Portfolio managers see higher default rates - but say loan market should come out alright

By Paul Deckelman

New York, Dec. 5 - The default rate is likely to rise to as high as the 4% to 5% area within the next two years, from current low levels around 1% - but that doesn't necessarily mean that the bottom will drop out of the credit markets, according to several experienced portfolio managers.

They told an audience of financial professionals Wednesday at Standard & Poor's Annual Leveraged Debt and Recovery Credit Conference in New York that while it is virtually certain that default rates will rise quite sharply compared with the unusually low-default environment the markets have enjoyed over the past several years, circumstances are quite different from those which prevailed the last time the markets saw a sustained default cycle, back in 2001 and 2002.

For one thing, loan portfolios are much more diverse than they were back then, spreading default risk around rather than concentrating it in a few areas. The probability of a considerably higher default rate has already been priced into the values of loans in those portfolios. Also, not all defaults are created equal - several of the managers explored the notion of "good defaults" that are fairly easy resolve, versus "bad defaults" which could take a year, two years or more to work out.

"I guess we're close to increasing defaults," said Payson F. Swaffield, the chief income investment officer for Eaton Vance Management, adding, somewhat ironically: "The next question is, who cares?"

He said that while of course, investors care - or at least they should care - the reality is that one reason for the likely ramp-up in defaults is the amount of lower-quality paper out there.

He pointed out that from last December until this past July, "we saw a dramatic - almost traumatic - increase in leverage ratios, and that in part was why Wall Street was stuck with some overhanging deals."

He predicted that "a certain bunch of those loans" actually will default and contribute to the overall increase in defaults in the leveraged loan market. But he added that "you can actually have a spike in default rates - but you may have more traditional loan managers who took very small positions in those credits, or actually avoided them all together."

He opined that the widest exposure to such defaultable loans would be among investors "who invested money with new players in the loan market, in much more risky strategies."

Swaffield went on to say he could rhetorically ask "who cares?" about the default rates because "it's already priced in" to loan portfolios.

"Today, our portfolios are priced, basically, as they were, or even at a greater discount than they were when default rates were at 7%," when the bottom fell out of the tech and telecom sectors back in 2001-2002. In that way, he said, "if I say it's 4%, that's good for me."

He expects defaults to hit about 5% within the next 20 months.

Invesco's Stoeckle says 6%-plus priced in

The repricing of loan portfolios "has already occurred," as if the default rate were 6% or 7% agreed Gregory Stoeckle, a senior portfolio manager in charge of the global bank loan business at Invesco.

It's his opinion that the actual default rate "is not going to be that severe" - he sees it going to around 4% in the next 18 months.

Stoeckle said that "we have just come through an incredible bull market run on credit," characterized by "an aggressive underwriting cycle." So many of the deals which came to market during the 2007 first and second quarters "had very little margin for error," giving them "a natural bias toward default."

He saw the beginning of "some kind of [new credit] cycle within the next 12 months.

Carlyle's Zupon sees diversification

Michael J. Zupon, a managing director of the Carlyle Group and the chief investment officer of its U.S. leveraged finance unit, sees a default rate of 2½% to 3½% for the next 12 months and 3½% to 5% for 12 to 24 months out. He said there is "the possibility that we may do better" - although he also noted that there's about a 20% chance of a severe corporate earnings decline further constraining liquidity and impacting the loan market.

However, it's his view that the Federal Reserve will likely take the necessary steps to maintain liquidity, and he noted that a number of companies within the important financial sector have recently recapitalized themselves, including Fannie Mae, Freddy Mac, Citigroup and E*Trade Financial Corp.

But even if that worst-case scenario were to occur, the impact on the value of loan portfolios would likely be limited. Zupon said that he and other experienced portfolio managers "are running much more diversified portfolios than during the last cycle," when managers routinely took "much more selection risk."

He also said that managers nowadays were generally taking smaller positions on individual credits within their portfolios, so that if a credit were to go bad, its negative impact would be lessened.

He said that while diversification takes some of the risk out of running a portfolio, it also "lessens the ability to be a hero in the market" by having a big position in a risky credit that pays off. Overall, though, he said it's a good thing.

Good defaults, bad defaults

Besides his belief that loan portfolios are now in a stronger position to withstand a rise in defaults, Zupon brought up the concept that there are defaults - and then there are defaults, or as he put it, "good defaults and bad defaults" - in other words, those which will see high recoveries for their creditors in a relatively compact time frame, versus defaults which provide poor recoveries and a dragged out workout process.

The Carlyle portfolio manager said that while "it's very difficult to pick which names are going to default - if not impossible, like finding a needle in a haystack - it's pretty easy to pick which ones, if they do default, are going to be real problems.

He said that portfolio managers, no matter how enthusiastic about a particular credit they may be, should envision "two years forward, and we're sitting in a workout. Is this a name that you're going to say to me is a fundamentally good business and there are five other people" that want to buy it or invest in it, "Or is it a name where you're going to coming to me and saying 'this is a huge problem, and no one wants to come into this business and it's going to be three to five years'" before everything is turned around?

The managers agreed that one factor which may play a key role in determining whether a credit would be a "good default" or a "bad default" is the makeup of its capital structure. Invesco's Stoeckle maintains "we definitely are going to see a more complex landscape" than prevailed last time around in terms of greater use of second-lien debt and other more complicated uses of collateral.

Capital structure complexity

Swaffield of Eaton Vance noted that at "any number of companies," term loans were issued behind asset-backed loans, and in some cases, if the ABL was big enough, say $1 billion or more, "they would likely have to be taken out by the [debtor in possession] facility. That DIP may consume all of the availability, so there maybe no additional liquidity they can get to keep [the company] alive during Chapter 11."

Zupon meantime said that the more complex capital structures seen in companies going through a restructuring nowadays, as opposed to the past, could complicate negotiations and make a workout take longer.

"Today, you have multiple tranches [of debt] and different interests," sometimes mutually exclusive, with their respective owners each pursuing their own strategies, he said, while in the old days, "when it was all banks, they took the same approach - they were like-minded, working toward the same goal."

Despite such negative factors, though, the portfolio managers are generally optimistic about the chances of making money in such an environment.

Zupon said that "we are in effect in an insurance business. We're writing protection against defaults. What's happening is that if defaults rise, the cost of insurance goes up. Spreads in our portfolio are going up to compensate us for the defaults. And if defaults go up again, spreads are going to go up again."

He said that "if you're able to hold your portfolio through the cycle and you've got a good manager and are well-capitalized, you can run an investment portfolio - as we've done for the last eight years - with zero defaults."

Swaffield feels that the repricing that has taken place in the loan market has created "a fantastic opportunity" for savvy loan managers get good assets at a steeply discounted price that "blows away" even the threat of higher default rates and possibly lower recovery rates.

"The bad news - we've already had that. I think [the new territory the market is in] is good news."

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