Traders work on the floor of the New York Stock Exchange (NYSE) in New York, U.S., on Friday, Oct. 27, 2017. Stocks climbed and the dollar rallied after the U.S. economy saw its strongest back-to-back quarterly growth in three years, while bonds rose as speculation mounted about the next Federal Reserve chair. Photographer: Michael Nagle/Bloomberg
When the economy inevitably turns, the yield oasis might look more like a sinkhole © Bloomberg

No one knows when the US credit cycle will keel over. But when it eventually does, the outcome is likely to be unusually nasty, brutish and protracted.

The US corporate bond market has been on fire this year, with companies raising a record $1.14tn of debt. Even junk-rated companies enjoy average borrowing costs of less than 6 per cent. That might look miserly, but corporate debt has been a welcome oasis of yield in a desert where close to $10tn of sovereign bonds still trade with negative interest rates.

Yet when the economy inevitably turns, this oasis might look more like a sinkhole. Many creditors are likely to face more severe losses than they have in the past, and more arduous debt workouts.

The debt boom has been accompanied by a sharp deterioration of the legal protection offered to creditors, as borrowers have taken advantage of desperate investors to weaken or scrap “ covenants” designed to help insulate lenders from financial shenanigans. This means that any recoveries in a default are likely to be much lower in the future than the historical norms.

The typical bankruptcy recoveries naturally wax and wane with economic cycles, and are typically much worse in a recession than when growth is buoyant. They also differ between types of debt, with loans typically enjoying better returns than bonds.

S&P Global has crunched the recoveries of more than 4,100 defaulted loans and bonds of almost 1,000 US companies that had to restructure their debts or enter insolvency between 1987 and 2016. It found that the recoveries on loans averaged 74 per cent, while the recovery rate for bonds averaged 38 per cent.

These are broad categories, and recoveries can vary greatly depending on the “seniority” of the debt. For example, revolving credit facilities — almost like a corporate credit card offered by banks — and senior secured bonds have averaged mean recovery rates of 78 per cent and 56 per cent, respectively. Unsecured “term loans” and subordinated bonds usually only recover 51 per cent and 26 per cent respectively.

These historical recovery values are plugged into valuation models that investors use to calculate how much they could lose if defaults start ticking up. But given the marked deterioration of legal protection in recent years, these assumptions might ultimately prove as worthless as some of the bonds investors are buying.

Just how bad have things got? Talk to some hedge fund managers and it seems the legal documentation might as well have been written on the back of a napkin. That is obviously overdone, but Moody’s “ Covenant Quality Indicator” index has now been hovering near its weakest-ever levels for half a year.

Moody’s constructs this gauge by scoring newly issued bonds from 1 (the best legal protection) to 5 (the worst). The CQI is a three-month rolling average, weighted by each month’s total number of bonds. This index has now been higher than 4.4 in each of the six months through November, and above 4 for the past four years. In other words, a lot of fairly dodgy deals are being done.

Of course, covenants aren’t everything. Many bond investors say they are uncomfortable with but not freaking out over the deteriorating legal protections. They argue that, ultimately, thorough research is the most important way of avoiding dodgy debt. Some even argue that lighter covenants can make a restructuring smoother and quicker.

But that ignores another, less-appreciated development in the world of souring corporate debt: The heft and aggressiveness of “ distressed debt” funds that specialise in profiting from companies in trouble. These funds fulfil a vital role in providing money to troubled companies, or taking over stricken ones in a restructuring and helping turn them around. But distressed debt players are becoming more prevalent and aggressive, turning many situations into protracted legal trench warfare.

This is partly due to the lack of corporate distress in the post-crisis era, with low interest rates buoying even the shakier ships. That has forced hedge funds to crowd into the same situations and encouraged a scorched earth approach. If the credit cycle turns and defaults tick up meaningfully, the increasingly litigious approach may abate.

However, the industry is also increasing in size. The dedicated distressed debt hedge fund industry has nearly doubled in size over the past decade to almost $200bn, according to HFR. And there seems to be a rising willingness to pursue legal warfare by both creditors and debtors — a shift that goes beyond the cyclical reasons.

Chances are that the corporate debt boom will continue for a while yet. But when it does unravel, the only sure-fire winners are likely to be the lawyers.

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