WHEN WILL THE BANKRUPTCY WAVE ARRIVE?

High yield investors constantly have to worry about the probability of their investments failing. After years of recession, the so-called “default rate” typically rises, with the peak usually being reached shortly after a recession, or at the beginning of an upswing. This is the forecast for 2021. Is there a risk of mass death among companies below investment grade in the coming year? Felix Fischer, Head of Research at Lucror Analytics, explains whether this will be the case and to what extent corresponding expectations in the high yield market have already been factored in.

Felix Fischer is Head of Research at Lucror Analytics, based in Singapore. He began his professional career at DEKA in Frankfurt and then worked for HypoVereinsbank (Unicredit) in Munich, Lehman Brothers in London and PIMCO in Munich. He is one of the founding members of Lucror Analytics and has been with the company since 2010, with a focus on high yield research.

Mr. Fischer, one hears and reads a lot about the COVID-19 related bankruptcy wave. Why has this not yet happened, or at least not to the extent that the rating agencies have been forecasting for many months?

In this regard, a fundamental distinction must be made as to what types of companies are meant and where they are based. In Germany, for example, extensive state aid has so far prevented numerous bankruptcies. This applies both to medium-sized companies that have received direct help and to larger companies such as TUI, which were able to benefit from government-guaranteed loans. In addition, the respective industry affiliation is of course a decisive factor. Catering, airline and tourism companies are affected to a completely different extent than companies from the pharmaceutical industry. But one thing is certain: without extensive state support, both direct and indirect (such as short-time work benefits), there would have been a number of bankruptcies yet unseen in post-war history.

The rating agencies are expecting a default rate in the mid-single-digit range for the coming year. Do you agree with this?

This seems entirely plausible to me. There will certainly be a slight increase in loan defaults. However, I do not expect a wave of bankruptcies. Most companies with a credit rating are relatively well positioned in terms of liquidity, even if there are further lockdowns.

Why should the high yield default rate in the coming year be lower than in 2010 (according to S&P it was around 10% worldwide in 2010)?

On the one hand, banks were much more cautious in lending in 2009 and 2010, but fund management companies were also unwilling to take on increased risks. For example, a solid investment grade company like Holcim had to pay 9% for its bonds in 2009 in order to successfully place them. Currently, interest rates are significantly lower and the willingness of investors and banks to take risks is much higher. The Italian company Industria Macchine Automatiche, rated B, recently successfully placed a significantly oversubscribed bond at 3.75%. Most of the weaker companies were able to refinance themselves or make provisions for (even) worse times in 2020. This was not the case in 2009, which was an important reason for the increased loan defaults in 2010. In this respect, I do not expect a similar increase in the default rate. However, there will be some defaults for weaker companies.

The iTraxx Crossover Europe 5yr CDS, a benchmark for the interest rates of high-yield companies, is currently around 250 basis points and has thus almost fallen back to the January 2020 level. How do you explain this enormous loosening on the credit market, which is in stark contrast to economic reality?

The development described is partly due to the very high demand for high-yield investments. The current low interest rate environment means that many investors are forced to look for alternatives in the fixed income sector in order to meet investor expectations. In addition, the default rate is currently still moderate. However, the spread levels are indeed historically low. This applies to both American and European HY bonds. In my opinion, however, Asian HY bonds are currently still attractive. Here, the recovery has not yet taken place to the same extent as in Europe and the USA, although the spreads here also shrank significantly in December. The markets focus too much on the tensions with the USA and take too little account of the solid economic framework and the fact that Asia is managing the COVID-19 crisis much better than the West.

The implicit default probability, measured on the iTraxx crossover, is 16-18% (with a 30% -40% recovery rate) for the next 5 years. Do you think this market expectation is realistic?

As mentioned earlier, I don't think there will be a massive spike in the default rate. In this respect, the market expectation is roughly realistic. Incidentally, an average of three to three and a half percent default rate per year is not that far off historically and I would still expect a recovery rate in the range of 30-40%.

Are there certain sectors that you believe are particularly at risk in 2021?

I see greater risks in sectors in which COVID-19 has triggered lasting change. This certainly includes airlines that will have to be prepared for a significantly lower number of business travelers in the future. In addition, COVID-19 has of course strengthened the trend towards e-commerce. Retailers who cannot present a conclusive e-commerce concept are therefore also at risk.

Source: Bloomberg, Lucror Analytics, as of 22 December 2020

A “default” in the bond world is firstly a broad term and does not always have to mean a total loss. What is the so-called "loss rate" and how is it likely to develop in 2021 - also in the context of history? How do you see the trend towards softening covenants (Covenant Lite) in this context?

The loss rate is the loss compared to the agreed repayment. If, for example, an investor only gets back 30% of the nominal amount of a bond after a default, the loss rate is 70%. I don't think that the loss rate will change permanently in 2021.

The softening of covenants, i.e. the terms of credit, is undoubtedly negative for investors. For one thing, companies are less restricted in terms of debt, investments and dividends. On the other hand, softer covenants mean that creditors are only involved much later. Often, “the child has already fallen into the well” before creditors can take countermeasures.

Do you think that, in view of the special COVID-19 situation, there will be more and more “follow-up” by equity providers or do you see “Debt for Equity Swaps” as a new trend?

In view of attractive company valuations and high liquidity, I think that equity investors are generally very willing to add fresh equity.

However, in certain situations (e.g. in the case of high over-indebtedness), debt for equity swaps will still be a useful instrument for recapitalisation. However, this also depends on the composition of the creditors. If, for example, hedge funds hold a large proportion of the bonds or loans, the willingness to undertake a debt for equity swap is generally higher and the implementation less problematic than if the majority of the debts are held by retail investors.

Let's take another look at the current situation on the high yield market. The differences in returns, even within the same rating category, were extremely high in the pre-COVID 19 period. Now this so-called "dispersion" has become even greater. With names like TUI or Stonegate Pub (a British pub operator), the implied 5-year probability of default is around 50%, while other bonds trade at low single-digit yields and the market here assumes an almost certain survival. Is the differentiation of the market correct or do you see individual exaggerations?

There are undoubtedly attractive investment opportunities and bonds that investors should avoid right now. In the case of Stonegate and TUI, however, one should bear in mind that COVID-19 has created a lasting risk for the business model, as the pandemic will change consumer behavior. In addition, it should not be forgotten that TUI competitor Thomas Cook had to file for bankruptcy in 2019 even without COVID-19, despite the overall good framework conditions.

I think some of the capital goods sector bonds are interesting. For example, Norican debt securities are yielding around 10%, although the company was still cash flow positive despite the declining sales during the COVID-19 crisis. I also consider bonds from Novafives and Schenck to be quite interesting. These companies are well positioned to weather the crisis and should benefit from increased demand for maintenance after the lockdowns.

How do you personally find the term “zombie company”, which has been used a lot recently?

“Zombie company” is certainly not a nice saying. However, it is true for companies that no longer have an adequate capital structure and can only keep themselves afloat through emergency loans, additional equity capital and/or "selling the silverware". In these cases capital restructuring is usually appropriate. Unfortunately, the legal framework in many European countries is not conducive for meaningful recapitalisation. In the high yield market - especially with companies that have a credit rating - I hardly see any zombie companies at the moment.

Mr. Fischer, thank you very much for your time and your interesting assessment!