New York University Salomon Center Leonard N. Stern School of Business. Special Report On

Transcription

1 New York University Salomon Center Leonard N. Stern School of Business Special Report On Defaults and Returns in the High-Yield Bond and Distressed Debt Market: The Year 2009 in Review and Outlook By Edward I. Altman with Brenda J. Karlin February 2010

2 Contents Executive Summary... 3 Defaults, Default Rates, and Recoveries... 4 Bankruptcies... 8 Industry Defaults Age of Defaults Fallen Angel Defaults Default Losses and Recoveries Distressed Exchanges Liquidation Recoveries Forecast Recovery Versus Actual Related Recovery Statistics Mortality Rates and Losses Returns and Spreads New Issues and Other Changes in the High-Yield Market Credit Quality and Trends in New Issuance Proportion and Size of the Distressed and Defaulted Public and Private Debt Markets Forecasting Default Rates and Recoveries Appendix A: Quarterly Default Rate Comparison Appendix B: Defaulted Corporate Straight Debt Issues Appendix C: Distressed Exchanges Appendix D: Leveraged Loan Defaults Appendix E: Chapter 11 Filings by Liability Size Appendix F: Defaults by Industry Appendix G: 2009 Emergences from Default Acknowledgments Dr. Altman is the Max L. Heine Professor of Finance and Director of the Credit and Debt Markets Research Program at the NYU Salomon Center, Leonard N. Stern School of Business and a consultant to Paulson & Co. Brenda Karlin is a Research Associate at the NYU Salomon Center. We appreciate the assistance of Vallabh Muralikrishnan and Hemant Sharma of the NYU Salomon Center and the several market makers who provided us with price quotations. We offer a special thanks to the various rating agencies, Daniel Sweeney and Johnathan Blau of Credit Suisse, Steven Miller of S&P LCD, Kerry Mastroianni of New Generation Research and Daniel Kamensky of Paulson & Co.. 2

3 From a default and performance perspective, the year 2009 proved to be a year of incredible contrasts for investors in high yield bonds, with a record amount of defaults ($123.8 billion) occurring, surpassing the previous record in 2002 ($96.8 billion). However, absolute returns and returns versus 10-yr Treasuries were at their highest historical levels, new issuance increased more than threefold in a one-year period, and only 15% of high-yield bonds outstanding were classified as distressed by year-end, compared to 82% one year earlier. In several ways, 2009 was reminiscent of 1991 when the default rate also topped 10 percent, yet absolute and relative returns (43.23% and 26.05%) registered record high levels (to that point). In both years, investors had expected much worse conditions in the subsequent year, and required yield spreads at the start of each year were at record-high levels. The default rate rose to 10.74%, the highest annual default rate since 2002, and the second highest default rate in our entire time series. The fourth-quarter 2009 default rate was 2.59%, increasing from the third-quarter 2009, but at a lower level than one year earlier (2.90%). Default losses on high-yield bonds came in at 7.30%, based on a weighted average recovery rate of 36.1% just after default, slightly below the historical average. The weighted average recovery on bankruptcy and payment defaults was somewhat lower at 34.6%, compared to 42.7% for distressed exchange default recoveries. Returns on high-yield bonds reached historically high levels, ending the year at 55.19% (Citi Index). The excess return versus 10-yr US Treasuries was 65.11%, more than double the previous record high of 29.37% in Yield-tomaturity spreads versus 10-yr US Treasuries decreased to 5.13% by year-end 2009, 1,218bp lower than year-end 2008, but in-line with the historical average of 5.23%. Defaulted bonds and bank loans also did extremely well, with a combined return of 56.0%. The distressed ratio of bonds yielding more than 1,000bp above the risk-free rate decreased dramatically to 15.3% as of the end of 2009, from 26.8% three months earlier and an astonishing 82.0% at year-end This metric has decreased steadily over the ensuing thirteen months. Estimates of the face value size of the distressed and defaulted debt markets decreased significantly to $1.61 trillion, as of December 31, 2009, down more than 50% from $3.59 trillion one year earlier. This decrease is attributable to the dramatic drop in the distressed ratio. The market value estimate also decreased to approximately $1.01 trillion. Based on our mortality rate methodology and new issuance in the last ten years, stratified by original bond rating, the Altman forecast for the high-yield bond market s default rate in 2009 was 7.98%, and based on several different models was 13.6%, compared to an actual default rate of 10.74%. This year, based on four different methodologies, the 2010 forecasts range from 3.86% (distressed ratio method) to 14.00% (recession scenarios method), with the consensus average rate of 6.70%, if the economy double-dips into a recession or never emerges from the current downturn, and 4.27% if it does not. 3

