In 2008, investors and journalists obsessively followed the price of credit default swaps, derivative contracts that investors use to hedge against defaults.
As the financial crisis unfolded, CDS prices were a financial canary in the coal mine. When it became more expensive to insure a bank bond against default, it signaled serious problems for the bank. Fortunately, this macabre game has ended: most banks are so much better capitalized that their CDS prices are now terribly stable.
But a new CDS signal is emerging that is worth noting. Not because the trend itself has systemic implications, but because of what it suggests about what is happening to struggling companies.
The question revolves around what creditors can expect to recover in bankruptcy. Most CDS contracts state that financiers need to know what a company’s cheapest bond will be worth at the time the company defaults. This is because CDS contracts make investors whole by paying them the original face value of the bond minus its market value. When a business goes bankrupt, financiers hold an auction to determine the market price, and the resulting prices offer a guide to the value of the company’s remaining assets according to creditors.
Over the past decade, average CDS auction prices have fluctuated in the range of 10 to 60 cents on the dollar, but have generally been in the range of 30 to 40 cents. However, the nine U.S. auctions conducted from the year through August produced an average price of just 9 cents – and just 2.4 cents if you look at the four worst: Chesapeake, California Resources, Neiman Marcus Group, and McClatchy. “Credit collections with CDS auctions have been extremely low,” Brad Rogoff wrote in a Barclays memo.
The micro-level explanation for this decline is a change in capital structures. Ten years ago, it was difficult for struggling businesses to raise emergency funds, such as “debtor in possession” loans, when they hit the wall. But this year, that capital “has been readily available to most companies who have sought it out,” notes Rogoff.
This allowed struggling businesses to spread out longer, as so-called corporate zombies. And because loans take precedence over bonds in bankruptcy, the practice has also weakened bondholder claims, sparking scuffles in some bankruptcies, including U.S. mattress maker SertaSimmons and California-based beachwear group Boardriders.
Claims from bondholders were further undermined by stealth debt swaps and asset transfers, including the one known as the “J-Crew trap”. Named after the recently bankrupted U.S. retailer, it refers to a move led by the company’s private equity owners in 2016 in which they transferred the intellectual property rights to new lenders, out of the scope of the original creditors. Similar tactics have emerged in other struggling groups such as Travelport.
These trends are just a symptom – not the root cause – of the real reason for low collection rates: super cheap money. The reason DIP funding is so plentiful, just like high leveraged funding before a company hits a wall, is that asset managers have entered the lending industry to increase their returns in a world with low interest rates. And the reason struggling companies were able to get into games like the J-Crew trap is because creditors have stopped imposing restrictive covenants that could prevent this.
Indeed, four-fifths of US loans issued last year were covenant-lite, meaning they had little or no control over borrower behavior, compared to one-fifth at the start of the year. decade. This is because investors are so desperate to seek returns in a zero rate world that they no longer dare to impose restrictive covenants.
Indeed, the hunt for yield is so rampant that junk bond yields have fallen from 12% in March to less than 6%. Cheap money, in other words, allows some zombie businesses to spread out, even as creditors’ value shrinks – until they collapse.
This is why it is useful to take note of these low CDS recovery rates. The sample size is so small that it is difficult to predict the extent of the problem. But investors and policymakers should be asking tough questions about corporate zombies – and whether it’s wise to let them all continue to stumble on the crutch of cheap money.
Investors should also insist on tough conditions when granting loans to risky companies. This is doubly true given the IMF’s warning last week about threats of extremely high leverage from U.S. companies – and the risks of another economic downturn as the Covid-19 pandemic flares up again. .