Defaulted debt trades low compared to recovery value, says S&P managing director

By Sara Rosenberg

New York, Dec. 4 - Initial trading prices for defaulted debt seem to underestimate the value of the security's nominal ultimate recovery, David Keisman, managing director at Standard & Poor's, said Wednesday. This anomaly could be a good buying opportunity for investors who are willing to hold on to the paper for a while in order to make a profit.

The trading prices "do not seem to differentiate based on the quality (debt cushion, quality of collateral) of an instrument's structure," Keisman said at the rating agency's Loan Ratings & Recoveries in the Current Economic Climate conference.

From 1988 through the third quarter of 2002, the average trading price recovery for bank debt was 60.6%, compared to a nominal ultimate recovery of 88.9%, giving an internal rate of return of 20%. The average trading price recovery for senior secured notes was 50.2%, compared to a nominal ultimate recovery of 76.5%, giving an internal rate of return of 20.5%. The average trading price recovery for senior unsecured notes was 37.9%, compared to a nominal ultimate recovery of 54.9%, giving an internal rate of return of 23%. The average trading price recovery for senior subordinated notes was 30.2%, compared to a nominal ultimate recovery of 38.2%, giving an internal rate of return of 7.7%. And, the average trading price recovery for subordinated notes was 29.5%, compared to a nominal ultimate recovery of 36.3%, giving an internal rate of return of 8.9%, according to Keisman.

For the same 1988 to third quarter 2002 period, recovery rates (if an investor held on the debt for about two years) were 81.6% for bank debt, 67% for senior secured notes, 46% for senior unsecured notes, 32.4% for senior subordinated notes, 31.2% for subordinated notes and 18.7% for junior subordinated notes.

Keisman noted that recovery rates have been lower recently. For the five-year period of 1998 through the third quarter of 2002, recovery rates were 74.3% for bank debt, 47.2% for senior secured notes, 31.8% for senior unsecured notes, 16.1% for senior subordinated notes, 15% for subordinated notes and 2.5% for junior subordinated notes.

"In today's difficult credit environment, with defaults up and recoveries down overall, we are finding that old-fashioned credit analysis and diligence matters more than ever," said Steven Bavaria, director and head of S&P's loan ratings group. "Our data show that loans with the highest structural quality are providing more relative value in this environment."

As the data indicates, recovery levels for secured leveraged credit facilities are significantly higher than for unsecured high-yield bonds. This fact has had varying rating ramifications on collateralized loan obligations versus collateralized bond obligations.

"From a ratings-volatility perspective, arbitrage CLOs have performed more favorably than CDO transactions backed predominately by corporate bonds," said David Tesher, managing director and head of S&P's Fixed Income CDO/CLO group. "Leveraged loans that have defaulted in CLOs have experienced higher recoveries than defaulted bonds in CBOs."

In the current market environment, some defaulted high-yield bonds have only received back pennies on the dollar, while the underlying recovery level for a well-secured leveraged loan has been as much as par, Tesher added.

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