4 Defaults, Default Rates, and Recoveries The high-yield bond default rate in 2009 soared to levels unprecedented over the past seven years witnessed the second highest dollar denominated default rate in our time series (from 1971), lower only than the rate realized in The rate increased from 4.65% at year-end 2008 to 10.74% for all of Defaults include straight corporate bonds whose firms went bankrupt, missed an interest payment and did not cure it within the grace or forbearance period, or completed a distressed exchange. The 2009 rate is based on a mid-year market size of $1.153 trillion, up by $62 billion from a year earlier. In all, $123.8 billion of defaults, the largest dollar amount ever, was recorded in 2009 (Figure 1), surpassing 2002 by $27 billion. Note in Figure 1 that the historical weighted-average annual default rate is 4.55% over the 39 year period ( ). This weighted-average rate is up considerably compared to 3.94% at the end of Our weights are based on the par value of high-yield bonds outstanding in each year. The arithmetic annual average default rate climbed to 3.33% from 3.14% one year earlier. In the fourth quarter of 2009, the default rate was 2.59%, larger than one quarter earlier (0.83%), but lower than both the first two quarters of 2009 as well as the fourth quarter of 2008 (Figure 2 and Appendix A). Two-thirds of the dollar amount of defaults in the fourth quarter was related to the bankruptcy filing by CIT Group. Indeed, had this default not occurred, the quarterly default rate would have been a mere 0.74%, the lowest since the third-quarter 2008, indicating a slow-down in the rapid pace of defaults which has plagued the market in the past year. Eighteen issuers defaulted in the fourth quarter on 76 issues. The most sizeable defaults during the year were CIT, defaulting on over $22 billion of outstanding bonds, Charter Communications, defaulting on almost $13 billion, and General Motors, which defaulted on over $10 billion. Abitibi Bowater, Ford Motor, Harrah s, Nortel, and R.H. Donnelley each defaulted on outstanding bonds of more than $3 billion. In all, 119 issuers constituting 405 issues defaulted in 2009 (Appendix B), considerably greater than the 63 issuers and 154 issues that defaulted in The average dollar amount of defaulting bonds per defaulting issuer in 2009 was $1.04 billion, compared to $796 million in 2008, and $288 million in Lehman Brothers is not included in the 2008 statistics since its bonds were not rated noninvestment grade before defaulting. In our default statistics, we include those bonds from distressed exchanges actually tendered. For example, in the Ford Motor Co. exchange, $3.35 billion of bonds were exchanged of the $8.2 billion outstanding and subject to the exchange offer. In 2009, there were a record 53 distressed exchanges, involving 45 companies, comprising $22.9 billion of defaults (18.5% of the total). See Appendix C for the list of 2009 distressed exchanges and later our discussion of these restructurings. In 2009, S&P and Moody s issuer-denominated default rates were 10.93% and 13.22%, respectively. Moody s 16.50% dollar-denominated default rate was greater than its issuer-denominated rate, as is usually the case in a stressed year. Fitch s dollar-denominated default rate for 2009 was 13.70%. The issuer-based default rate for the last 12 months in the US leveraged loan market was 8.07% (Figure 3), and 9.61% based on amount of issuance, according to S&P s LCD compilations. This is in contrast to the significantly smaller rates of 4.35% and 4

5 3.75%, respectively, at the end of Sixty-four leveraged loan issuers defaulted in 2008 (Appendix D), compared to forty-one in According to our comparison between high-yield bond defaults (Appendix B) and leveraged loan defaults (Appendix D), 27 firms had both bonds and leveraged loans default in Since the U.S. economy went into a recession in December 2007, and technically was still in recession in 2009, both 2008 and 2009 are included as recession years. Whereas the default rate began increasing two years, or so, before the start of the two prior recessions, this time the increase in default rates coincided with the beginning (Figure 4). In all five prior recessions since 1972, it is clear that the default rates peaked near the end, or soon after the recession. Since 2010 s economic outlook is highly uncertain, our default rate forecast will be based on both recession and nonrecession scenarios. 5

6 Figure 1. Historical Default Rates Straight Bonds Only, Not Including Defaulted Issues From Par Value Outstanding, (Dollars in Millions) Par Value Year Outstanding a ($) Defaults ($) Default Rates (%) ,152, , ,091,000 50, ,075,400 5, ,600 7, ,073,000 36, ,100 11, ,000 38, ,000 96, ,000 63, ,200 30, ,400 23, ,500 7, ,400 4, ,000 3, ,000 4, ,000 3, ,907 2, ,000 5, ,600 18, ,000 18, ,258 8, ,187 3, ,557 7, ,243 3, , , , , , , , , , , , , , , , Standard Deviation (%) Arithmetic Average 1971 to Default Rate 1978 to to Weighted Average Default Rate b 1971 to Median Annual Default Rate 1978 to to to a As of midyear. b Weighted by par value of amount outstanding for each year. Source: NYU Salomon Center. 6

