head of high yield bond portfolio management at DB Advisors, Deutsche Bank's institutional asset management business. "But there will be a big dispersion depending on the individual credit, the assets and capital structure. [The market] will definitely see zero recovery rates on some bonds, therefore credit analysis over the next few years will be very important."

As of Nov. 10, roughly 16% of all speculative-grade senior secured debt rated by Standard & Poor's had a recovery rate of 50% or below. Meanwhile, 67.4% of all senior unsecured debt and 90.4% of all subordinated debt fell into the same category.

Moody's Investors Service's assessments project recovery rates on first-priority, first-lien senior secured bank loans to be 68% upon default, compared with the historical 87% rate. The rating agency expects recovery rates on U.S. second-lien loans to be only 21%, compared with the historical average of 61%. For senior unsecured bonds, Moody's expects an average recovery rate of 32%, compared with the historical average of 40%. Subordinated bonds fare even worse at 18%, compared with their 28% historical average. During the downturns between 1990 and 1993 and 2000 and 2003, the average recovery rate for all the debt rated by Moody's hit around 45%.

What makes this downturn far worse for recovery rates is the lack of financing available to a company after it defaults on its debt. "Recoveries are being much further constrained in this cycle due to the extraordinarily difficult conditions in the overall credit markets," said David Frey, a senior portfolio manager at Stanfield Capital Partners. "Low recovery rates will be more pronounced for those companies viewed to have strong asset values but weak current cash flow generation, like Tribune. Realizing asset values requires the ability to actually sell the assets, and in the current environment there are few buyers and very limited funding."

Defaults and recoveries go together like alcohol and a hangover; the latter can not exist without the former. Moody's forecasts the U.S. speculative-grade default rate will climb to 15.8% by November 2009 and 29.1% by December 2013, according to a report published last week.

"The lack of DIP financing for debtors coupled with the unsustainable capital structures, which financed over the past several years, has and will continue to challenge recovery values for all classes of debt," an investor said. "Current trading levels for unsecured defaulted issuers, such as Pierre Foods (trading at five cents) and Masonite and Hawaiian Telecom (both trading at six cents) are evidence that the unsecured debt will be particularly hard hit in this cycle."

If a company is unable to get financing after it defaults, its only option is to liquidate. And after it does so, debt holders are left sorting out the scraps.

Hard Rock Park, a theme park in Myrtle Beach, S.C. with rock 'n' roll-themed rides such as the Led Zeppelin roller coaster and a Reggae-inspired water park, filed for Chapter 11 just nine months after it opened. When the park's owner couldn't obtain financing, the Chapter 11 was converted to a Chapter 7 filing in order to liquidate its assets.

In a recent study, S&P focused on a sampling of approximately 76 speculative-grade rated issuers, primarily those with a corporate credit rating of B- or below and with rated debt in excess of $1 billion, to asses how their recovery ratings would change if they met the same fate as Hard Rock Park. The rating agency found that recovery ratings declined to a 50% to 70% retrieval of principal from 70% to 90%. Most of the companies S&P reviewed were in the media and entertainment and consumer products sectors.

So how does one distinguish between a company that, if it defaults, gets a DIP loan, thus boosting the recovery rate for lenders, and one that has to liquidate? Count the greenbacks.

"We continue to focus on liquidity and refinancing risks in our portfolios, and we have negligible exposure to companies with facilities maturing within the next two years," said Frey.

The investor added, "A lot of loans made to finance acquisitions were based on overly aggressive assumptions of enterprise value. I think some of the loans will do better in a recovery scenario than others. For example, a company like Hawker Beechcraft, that has a strong market position, high barriers to entry and a lot of hard assets will likely fair better in a restructuring than a company like ServiceMaster, that is asset-lite and provides commodity type services that have to compete with thousands of local competitors and do-it-yourselfers.."

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