High yield debt: This time it’s different

By Mark A. Brostowski and William J. Heffron, partners and managing directors, Regiment Capital Advisors LP

In February, Standard & Poor’s warned that it expected U.S. corporate credit quality to deteriorate rapidly in 2009 and added that it expected recoveries against borrower defaults to be lower than historic norms. It is also very likely that the standard deviation around that average recovery will be much greater than in the past. As such, careful analysis of each credit is of paramount importance.

Several fundamental factors support the expectation for reduced recovery rates.

First, the sheer amount of debt that existed on corporate balance sheets prior to the credit crunch greatly exceeded the leverage seen in previous cycles, as seen in Figure 1.

Senior and Total Leverage for all Leveraged (Figure 1)

6.00

5.00

4.00

Senior Leverage 3.00 Total Leverage

2.00

1.00

- 2001 2002 2003 2004 2005 2006 2007 2008

Source: Standard & Poor's Leveraged Commentary and Data

In general, leverage multiples increased approximately 1.2 times in the recent cycle. This increase may not appear large. However, when one considers that the leverage multiple increased based on peak EBITDA, the multiple understates the actual increase.

Second, the structure of loans underwritten from 2005 through early 2008 resulted in a large amount of second lien and covenant-lite loans. In such cases, the inability of lenders to get “an early seat at the table” when the borrower’s operating performance has weakened substantially can impact recoveries. Instead of protecting their collateral, lenders – without any recourse under the credit agreement - may watch companies sell assets to generate cash to pay maturities of unsecured creditors, make payments to subordinated lenders and/or draw down critical cash reserves.

Third, lenders’ appetite and capacity for providing debtor-in- possession (DIP) financing has diminished in the current climate, leading holders of senior secured debt to provide DIP funds. Lyondell Chemical, which filed for bankruptcy in January, is a good example. The senior lenders to Lyondell that provided a DIP are insisting on tighter control of the reorganization process and, by implication, a better bargaining position at the table.

Fourth, the equity cushion that existed prior to the credit crisis has largely disappeared, leaving high yield investors, who rank below providers of leveraged loans and other , very exposed. From January 2000 through March 2009, the S&P 500 index traded at an average total enterprise value/ EBITDA multiple of 10.4 times. The current value is around 7.5 times. These lower multiples have led to little or no equity protection, translating into weaker loan-to-value ratios for credit investors.

What are the consequences of these developments? We believe that high yield bond recoveries will be significantly impacted by the combination of a vanishing equity cushion (due to lower multiples) and a larger senior debt balance in front of bonds. The exception may be “bottom heavy” capital structures that have high yield debt and very few senior lenders. In general, however, we believe that selected bank loans – at their current prices and standing at the top of the capital structure – offer a more attractive risk-adjusted return potential.

Before investors pursue a bank loan investment, they need to do very thorough credit analysis. The investor focus should be on the borrower’s capital structure and the lender protections documented in the credit agreement. As noted previously, a weak credit agreement could significantly impact lender recoveries.

In all, at current market prices, many loans are trading at a 50-80% discount to the borrower’s enterprise value of just two years ago. We think that this discount, in selected credits, is excessive and the potential return, assuming only a slight improvement in the economy, is substantial.