7 Figure 2. Quarterly and the Four-Quarter Moving Average Default Rate Quarterly Moving t Rate Quarterly Defaul 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% % 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 4 - Quarter Moving Av erag e Source: NYU Salomon Center. Figure 3. S&P Leveraged Loan Index 12-Month Moving Average Default Rate (Number of Issuers) 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 8 Dec-9 Source: Standard & Poor s LCD. Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Figure 4. Historical Default Rates and Recession Periods in the US High-Yield Bond Market, % 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Periods of Recession: 11/73 3/75, 1/80 7/80, 7/81 11/82, 7/90 3/91, 4/01 12/01, 12/07 12/09 (still continuing as of 12/09). Sources: Figure 1 of this report and National Bureau of Economic Research. 7

8 Bankruptcies As can be seen in Figure 5, the amount of total liabilities for Chapter 11 bankruptcies in 2009 was $604.0 billion, based on 234 filings. Where total liabilities exceeded $100 million, the total liabilities for filings in 2009 are larger than any prior year, except for last ($720.8 billion), which included the Lehman Brothers filing. General Motors Corp. was the largest bankruptcy filing in 2009, with $172.8 billion in liabilities. Without Lehman, this past year s liabilities in bankruptcy would have exceeded 2008 by almost $500 billion, and would be greater than the previous peak in 2002 by almost $250 billion. Appendix E lists this year s large Chapter 11 bankruptcies. Our bankruptcy list includes a large number of LBOs. So far this year, there were 74 bankrupt LBOs (six in which the PE firm had only a minority interest), 25 more than the 49 of such filings for all of Figure 5. Total Filings and Liabilities a for Chapter 11 Protection, of Public Companies Filing $800 $700 Pre- Petition Liabilities, in $ billions (left axis) Number of Filings (right axis) Excluding Lehman Brothers 145 filings and liabilities of $107.8 billion $ Billion $600 $500 $400 $300 $ Including Lehman Brothers 146 filings and liabilities of $720.8 billion $100 $ (Incl. LEH) 08 (Excl. LEH) filings and liabilities of $604.0 billion a Minimum $100 million in liabilities. Sources: Appendix E from the NYU Salomon Center Bankruptcy Filings Database. The number of billion-dollar bankruptcies in 2009 increased two-fold from 21, last year, to 43, higher than the 41 recorded in 2002, the prior record year. The majority of the larger bankruptcies were in the auto/motor carrier, financial services, communications, and construction/real estate sectors (Appendix D). According to New Generation Research, the number of public companies filings was 207 (Figure 6). The average of total liabilities for all 234 bankruptcy filings in 2009 was $2.6 billion, down from $4.9 billion one year earlier. The latter figure would have been just 0.7 billion without Lehman. 1 List compiled by E. Griffith, published on 8

9 Figure 6. Historical Bankruptcy Filings Total Filings b (>$100 Total Filings Total Liabilities b ($ MN) Average Liabilities b ($ MN) Year Total Filings a Million) ( $1 Billion) (>100 Million) (>100 Million) Total ,866, ,746.7 a Represents both Chapter 7 and 11 public company filings (Source: New Generation Research). b Filings of all companies, including private firms, with Total Liabilities greater than $100 million (Source: NYU Salomon Center Bankruptcy Filings Database). c Filings with Total Liabilities greater than $1 billion (Source: NYU Salomon Center Bankruptcy Filings Database). In Figure 7, we compare the date of default with the Chapter 11 filing date for firms that defaulted on bonds and also went bankrupt going back to Based on 833 observations from the NYU Salomon Center Master Default and Bankruptcy Databases, both events occurred on the same date in 408 instances (49%). In the remaining 51% of the cases, the lag between the default date and bankruptcy date varied considerably, with decreasing levels as the two dates became further separated from each other. Of course, some defaulting issuers never formally file for bankruptcy as their problems are settled out of court or the default comes as a result of a distressed exchange, and they do not file for bankruptcy in subsequent years (many do, however see our discussion at a later point). 9

