'Aggressive' bond issuance, increased bank debt could spell trouble ahead for bondholders, Fitch warns

By Paul A. Harris

St. Louis, Feb. 23 - Aggressive issuance in the junk bond market coupled with an ongoing migration of issuers to the bank loan market from high yield could signal trouble ahead for bondholders, Fitch Ratings warned in a report released last week.

Analyst Mariarosa Verde, lead author of "The Shrinking Default Rate and the Credit Cycle - New Twists, New Risks," told Prospect News on Friday that the mix of factors currently at play in the leverage markets might be expected to send default rates ramping up from their present historic lows and erode bondholders' rates of recovery in bankruptcies.

"Aggressive" uses of proceeds

According to the Fitch report, which examined uses of proceeds for high-yield bond issuance going back to 1990, as economic growth steps up so does the proportion of growth-oriented bond issuance - i.e., mergers and acquisitions and leveraged buyouts - while the volume of debt refinancing deals diminishes.

"Global high yield use of proceeds data obtained from Merrill Lynch show that in 2006, 35% of the proceeds of newly issued high-yield bonds was used to fund M&A and LBOs, up from 31.5% in 2005 and triple the level of new issuance dedicated to such activities in 2002 and 2003," according to the report.

"In contrast, refinancing was a stated use of proceeds in just a little over 40% of new bond sales in 2006, compared with roughly 70% or more in 2001, 2002 and 2003."

Verde, who characterizes debt refinancing deals as "debt neutral" and growth-oriented uses as "debt additive," said that 2006 actually saw a net increase in total debt among leveraged issuers.

In a sample of 260 companies rated BB or B, debt increased 12% through the third quarter of 2006.

"That was a significant departure from 2004 and 2005, where debt either shrank or moved up only slightly," she added.

Verde conceded that leverage has remained fairly level throughout this period, but chalked it up to solid profits and maintained that in the event of an economic slowdown leverage will almost certainly rise.

More low-rated issuance

The Fitch report also zeroed in on the new issuance ratings mix.

In 2005, the share of issuance rated CCC or lower was 20.5% of the total issuance. In 2006, that percentage fell to 15.2%.

Compare that to 2002 and 2003, when CCC or lower paper only came to approximately 10% of total high-yield issuance.

To further illustrate, Verde said that 2002 saw $12 billion of new issuance that was rated CCC or lower. In 2005 it was $31.4 billion. Last year, CCC or lower issuance declined to $22 billion.

However Verde contended that the decline can in part be traced to a recent phenomenon in the leverage markets: the flight of issuance to bank loans from bonds.

For example, in 2002 and 2003 the dollar amount of bank loan issuance outpaced that of high-yield issuance by approximately two to one. By 2004, the ratio was approximately three to one, in favor of bank loans. And in 2006, bank loan issuance outpaced high-yield issuance approximately four to one.

"It's possible that a lot of the riskier issuance has migrated to the leveraged loan markets," the analyst said.

Recovery rates could decline

As riskier companies issue bank debt, often in the form of second-lien loans, bondholders' prospects in bankruptcy scenarios could become eroded, Verde contends.

"If you look at the capital structures of most leveraged issuers, typically 60% consists of loans and 40% is bonds," she said.

"Now anecdotal evidence is emerging that the share of loans in capital structures is growing beyond that 60% ratio."

This increase in secured debt in the capital structures of leveraged companies takes place against a backdrop of recovery rates that are presently at all time highs, the analyst pointed out.

For 2005, Fitch's weighted average recovery rate was 64% of par.

"Right now bondholders are actually doing comparatively well in bankruptcies," Verde asserted, adding that the long-term average recovery rate is 40% of par.

However, the prospects for future recovery rates may be weakening if the trend among issuers to carry more loans on their capital structures continues, because in a bankruptcy scenario the added loans will leave bondholders farther back in the line of creditors.

Verde asserts that this scenario could result in recovery rates that are actually below the historic average in the next economic downturn.

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