For institutional investors with loans in their portfolios, times are bad and could get worse.
Standard & Poors is projecting default rates for leveraged loans to shoot up to 13 to 15 percent this year, up drastically from 3.75 percent last year. Not only are more loans are defaulting, adds Fitch Ratings, but the recovery rate — the money investors can collect in case of default — is also declining and could drop farther if the economy continues to slump.
Darin Schmalz, a Fitch analyst, says he sees senior secured loans that historically collect above 90 cents on the dollar recovering only 50 to 70 cents on the dollar now. Factors hurting the recovery rate include deteriorating corporate profits and faltering cash flows, along with plummeting asset values in a predominately buyers’ market. “What this means to loan investors is that they will have to make difficult decisions,” Schmalz says. “Investors may have to work with companies to get through this difficult time in order to stave off bankruptcy.”
Institutional Investors piled up loan investments through collateralized loan obligations during the credit boom. CLOs pool corporate loans and issue securities backed by these loans. About $2.5 trillion in leveraged loans were issued from 2005 to 2007, according to data provider Dealogic, and 60 percent of those were held by institutional investors through CLOs, Schmalz estimates.
Huge problems may lie ahead, however, as $81 billion in leveraged loans reach maturity this year, and a total worth $683 billion come due in the next three years.
Mercy is already being sought by borrowers, Schmalz says, through a wave of covenant-relief requests, particularly from middle-market companies with revenue of $10 million to $60 million. Given the still tight credit market and the fragile condition of banks, loan investors stand to gain by working with companies that are in trouble (granting more covenant relief, for example). Schmalz says there have been recent examples to prove his point, though he says he can’t discuss specifics for confidentiality reasons.
Clearly, however, there are obstacles to investors who want to rearrange terms with lenders. One is that many investors don’t have the personnel and resources to undertake such projects. Another is that not all lenders have the same objective. Finally, taking steps to ease terms of repayment is somewhere few have gone before.
“Investors haven’t gotten too involved in restructuring in the past,” says Schmalz. “But giving the complexity of covenants and the real threat of bankruptcy, they might have to.”