10 Figure 7. Time Differential Between Default and Bankruptcy Filing a ( ) 60% (408) 50% %of the Total Observations 40% 30% 20% 10% 0% *Based on 833 observations Source: NYU Salomon Center Default and Bankruptcy Filings Databases Number of Months Lag a Based on 833 observations. Source: NYU Salomon Center Default and Bankruptcy Filings Databases. Industry Defaults Figure 8 lists the number of high-yield bond defaults by industry. Of the total 119 defaulting issuers in 2009, general manufacturers, communications and media, leisure and entertainment, and real estate/construction were industries in which a total of 78 firms defaulted. Nine issuers defaulted in the auto/motor carrier sector, eight in energy, and seven in both financial services and transportation. The remaining ten defaulting issuers were spread over various industries. Appendix E presents a more detailed breakdown of all 119 defaulting issuers. Figure 9 shows high-yield corporate bond defaults across industries per dollar amount since Communications and media lead the 2009 totals, due primarily to the Charter Communications and R.H. Donnelley defaults. As in the past, we observe that the communications and media sector far outdistanced all other sectors in the dollar amount of defaulting issues over the last 19 years, primarily the result of the telecom meltdown during , as well as 2009 s defaults due to large-scale bankruptcies. 10

11 Figure 8. Corporate Bond Defaults by Industry (Number of Companies) Industry Total Auto/Motor Carrier Conglomerates Energy Financial Services Leisure/Entertai nment General Manufacturing Health Care Miscellaneous Industries Real Estate/Construct ion REIT Retailing Comm. & Media Transportation (Non Auto) Utilities Total ,335 Source: NYU Salomon Center. Figure 9. Corporate Bond Defaults by Industry (Dollars in Millions) Industry Total Auto/Motor , ,573 2,692 1,382 16,872 30,544 Carrier Conglomerates ,065 Energy , ,200 4,085 11,857 8, ,511 1,993 37,558 Financial ,968 5,062 3,803 1, ,973 29,274 73,721 Services Leisure/ 498 1, ,100 2,891 3,437 21, ,286 6, ,022 10,395 57,541 Entertainment General 2,675 3, ,092 2,507 3,138 2,455 2, ,396 1,486 2,379 3,747 25,766 55,902 Manufacturing Health Care 18 1, ,214 1, , ,947 Miscellaneous 1,968 4,911 1,378 1, , ,290 7,615 8,352 9,715 5,594 4,494 1, ,396 1,505 1,787 56,912 Industries Real Estate/ 2, ,110 1, , ,158 4,803 15,921 Construction Retailing 4,443 2,937 1, , ,504 1,241 2,052 3,081 1,586 4, , ,412 1,015 32,623 Communications ,549 2,980 5,983 34,827 47,953 7,603 2, , ,904 30, ,461 & Media Transportation 1,028 1, , ,890 1,430 4,711 2,086 2,421 12, ,928 (Non Auto) Utilities 1, ,150 1,417 5,273 Total 14,631 18,021 4,883 1,926 3,723 4,536 3,465 4,200 6,994 23,440 29,976 68,934 96,673 36,764 11,657 35,954 7,559 5,473 50, , ,801 Source: NYU Salomon Center. Age of Defaults Figure 10 shows the age distribution of defaults in 2009 and for the period It appears normal that the number of defaults is low in the first year after issuance. What typically follows is an increase in default rates in years two through four. Indeed, 2009 essentially mirrors the cumulative default proportions over , in terms of marginally increasing default frequencies in years one through three, slightly lower rates in years four and five versus three. There was a somewhat interesting increase in six-year-old issues and a disproportionately large cohort 11

12 (15%) of bonds issued ten or more years prior to default. Many bonds that were ten years or older that defaulted in 2009 were originally investment-grade issues. Again, as in 2008, a small proportion (5%) defaulted during the first year after issuance. The historical average is 8%. Figure 10. Distribution of Years to Default From Original Issuance Date (By Year of Default), / / Years to No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of Default Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Total Years to No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of No. of % of Default Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Issues Total Total , Source: NYU Salomon Center. Fallen Angel Defaults Twenty-three issuers (19% of the total in 2009) were responsible for 129 (32% of the total) defaulting issues that were investment grade at some time prior to default. This results in a fallen-angel issuer default rate of 8.07%, considerably higher than the historical average of 3.88% (Figure 11). The fallen-angel default rate for is slightly below the historical average annual rate for original issue defaults in the high-yield bond market (4.60%). This differential (3.88% vs. 4.60%), however, is not statistically significant due to a relatively high standard deviation of around 260bp per year between the two rates. Figure 12 shows the fallen angel proportion of defaults from 1977 to the present. In 2009, 32% of defaulted issues were originally rated investment grade, somewhat above the historical average of 27%. 12

13 Figure 11. Fallen Angels Versus Original(S&P)Issue and All High Yield Default Rates a (In Percent) Fallen Angel Average 12-Mo. Default Rate Original Issue Speculative Grade Default Rates All Speculative Grade Bond Default Rates Altman Dollar Weighted Annual Default Rates Year Arithmetic Average Standard Deviation a All S&P issuer based except for Altman rates. Sources: NYU Salomon Center and S&P. 13

