It's not just bond investors that will suffer from low recoveries. Amid the pandemic downturn, loan investors could find themselves losing 40 to 45 cents on the dollar, compared with historical averages of 30 to 35 cents, according to Barclays.
One factor that is hurting money managers is the erosion of investor protections known as covenants, as more and more high yield and leveraged loan deals are covenant-lite, meaning they feature minimal such safeguards. When corporations had more restrictive covenants, borrowers had less room to fix their debt outside of court, sending them into bankruptcy closer to the first sign of trouble.
Now companies have more leeway to seek extra financing when they're in trouble, and to give lenders providing additional funds the right to jump to the front of the line if the company does go bankrupt.
"Covenant-lite paper usually means by the time you get back to the table with the borrower, the house is on fire," said Sanjeev Khemlani, a senior managing director at FTI Consulting. "All of that extra time you had before, that's just gone away."
Investors that bought a J. Crew Group term loan at par back in 2014 may have thought they were making a relatively safe bet, since it was secured debt. When the company started struggling a few years later, it moved intellectual property including its brand name into a new entity, a move enabled by relatively loose covenants.
The company then exchanged some of its existing bonds for new notes secured by the intellectual property as well as preferred stock and equity in its parent company, as part of a broad restructuring. Loan investors ended up suffering: after the company filed for bankruptcy in May, the 2014 obligation was worth less than 50 cents on the dollar, according to Bloomberg loan valuation estimates. J. Crew exited bankruptcy in September.
FTI's Mr. Khemlani, who advises lenders with senior claims on borrowers' assets, said investors should make an effort to "put some teeth" into their agreements with borrowers now as they fall into distress, regaining some lost protection.
In addition to shifting assets, companies have also been doing more distressed exchanges in recent years, where troubled corporations offer creditors new, debt that often ranks higher in the repayment pecking order in exchange for relief like lower principal or later maturities or both. Creditors that participate can stem their losses in the event of a bankruptcy, but investors that sit the deal out can end up worse off.
The popularity of distressed exchanges has also contributed to a general rise in secured debt in companies' capital structures. That means that more investors — holders of loans and secured bonds — are fighting for the same scraps when a company files for bankruptcy. Almost 20% of the debt in the U.S. high-yield bond market is now in some way secured, according to Barclays, vs. just 6% in 2000. The number of businesses that had taken out just loans and no other form of debt almost doubled between 2013 and 2017, according to J.P. Morgan Chase data.