Corporate defaults appear set to spike. A leading junk bond index is trading at levels that reflect investors’ expectations of a 10% default rate over the next 12 months, according to Garman Research.
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Troubled borrowers are deluging banks with requests to amend loans to avoid default. But this is risky for banks.
Take McClatchy Co., the US publisher of The Sacramento Bee and The Miami Herald newspapers, which has seen its cash flow squeezed by declining advertising revenues. It just cut a deal with lenders that loosened its cash flow-to-debt ratio limits, which it might have breached, and tweaked other aspects of its $1.2 billion (Rs5,640 crore) debt facility, in return for its paying a higher interest rate and adding collateral.
That may look smart for its lenders. After all, they make more on the loan, and if McClatchy craters, they have recourse to the new collateral. And giving any troubled company more breathing room could allow it time to recover. But there’s a downside. Extra time could allow the borrower to go further into an asset-destroying spiral, leaving less for lenders to recover if it eventually files for bankruptcy.
In McClatchy’s case, investors are worried about the latter possibility. The company’s outstanding bonds are trading at distressed levels, meaning their prices are low enough that the effective annual interest rates are equal to risk-free government borrowing rates plus at least 10 percentage points. Companies with bonds trading at such levels are nearly 20 times more likely to default within one year than non-distressed issues,according to Garman.
Meanwhile, there’s some $40 billion of US high-yield debt due to be repaid next year. If markets remain closed, borrowers may find that impossible to refinance.
It gets worse. Historically, lenders have recovered an average of 40 cents on the dollar in bankruptcy. But the recent credit boom allowed even marginal companies to raise debt—and lots of it. The greater proportion of ultra-junky borrowers in the high-yield debt universe means recovery rates could be well below the historical average.
McClatchy isn’t alone. Many companies are negotiating loan amendments, and a lot of those have debt trading at distressed levels. Bankers facing these companies across negotiating tables must decide whether the additional return they can demand is worth the risk that borrowers will go bankrupt later on anyway, when there may be even less value to recover.