14 Figure 12. Fallen Angel Defaulted Issues by Original Rating, Year Total No. Defaulted Issues a Grade (%) Originally Rated Investment Total 2,704 27% a Where we could find an original rating from either S&P or Moody's. Sources: Moody's, NYU Salomon Center, and S&P. Default Losses and Recoveries The weighted-average recovery rate (based on market prices just after defaults) on high-yield bond defaults in 2009 remained below the historic average of 44.8% to end the year at 36.1%. This is lower than the recovery rate of 42.5% in 2008, and is the lowest rate since The default loss rate in 2009, without an adjustment for fallen angels and including the loss of 0.438% (43.8bp) from lost coupons, was approximately 730.0bp (Figure 13). If we remove fallen angel defaults (129 issues) the loss would have been 1,009.2bp on original issue high-yield bonds. Unlike the prior two quarters, the recovery rate on fallen angels was higher than on original non-investment grade bonds demonstrating a return to the norm. This was the result of the CIT defaults, which recovered roughly 65%, diluting the effect of the GM default earlier in the year, which had recovered only about 10%. Over the 32-year period from 1978 to 2009, the arithmetic average annual loss rate on highyield bond defaults is 2.45%, 3.09% on a weighted-average basis (Figure 14). 14

15 Figure Default Loss Rate Unadjusted for Fallen Angels (%) Only Fallen Angels (%) All Except Fallen Angels (%) Price Adjusted for Fallen Angels (%) Background Data Average Default Rate Average Price At Default a Average Price At Downgrade b Average Recovery Average Loss Of Principal Average Coupon Payment Default Loss Computation Default Rate X Loss Of Principal Default Loss of Principal Default Rate X Loss of 1/2 Coupon Default Loss of Coupon Default Loss of Principal and Coupon a If default date price is not available, end-of-month price is used. b Downgrade to noninvestment grade. Note: Average Default Rate of Only Fallen Angels is based on number of issuers. Sources: NYU Salomon Center and various dealer quotes. 15

16 Figure 14. Default Rates and Losses, a (Dollars in Millions) Par Value Outstanding a Par Value of Default ($) Default Rate (%) Weighted Price After Default ($) Weighted Default Loss Coupon (%) (%) b Year ($) ,152, , ,091,000 50, ,075,400 5, ,600 7, ,073,000 36, ,100 11, ,000 38, ,000 96, ,000 63, ,200 30, ,400 23, ,500 7, ,400 4, ,000 3, ,000 4, ,000 3, ,907 2, ,000 5, ,600 18, ,000 18, ,258 8, ,187 3, ,557 7, ,243 3, , , , , , , , , Arithmetic Average Weighted Average a Excludes defaulted issues. b Default loss rate adjusted for fallen angels is 9.3% in 2002, 1.82% in 2003, 0.59% in 2004, 1.56% in 2005, 0.039% in 2006, 0.20% in 2007, 3.42% in 2008, and 7.38% in Source: NYU Salomon Center. Figure 15 lists the average recovery rate by seniority for The recoveries on all seniorities were significantly lower than the historical norms. In 2009, 29 of the defaulting issues were senior secured, with an average recovery rate of 43.70%, compared to a historical average of 57.8% (57.4% median). This is higher than the third-quarter recovery of 38.74%, primarily due to a Nortek, Inc. senior secured default of $750 million with a recovery rate of 101%. Two hundred twenty-six of the issues were senior unsecured with an average recovery rate of 37.2%, compared to a historical average of 37.7% (45.6% median). This rate was largely affected by the low recovery rates of several large, defaulting issuers, including Abitibi Bowater, General Motors, and Charter Communications. There were 31 issues that were senior subordinated with an average recovery of 24.1%, compared to a historical average of 30.6% (32.7% median). Four were subordinated with an average recovery of 12.6%, compared to a historical average of 30.9% (29.7% median). Seven were issued as either discount or zero coupon notes with an average recovery of 16.8% compared to a historical average of 25.4% (18.2% median). One hundred eight issues could not be priced. The historic 31-year 16

17 median for all high-yield bond defaults stayed constant at 41.8%, while the arithmetic average dropped slightly to 37.6%. These latter statistics are based on a sample of over 2,500 defaults. Figure 15. Weighted Average Recovery Rates on Defaulted Debt by Seniority per $100 Face Amount, Senior Secured Senior Unsecured Senior Subordinated Subordinated Discount and Zero Coupon All Seniorities Default Year No. % $ No. % $ No. % $ No. % $ No. % $ No. $ Total/Avg , Median Standard Dev a a Standard deviations are calculated based on the yearly averages. Sources: NYU Salomon Center from various dealer quotes. Distressed Exchanges Distressed exchanges usually represent a firm s desperate attempt to avoid a formal bankruptcy filing or a payment default on outstanding debt. They were particularly popular in 2008 and 2009 as the successful outcome of Chapter 11 reorganizations became very uncertain in a difficult D.I.P. and exit financing Chapter 11 environment. It is also possible, however, that a proposed distressed exchange could represent a firm s strategy to extract concessions from creditors when the firm has little likelihood of failing, despite a stressed macroeconomic environment. Distressed exchanges take several forms including a debt for debt, cash for debt, equity for debt exchange, and various other forms that might include multiple new 17

18 securities in exchange for the more immediate problem security. Over the last two years, debt for debt exchanges were popular (61 of the 197 exchanged issues), as well as cash for debt (57) and debt + cash for debt (58). Surprisingly, only 16 involved all or partial equity exchanges, perhaps a reflection of the reluctance on the part of creditors to accept such a minority claim when the debtor is so weak. Distressed exchanges (DEs) in 2009 accounted for about 37.8% of the defaulted issuers (45 out of 119), but only 18.5% of the defaulted dollar amount. From 1984 through 2009, DEs accounted for about 10.6% of all defaulting issuers and 11.9% of all defaulted dollar amounts (Figure 16). Despite the record number of DEs in 2009, the pace at which DEs were being sought as a restructuring alternative seems to have slowed toward the end of the year, as there was no significant exchange offer yet to be completed. Figure 16 indicates the popular re-emergence of DEs over the last 24 months compared to the last 25 years. Indeed, during this period, approximately 51% (59 of 116) of all DEs took place, and there is no guarantee that a DE will, in fact, save the company from a subsequent bankruptcy. As we have compiled in a recent study, about 46% of all DEs up to 2007 resulted in a subsequent Chapter 11 or Chapter 7 bankruptcy filing and 30% of the DE firms were acquired. The data would appear to indicate a DE is oftentimes just a short-term fix (see Altman & Karlin, ). Note that we have not tracked the eventual fate of the distressed exchanges in 2008 and 2009 since those firms have not had a significant enough post-exchange period for our statistics to be relevant. 2 The Re-emergence of Distressed Exchanges in Corporate Restructurings, E. Altman and B. Karlin, NYU Salomon Center Working Paper, 2009 (see E. Altman s website) and published in The Journal of Credit Risk, Summer

19 Figure 16. High Yield Bond Distressed Exchange (D/E) Default and Recovery Statistics, D/E Defaults ($) Total Defaults ($) D/E Defaults (%) to Total $ D/E Defaults (No. of Issuers) Total Defaults (No. of Issuers) D/E Defaults (%) to Total No. of Issuers D/E Recovery Rate a All Default Recovery Rate a Difference Between D/E & All Default Recovery Rate Year , , , , , NA NA NA , NA NA NA , , , , , , , , , , (23.12) , NA NA NA , NA NA NA , NA NA NA , NA NA NA , NA NA NA , NA NA NA , (9.37) , , , , (15.05) , (25.93) , (6.50) Totals/Averages $69, $580, % % b b 9.82 a Weighted-average recovery rates for each year. b Arithmetic average of the weighted-average annual recovery rates; only those years with DEs counted. The arithmetic average of each individual DE (116) for the entire sample period was 48.24% and the average for the non-de defaults (983 observations) was 36.72%. Source: NYU Salomon Center. Recovery Rates on Distressed Exchanges Because DEs are not as dramatic a reflection of a firm s distressed status as a bankruptcy or nonpayment of cash interest on debt, one might expect the recovery rate on DE defaults to be higher than other, more serious distressed situations. Of course, one reason for the larger recoveries in DEs is lenders need to be offered a premium in order to be persuaded to participate in the exchange. Figure 16 shows the arithmetic average recovery rate on all DE defaults was 51.8% for , compared to 42.0% for all defaults, and 36.7% for all non-de defaults. In 2008, DEs recovered 52.2%, while non-de defaults recovered only 27.1%. As the 2009 recovery rate on DEs equaled 42.7% versus 36.1% on all defaults, the spread has widened significantly since earlier this year, particularly the first quarter, when the recovery on all defaults was higher than on DEs. In Figure 17, we calculate a difference in means test between the arithmetic average recovery rate (48.2%) on the 116 DE issuers (269 issues) during and the average recovery rate on all non-de defaults (36.7%) of the same period. We found that given the above, the DE recovery rate is significantly higher (t = 7.49) at the 1% confidence level. It is not surprising that bondholders will choose, in many instances, to accept a recovery with certainty from a DE, rather than take the chance of holding 19

20 out for an uncertain and likely lower recovery in bankruptcy (see below). Our results do not include data for situations where a DE offer is rejected. Figure 17. Difference in Means Test Between Recovery Rates: All Nondistressed Exchange Defaults Versus Distressed Exchanges (D/E), All Defaults Excluding D/E (Issues) Distressed Exchange (Issues) Sample Size Mean Recovery Rate Standard Deviation Variance t-test a a Sources: NYU Salomon Center, and authors compilation. In Figure 18, we calculate a difference in means test between the weighted average recovery rate on the announcement date of a DE versus the completion date for both 2008 and Of the 42 defaulted issues in 2008 due to a DE, in which prices were available for both the announcement and completion dates, the weighted average recovery was approximately 13 percentage points higher on the completion date. Though completion date recoveries also proved to be higher in 2009, they were much less so, with only a 4.9% difference in pricing between the two dates. So, the prices of the distressed exchange bonds were significantly higher at the completion of the exchange than when it was first announced based on the 2008 sample, but the difference was much less significant in the 2009 cohort. Overall, the completion date price was higher than the announcement date in 79 of the 148 issues, just over 50% (53.4%) of the cases. Figure 18. Distressed Exchange Weighted Average Recovery Rates: Announcement Date versus Completion Date, # of Completion Year Observations Announcement Date Date Difference t-test (12.97) a (4.91) b a Significant at the.01 level. b Significant at the.10 level. Source: NYU Salomon Center. 20

21 Liquidation Recoveries As we, (Altman & Karlin (2009) 3 ), and others have discussed, the recent credit crisis has heightened the risk that a Chapter 11 filing could result in a failed reorganization, ultimately culminating in a liquidation of assets and subsequent payment of proceeds to creditors. As noted earlier, the reduced availability of either debtor-in-possession (D.I.P.) or exit financing makes a successful reorganization less likely. Even under more normal conditions, firms may have little or no prospect of generating sufficient cash flows to cover even a reduced debt burden and, in essence, the liquidation value of the enterprise is deemed greater than the going-concern value. Given these prospects, a key question for major stakeholders, particularly creditors, is the likely recovery given liquidation, and how that value compares with the debt price just after the filing of the initial Chapter 11. These are the questions we will now examine. Liquidating Chapter 7 s versus Chapter 11 s 4 Liquidations after an initial Chapter 11 filing can take two main forms either a conversion to Chapter 7 or a liquidating Chapter 11. The primary differences between these two forms may affect the expected recovery for creditors from the estate based on the revenues, timing, costs, and the administration of the liquidation process. The liquidating Chapter 11 is more popular with some debtors because the business continues with the incumbent board and management remaining as the debtor-in-possession to manage the liquidation, as opposed to the court appointed Trustee in a Chapter 7. The latter has the task of liquidating the estate as expeditiously as possible, with limited powers to operate the business. To illustrate some differences, in a Chapter 11 case, commercial real property leases may be assumed or rejected up to 210 days (120 days with a possible 90 day extension) after the initial filing, while in a Chapter 7 they must be assumed or rejected within 60 days. Thus, a Chapter 7 Trustee is more likely to expedite a sale process and not explore alternative options to maximize value. The Trustee is usually paid a percentage (not to exceed 3%) of the total amount dispersed. As such, creditor distributions will be reduced by the fee, although the proceeds are likely to come earlier than in a liquidating Chapter 11. On the other hand, since a committee of unsecured creditors is usually not appointed in a Chapter 7, this process is not burdened by the delay of having all decisions reviewed by the committee as well as the need to negotiate with the unsecured creditors to garner their votes for liquidation without the threat of objections and lawsuits not to mention the likely cost of these objections and delays usually borne by the estate. Another potentially significant cost of the Chapter 11 process is the professional fees incurred by all constituencies in drafting and reviewing the plan and disclosure statement, as well as for hearings and objections. A further expense of the Chapter 11 process is the payment in full, in cash, of any administrative and priority claims before any funds are distributed to creditors. 3 E. Altman and B. Karlin (2009), Defaults and Returns in the High Yield Bond Market: The Year 2008 in Review and Outlook, NYU Salomon Center Special Report, February. 4 Thanks to Daniel Kamensky of Paulson & Co. for his helpful comments on the differences between these two processes. 21

22 In essence, the creditors need to weigh the benefits of greater control of the process under the Chapter 11 liquidation versus the additional time and expenses. Many creditors, however, are not experienced enough to do this tradeoff analysis. While a proceeding under Chapter 11 may involve more costs and delays, limited power to consider alternatives in a Chapter 7 will oftentimes swing the decision in favor of the Chapter 11 liquidation, thereby making it more popular, especially when creditors are more sophisticated and more is at stake. Indeed, our research shows that over the 20-year period , 92 relatively large companies with publicly held bonds outstanding liquidated under Chapter 11, while just 28 companies converted first to a Chapter 7 and then liquidated (about a 3.3:1 ratio). If we expand our sample to include all Chapter 11 filings, regardless if publicly held bonds were outstanding, the number of Chapter 11 liquidations increases to 351 vs. 298 Chapter 7 conversions (a 1.2:1 ratio) over the same 20-year period. 5 So, it appears that larger firms with more complex capital structures prefer the Liquidating Chapter 11 alternative more frequently than do all debtors in bankruptcy. Figure 19 shows the frequency of Chapter 11 liquidations and Chapter 7 conversions, by year, over the period , with a further distinction being whether or not the firms had publicly traded bonds outstanding. Figure 19. Chapter 11 Liquidations versus Chapter 7 Conversions, By Year and Whether Publicly Owned Bonds Were Outstanding (Number of Firms), Chapter 11 Chapter 7 All Chapter 11 All Chapter 7 Liquidations Conversions w/bonds Year Liquidations Conversions w/bonds Outstanding Outstanding Total Sources: New Generation Research (Boston) and NYU Salomon Center Default Database. Recoveries Several key questions are critical for existing creditors and potential distressed debt investors when a company defaults and files for the right to reorganize under Chapter 5 Thanks to New Generation Research, Boston, MA, for the relevant data accumulations. Data in the first ten years in our time series ( ) are less certain, especially the Chapter 7 conversions. 22

23 11. First, and foremost, is whether or not the price of debt securities will increase during and after the reorganization. Key to that conclusion is the likelihood that the firm will emerge from bankruptcy as a going concern, and whether the old debt securities will be exchanged for valuable new debt, equity claims, cash, or a combination of the aforementioned. Most studies, including Altman and Eberhart (1994) 6 and Keisman (2004) 7, have shown that the average rate of return between the initial default and the subsequent price at the time of emergence from the reorganization results in an annualized return between low single digits and 20%- 30%, depending upon the seniority and the sample period. Generally, senior debt securities do best with significant positive annual returns of 20-30%. If the company is not able to successfully reorganize, positive returns in the postbankruptcy period are less likely since values will no longer be based on a goingconcern concept. Regardless of the outcome, distressed investors usually assume a floor value given a downside scenario, and, certainly, liquidation qualifies as an extremely negative scenario. Also worth noting is the opportunity cost of lost potential returns given the sale of the securities at default and investment of the proceeds in alternative securities instead of holding onto the debt. For example, Altman and Eberhart assumed that the appropriate opportunity cost was the return on an investment in a portfolio of high-yield, junk-bond securities. We have analyzed a sample of bonds from companies that filed for reorganization under Chapter 11 and eventually liquidated under a Chapter 7 conversion or a liquidating Chapter 11. The number of Chapter 7 conversions or Chapter 11 liquidations over the 20-year period for firms with publicly held bonds outstanding, for which we had prices at the time of filing, is 87, with 141 individual issues. Of these, we were able to trace the price of the bonds just prior to liquidation on 72 of these issues (42 firms, see Figure 20). The average price of the 72 issues at the time of the initial filing was $20.18 of par value, compared to an average price of just $13.22 upon liquidation. The difference of just less than seven percentage points is extremely significant (t-test = 7.1). The average price of the 141 issues upon filing is essentially the same ($20.65) as the smaller sample of 72 ($20.18) that we were able to find prices for both at the time of filing and at liquidation. Of the 72 securities, all but 12 (six firms) had a lower price at liquidation than at the time of the initial filing. The negative performance of liquidating companies is far more clear for those firms that converted to a Chapter 7 than those liquidating under a Chapter 11, and the security prices of the Chapter 7 firms were also considerably lower at the time of the initial filing. This implies that those firms that eventually liquidate under a Chapter 7 conversion are in far worse shape with fewer reorganization prospects than those who eventually do liquidate, but under a Chapter 11 process. For example, the average price of the 15 bonds of Chapter 7 companies at the time of filing is $8.19 compared to just $1.91 upon conversion to Chapter 7 (t = 2.94). The comparable statistics for the 57 Chapter 11 liquidations were $23.93 and $16.76, respectively. 6 E. Altman and A. Eberhart (1994), Do Seniority Provisions Protect Bondholders Investments?, Journal of Portfolio Management, Summer. 7 D. Keisman (2004), Ultimate Recovery Rates on Bank Loan and Bond Defaults, Loss Stats, S&P (NY). 23